November
26, 2008
Mr. H.
Christopher Owings
Assistant
Director
United
States Securities and Exchange Commission
100 F
Street, NE
Mail Stop
3561
Washington,
D.C. 20549-3561
RE: Calpine
Corporation
Form 10-K for Fiscal Year Ended
December 31, 2007
Filed February 29,
2008
Form 10-Q for the Quarterly Period
Ended September 30, 2008
Filed November 7,
2008
File No. 1-12079
Dear Mr.
Owings:
This
letter is being furnished on behalf of Calpine Corporation (“Calpine”) in
response to the comments of the Staff of the Securities and Exchange Commission
(the “Commission” or the “Staff”) contained in a letter to Jack A. Fusco,
Chief Executive Officer of Calpine Corporation, dated November 13, 2008,
with respect to the above referenced filings. As used in this letter, “we,”
“us,” “our,” the “Company” and “Calpine” refer to Calpine Corporation and its
subsidiaries unless the context requires otherwise.
For your
convenience, we have set forth the Staff’s comments in full followed by our
responses.
Form 10-K for Fiscal Year
Ended December 31, 2007
|
|
1.
|
We
note your response to our comment two of our letter dated
September 25, 2008 requesting information regarding your properties
and your proposed response to provide additional information in your
future filings. We do not object to your proposed disclosure, however
please note regulation S-X § 210.410 defines oil and gas producing
activities as excluding the production of geothermal steam, ..., or
associated geothermal resources as defined by the Geothermal Steam Act of
1970, thus we believe your analogy to, and the use of Industry Guide 2
(Oil & Gas) in reference to reserves and/or your accounting policy is
not appropriate. Please refer to Industry Guide 7 for your reserve and
accounting guidance in future
filings.
|
Response:
We
will comply with the Staff’s request and refer to Industry Guide 7 for our
reserve and accounting guidance in our future filings with the
SEC.
Page
2
November
26, 2008
|
|
2.
|
We
note your response to comment six of our letter dated September 25,
2008 that you have not yet determined the total cost of the Russell City
project and that, in any event, you do not expect the costs to be material
to the company. Please revise your response to state
this.
|
Response:
We
agree, and state here and in response to comment 6 of the Staff’s letter
dated September 25, 2008, that we have not yet determined the total cost of
the Russell City project, and that, in any event, we do not expect the costs to
be material to Calpine on a consolidated basis.
|
|
3.
|
We
note your response to our comment 17 of our letter dated
September 25, 2008 concerning your accounting policy disclosure for
geothermal projects. Please include your amortization schedule policy
disclosure in your future filings.
|
Response:
We
will comply with the Staff’s request in our future filings with the
SEC.
Form 10-Q for the Quarterly
Period Ended September 30, 2008
Financial Statements and
Notes
Note 1. Basis of
Presentation and Summary of Significant Accounting Policies,
page 6
Deconsolidation,
page 7
|
|
4.
|
We
note your response to comment 14 of our letter dated September 25,
2008 and your disclosure indicating that you have deconsolidated
Auburndale in light of Pomifer’s election to exercise its cash purchase
options. The options entitle Pomifer to an additional 20% of Auburndale’s
cash distributions, 90% in total. In this regard, please provide us your
complete FIN 46(R) analysis behind your conclusion given the
reconsideration event with respect to Pomifer’s exercise of the purchase
option. In particular, clarify and explain if you are the party who will
absorb the majority of the entity’s expected losses as well as receiving a
majority of the entity’s expected residual returns before the
reconsideration event. If so, explain to us in more detail how that
conclusion has changed since the reconsideration event. Specifically
address in your response why you are no longer the party who will absorb
the majority of the entity’s expected losses. Your response should explain
your appropriateness to deconsolidate Auburndale when Pomifer was entitled
to 90% of the cash distributions but not when it was at
70%.
|
Response:
The
initial determination that we should consolidate Auburndale was made in
September 2003. Our analysis at that time was based on the
following:
|
|
·
|
Qualitatively, the structure
of the preferred interest was designed to provide Pomifer with a senior
position in the net cash flows of the project and a guaranteed rate of
return through the
maturity
|
Page
3
November
26, 2008
of
the preferential period in 2013. The project was anticipated to generate
positive cash flows over its life sufficient to repay Pomifer, so if at any
point in time a negative event occurred, Calpine’s equity position
(approximately $28 million) would absorb the first dollar risk of loss which was
not expected to exceed the fair value of Calpine’s equity at risk.
|
|
·
|
A quantitative analysis was
performed to substantiate our qualitative assessment. Our analysis
considered various potential scenarios on a probability weighted basis.
