A Lump of Coal for Christmas You have recently been promoted to audit senior at an international accounting firm, lontana Power Company (MPC), a NYSE client. You were asked to a major portion of the work at Western Energy Co. (WEC), a wholly-owned subsidiary of MPC. Most of the audit work has already been done, but you must stu trip to the site to complete a few procedures. There are some serious audit issues to contend with this year, but as you work on a memo to the engagement partner you are distracted by thoughts of the harsh winter weather conditions you will likely encounter in the remote town of Colstrip. As its name suggests, Colstrip, Montana has been associated with the production and mining of coal throughout its history. Located near the Montana-Wyoming border, Colstrip is in the heart of the Powder River Basin, one of the largest supplies of sub-bituminous coal in the world. The town was founded in 1923 by the Northern Pacific Railroad to supply coal for steam locomotives. The mine shut down in the 1950's, and the town's population dwindled to about 100 residents, until the mine was reopened by WECo in the late 1960's. Montana's coal reserves are estimated to exceed 120 billion tons, more than one- fourth of the U.S. total, ranking it first among the 50 states. The State ranks eighth in actual coal production, however, with less than one-fifth of the output of its Wyoming neighbor. Hyperactive environmentalism, complex Federal, State, and Tribal jurisdictions, and the nation's highest severance tax have combined to limit the development of coal resources in Montana. MPC's interest in the Colstrip development piqued when the U.S. experienced it's first serious energy shortage, in the 1970's. Everyone was scurrying to build new power plants. "All of a sudden, things are urgent," says John Brower, geologist and mineral economist at Montana Tech, in Butte. "The need for more electricity is painfully clear. The fuel that can respond quickest is coal. About 56% of the electricity in the U.S. comes from coal-fired plants, compared to about 24% from nuclear plants and only 8% from hydroelectric dams. With the serious environmental obstacles to development of the latter two sources, MPC officials viewed the billions of unmined tons of Powder River coal as a tremendous opportunity. In that enthusiastic frame of mind, they launched the construction projects that would bring the company to the brink of ruin: four coal-fired generating plants known as Colstrip 1 -4. Originally estimated at $500 million, the projected cost of the four plants had nearly doubled by the time ground was broken, seven years after the first permit was requested. This was only the beginning of what became known as the 'Colstrip curse.' Cost overruns were routine, and construction was repeatedly halted by litigation from the Environmental Protection Agency, neighboring Indian Tribes, and by the Environmental Defense Fund. At the same time, the Montana Public Service Commission (PSC) began questioning MPC's relationship with WECO, which was selling coal to the parent company at a profit. Although these transactions have no effect on MPC's consolidated financial statements, the PSC's obiections make it difficult to predict what future rates will be. Colstrip 1 & 2, each with 330 megawatts of generating capacity came 'on-line' after neroy crisis had subsided. The rush to build new generating plants had led to a glut in When MPC finally went before the PSC, requesting a 55 percent rate hike to cover the costs of construction, the PSC said that construction, the PSC said that the plant was not needed, and unanimously increase. The company had asked for an increase of $95 million, but the PSC $4 million. MPC appealed the ruling, and the matter is now pending before the lontana Supreme Court. The Company's attorneys consider it probable that the decision will be overturned. Now, more than a decade after beginning the process, MPC was hemorrhaging financially. The stock price tumbled from 41 to 19 when the PSC decision was announced, and later fell to 13 when the company announced that it was eliminating its dividend to conserve cash. Work on Colstrip 3 & 4 was temporarily halted, and management announced that they were negotiating with Puget Sound Energy to purchase a share of Colstrip 2. Planned Colstrip units 3 & 4 will have generating capacities of 700 megawatts each. If they are ultimately completed, the PSC will again have to determine the extent to which MPC may recover the costs, and it is quite possible that the Commission will vote to deny many if not all of the costs. If the projects were abandoned today, none of the costs would be recoverable, and the resulting write-off would eliminate more than two-thirds of MPC's stockholder's equity, but the company would survive. MPC's management remains committed to completing the project, and is willing to bet the company's future on it. Management has obtained stockholders' authorization to issue $500 million in new bonds and additional common shares to finance completion of the two units. If MPC does incur the additional debt and then is unable to make Colstrip 3 & 4 fully operational, it will almost certainly push the company into bankruptcy. Pushing aside thoughts of ground blizzards and -50 F wind chill, you try to focus on the following issues: How should the auditors respond to the cost overruns, the escalating costs-to- complete, and the possibility that some of the costs may be unrecoverable? Should the auditors modify their report because of uncertainty over the cost recoverability? Are any other modifications appropriate? Suggested References: Impairment or Disposal of Long-Lived Assets. ASC 360-10. Statement on Auditing Standards No. 126, "The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern" AU-C8570 Modifications to the Auditor's Standard Report" AU-C8705 & 706