Our calculation determined that Calpine would absorb greater than 50% of
the expected losses. The primary source of the expected losses was related
to the operation of the plant subsequent to the preferential period
(2013), which at the time forecasted that the preferred interest would be
repaid upon maturity, cash distributions would then be allocated 60% to
Calpine, and that the plant would operate as a merchant
facility.
|
FIN
46, paragraph 14 stated in relevant part:
“An
enterprise shall consolidate a variable interest entity if that enterprise has a
variable interest (or combination of variable interest) that will absorb a
majority of the entity’s expected losses, receive a majority of the entity’s
expected residual returns, or both. If one enterprise will absorb a majority of
a variable interest entity’s expected losses and another enterprise will receive
a majority of that entity’s expected residual returns, the enterprise absorbing
a majority of the losses shall consolidate the variable interest
entity.”
Based
upon the above, it was determined that we should consolidate Auburndale at
September 2003.
On
August 21, 2008, Pomifer exercised the purchase option and purchased the
right to an additional 20% of the future cash flows from Auburndale. This
triggered a reconsideration event under FIN 46(R), paragraph 15, which
states in relevant part:
“The
primary beneficiary also shall reconsider its initial decision to consolidate a
variable interest entity if the primary beneficiary sells or otherwise disposes
of all or part of its variable interests to unrelated parties or if the variable
interest entity issues new variable interests to parties other than the primary
beneficiary or the primary beneficiary’s related parties.”
As
a result of the reconsideration event, we performed a new analysis in August
2008 based on updated estimates, projections and key assumptions, several of
which changed negatively from the initial evaluation performed in
2003.
|
|
·
|
Qualitatively, the project has
not performed since 2003 as originally anticipated. In fact, only
approximately $14 million of the original $88 million preferred interest
had been repaid through July 2008. Given the changes in expected
performance of the project, we concluded that it was probable that the
preferred interests would not be repaid prior to the scheduled maturity in
2013 and that there is an increase in the amount of expected losses that
might be realized compared to our original analysis in 2003. As a result,
Pomifer would be subject to the variability of cash flows during the
period the project operates as a merchant facility, and therefore has
greater exposure to expected losses in excess of expected losses for
Calpine which has less capital at risk.
In
|
Page
4
November
26, 2008
summary,
compared to our 2003 analysis, the changes in expected economic performance of
the project has changed the allocation of expected losses such that Pomifer is
expected to absorb greater than 50% of the losses.
|
|
·
|
An updated quantitative FIN
46(R) analysis was performed as of the date of exercise of the purchase
option. The updated analysis also supported that Pomifer would absorb
greater than 50% of
the losses.
|
Based
on the above analysis, Pomifer was determined to be the primary beneficiary and
Calpine was required to deconsolidate Auburndale.
Commodity Derivative
Adjustments, page 8
|
|
5.
|
We
note your disclosure on page 8 that you discovered non-cash,
mark-to-market errors of $30 million related to certain commodity
derivatives that had not been properly recorded in prior periods. You
elected to record an out of period adjustment in the three months ended
September 30, 2008, citing the errors were immaterial to the prior
periods. In this regard, we are unclear why they are considered immaterial
to investors for the prior and current quarterly periods given the
apparent material amounts disclosed. Please provide us with a complete SAB
99 analysis supporting your conclusion that the errors were not material
to any reporting period. Your analysis should include “As reported” and
“As should have been adjusted” amounts or similar captions for the
different financial statement line items and the earning per-share amounts
affected by the correction of the errors for all reporting
periods.
|
Response:
We
have attached our internal SAB 99 memo (Exhibit 1) in response to your
question.
|
|
6.
|
In
addition, tell us if you plan to correct the accounting errors in the
quarterly financial information section within the 2008 Form
10-K.
|
Response:
We
do not plan to correct or restate for the accounting errors in the quarterly
financial information section within our future 2008 Form 10-K or in our future
Form 10-Q filings with the SEC in 2009. We believe the errors are immaterial and
therefore do not require restatement based on our analysis discussed in our
response to Comment 5. Our disclosure of the errors found and corrected in the
third quarter of 2008 was made in our September 30, 2008 Form 10-Q for the
purpose of transparency.
Page
5
November
26, 2008
*****
As
requested in the comment letter, we hereby acknowledge that:
|
|
·
|
The
Company is responsible for the adequacy and accuracy of the disclosure in
this filing;
|
|
|
·
|
Staff
comments or changes to disclosure in response to Staff comments do not
foreclose the Commission from taking any action with respect to the
filing; and
|
|
|
·
|
The
Company may not assert Staff comments as a defense in any proceeding
initiated by the Commission or any under person under the federal
securities laws of the United
States.
|
We
appreciate the assistance the Staff has provided with its comments on the above
referenced documents as originally filed, and we will be pleased to respond
promptly to any requests for additional information. My phone number is (713)
570-4654 and my fax number is (713) 353-9167.
|
Sincerely,
|
||
|
/s/
Kenneth Graves
|
||
|
Kenneth
A. Graves
|
||
|
Interim
Corporate Controller and Principal
|
||
|
Accounting
Officer
|
||
|
cc:
|
Mr.
Andrew Mew
|
|
|
Mr.
Scott Stringer
|
||
|
Mr.
Ramin Olson
|
||
|
(Securities
and Exchange Commission)
|
Attachments:
Exhibit 1
EXHIBIT
1
M E M O R A N D U
M
Date: November
6, 2008
To: Audit
Committee, Jack Fusco, Zamir Rauf, Thad Miller
From: Ken
Graves
Re: Evaluation
of Derivative Errors Found Subsequent to the Filing of the 2008 Q2 and Action
Plan
During
the third quarter of 2008, Calpine Corporation (Calpine or the Company)
determined that certain derivative contracts were not properly recorded as of
and for the periods ended December 31, 2007, March 31, 2008 and
June 30, 2008. As further discussed below, the Company and the audit
committee have assessed the impact of the errors on the financial statements and
have concluded that no restatement of previously presented financial information
is required. The following memorandum summarizes the issues noted and the
quantitative and qualitative analysis performed.
Issues:
Multiple
adjustments were recorded during the third quarter ended September 30, 2008
that pertain to the prior year and the first and second quarters of 2008. The
adjustments relate to various errors in recording the fair value of derivative
commodity instruments due to the following:
Omitted
transactions
On
August 20, 2008 and subsequent to filing the 2008 2nd quarter
10Q, management determined that the second quarter results improperly excluded
$65 million in losses on two power swap deals related to the Deer Park project.
These deals were excluded from the unrealized mark-to-market activity recorded
in operating revenue and disclosed in the financial statements due to an
inadvertent manual error when transitioning from a semi-automated accounting
process (Microsoft Access) to a manual spreadsheet (Excel).
As a
result of this error, management determined that further analysis of the
derivatives portfolio was required. As a result of this additional review,
management identified additional errors associated with the Company’s recording
of commodity contracts as follows:
Valuation
issues
Management
determined that there were 9 and 10 swing swap deals related to the Deer Park
project valued incorrectly at the end of the 1st and
2nd
quarters of 2008, respectively. Thus, Q1 and Q2 financials reflected excess fuel
expense of $7 million and $10 million, respectively, for a year-to-date total of
$17 million. The deals were valued and recorded incorrectly due to an
inadvertent manual error in assigning the correct price to the deals, following
the switch to Excel as described above.
Other
derivative contracts
As a
result of its review process, management also identified other derivative
contracts that were not properly recorded at fair value. The errors included
certain contracts that were omitted from the fair value calculation due to
improper classification in the system. In addition, there were certain contracts
designated as normal purchases and normal sales under FAS 133; however, the
contracts did not meet the documentation requirements to support the exemption.
The majority of these contracts originated in 2008 with an immaterial amount
originating in 2007. As a result of these errors, operating revenues were
(overstated) understated by $(54) million and $65 million for the three months
ended March 31, 2008 and June 30, 2008, respectively.
Other
considerations
During
the adoption of SFAS 157 in the first quarter of 2008, Calpine incorporated use
of bid-ask pricing in valuing certain of its commodity derivative instruments,
resulting in $21 million of additional expense (comprised of an $18 million
reduction of operating revenue and a $3 million increase in fuel expense).
During the preparation of the second quarter financial statements, the Company
reassessed its pricing convention and determined that it was appropriate to
consistently apply the use of mid-
SAB
99 Analysis
point
pricing as permitted under FAS 157. As a result, the Company reversed the
previously recorded adjustment. Management has determined that there were
certain errors in the original bid-ask adjustment recorded in the first quarter.
As such, management would reverse the bid-ask adjustment and use mid-point
pricing if it were to restate the first quarter results. Therefore, the original
adjustment in Q1 and subsequent reversal in Q2 are included in this analysis as
errors.
In Q3
2008, management determined that a gas purchase contract accounted for as a cash
flow hedge did not qualify for hedge accounting due to the resale of a portion
of the purchased gas. The gas contract was entered into by Whitby, an equity
method investment, which was part of the Canadian reconsolidation in Q1 2008. As
a result of this error, other operating revenues were overstated by $7 million
the three and six month periods ended June 30, 2008.
Hedge
Contract
A
contract designated as a hedge included two components (power and capacity) that
were entered into the system separately. However, the system only valued the
power sale component and not the capacity payment component. As a result,
accumulated other comprehensive loss was overstated by $95 million and $86
million at December 31, 2007 and June 30, 2008, respectively. The
misstatement does not affect the income statement or statement of cash
flows.
A summary
of the impact of these errors as well as previously identified and known
unadjusted misstatements (SUD items) on Q1 and Q2 operating results is as
follows (in millions):
|
Three
Months Ended
|
YTD
|
|||||||||||
|
3/31/08
|
6/30/08
|
6/30/08
|
||||||||||
|
Power
swaps
|
$ | — | $ | (65 | ) | $ | (65 | ) | ||||
|
Swing
swaps
|
7 | 10 | 17 | |||||||||
|
Other
derivative contracts
|
(54 | ) | 65 | 11 | ||||||||
|
Total
unrealized mark-to-market adjustments
|
(47 | ) | 10 | (37 | ) | |||||||
|
Liquidity
reserves
|
21 | (21 | ) | — | ||||||||
|
Whitby
adjustment
|
— | 7 | 7 | |||||||||
|
Total
derivative adjustments
|
(26 | ) | (4 | ) | (30 | ) | ||||||
|
Other
2008 SUD items
|
(3 | )(1) | (6 | ) | (9 | ) | ||||||
|
Total
impact to net income (loss)
|
$ | (29 | ) | $ | (10 | ) | $ | (39 | ) | |||
__________
(1) The
Q1 SUD items were recorded in Q2.
Accounting
Literature:
There is
no bright line test for determining materiality, and the SEC rules do not
expressly set forth the criteria required to be considered in determining
materiality. SEC staff guidelines address the factors to be considered and
certain accounting practices have developed in determining
materiality.
SAB
99
SEC Staff Accounting Bulletin (SAB) No.
99, Materiality, provides guidance on the criteria to be
considered in determining whether a misstatement is
material:
The
omission or misstatement of an item in a financial report is material if, in the
light of the surrounding circumstances, the magnitude of the item is such that
it is probable that the judgment of a reasonable person relying on the report
would have been changed or influenced by the inclusion of the correction or
item.1
1 FASB,
Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of
Accounting Information (“Concepts Statement No. 2”), 132 (1980). See also
Concepts Statement No. 2, Glossary of Terms – Materiality. This formulation in
the accounting literature is in substance identical to the formulation used by
the courts in interpreting the federal securities laws. The Supreme Court has
held that a fact is material if there is a substantial likelihood that the …
fact would have been viewed by the reasonable investor as having significantly
altered the “total mix” of information made available.
SAB
99 Analysis
SAB 99
provides further guidance around how to assess whether a misstatement is
material by referencing both quantitative and qualitative factors. Consistent
with this guidance, a combined quantitative and qualitative analysis must be
used to reach an objective conclusion. The staff also noted:
…the
use of a percentage as a numerical threshold, such as 5%, may provide the basis
for a preliminary assumption that – without considering all relevant
circumstances – a deviation of less than the specified percentage with respect
to a particular item on the registrant’s financial statements is unlikely to be
material. The staff has no objection to such a ‘rule of thumb’ as an initial
step in assessing materiality. But quantifying, in percentage terms, the
magnitude of a misstatement is only the beginning of an analysis of materiality;
it cannot appropriately be used as a substitute for a full analysis of all
relevant considerations. Materiality concerns the significance of an item to the
financial statement users. A matter is ‘material’ if there is a substantial
likelihood that a reasonable person would consider it important.
Consistent with this guidance, we will
evaluate the significance of the adjustments based on both quantitative and
qualitative considerations.
Discussion:
Overall
Considerations
The
unrealized mark-to-market adjustments fluctuate significantly from period to
period due to the volatility associated with gas and power prices. Due to the
nature of the company’s business, Calpine generally holds its derivative
contracts until maturity / physical settlement and does not capture the
unrealized value. Due to the volatility and nature of the fair value
adjustments, management excludes these amounts from measurement of the Company’s
overall and segment performance. The Company focuses on adjusted EBITDA, which
excludes unrealized mark-to-market adjustments, as its primary non-GAAP
financial measure in financial filings, press releases, debt covenant
calculations and other public information.
Management
believes investors and analysts also evaluate Calpine’s business primarily by
focusing on adjusted EBITDA (which excludes unrealized mark to market gains and
losses) and commodity margin. Additionally, management believes peer companies are evaluated
primarily based on adjusted EBITDA and spark
spread (equivalent to the measure Calpine refers to as commodity margin) rather
than net income. The
analysis in Appendix B
demonstrates that analysts and peer companies in Calpine’s sector focus on adjusted EBITDA for current and
projected performance rather than net income.
Calpine’s debt holders are focused on
cash flow and Calpine’s ongoing compliance with key financial covenants.
Adjusted EBITDA is a major component of Calpine’s material covenants under its
Exit Credit Facility, the Company’s primary current source of financing and as
such is an important metric to the Company and investors. Adjusted EBITDA and
cash flow were not impacted by these errors.
Net
Income Considerations
At least since 2005, Calpine’s net
income has not been a reliable key performance indicator due to variability
caused by various factors including Chapter 11 bankruptcy, the impact of
deferred tax valuation allowances, unrealized mark to market activities, etc.
The extreme variability in net income is evidenced in the table as follows (in
millions):
|
Net
Income by Quarter
|
||||||||||||||||
|
Year
|
Q1
|
Q2
|
Q3
|
Q4
|
YTD
|
|||||||||||
|
2008
|
$
|
(243
|
)
|
$
|
187
|
$
|
||||||||||
|
2007
|
$
|
(459
|
)
|
$
|
(500
|
)
|
$
|
3,794
|
$
|
(142
|
)
|
$
|
2,693
|
|||
|
2006
|
$
|
(589
|
)
|
$
|
(818
|
)
|
$
|
2
|
$
|
(360
|
)
|
$
|
(1,765
|
)
|
||
|
2005
|
$
|
(169
|
)
|
$
|
(298
|
)
|
$
|
(217
|
)
|
$
|
(9,255
|
)
|
$
|
(9,939
|
)
|
|
SAB
99 Analysis
This variability has been caused
by:
|
·
|
Reorganization items and the
impact of reorganization on
operations.
|
|
·
|
Income tax benefits have not been
recorded through net income due to valuation allowances on Calpine’s
significant deferred tax
assets.
|
|
·
|
Net income also includes
unrealized mark to market activities, which management believes investors
adjust for due to its nature and variability from period to
period.
|
Based on this extreme volatility in net
income and operating near break even in 2008, management has emphasized adjusted
EBITDA to measure materiality to the income statement rather than net income
(see further discussion below).
Materiality
During
the current year, Calpine is expected to be near breakeven from a net income
perspective. As a result and based on the factors as outlined above, management
has used 2.5% of adjusted EBITDA as an appropriate “rule of thumb” measure of
materiality. Management believes that this is at the lower end of an acceptable
range and that it is likely that the judgment of a reasonable investor relying
on our financial statements would not be changed or influenced by changes below
this threshold. As of September 22, 2008, forecasted adjusted EBITDA for
2008 is $1,687 million. Therefore, management calculated income statement
materiality based on 2.5% of forecasted 2008 adjusted EBITDA is approximately
$42 million.
Management
did not separately consider balance sheet materiality in developing its
EBITDA-based materiality measure applied to the income statement. However, the
misstatements identified also impacted the balance sheet. At June 30, 2008,
Calpine had total assets of almost $23 billion. Therefore, applying the income
statement materiality measure in evaluating the balance sheet is not meaningful.
Management determined using a balance sheet materiality measurement based on
0.5% of total assets, or approximately $113 million, for consideration in
measuring the significance of the errors to the balance sheet was appropriate.
As total assets did not change significantly between December 31, 2007 and
June 30, 2008, use of the same measure for both periods is considered
reasonable.
A. Quantitative
Assessment
Management
considered the quantitative significance of the errors to the income statement,
statement of comprehensive income and balance sheet as further described below.
The aggregate impact on the amounts previously reported, assuming that the
adjustments were recorded in the appropriate periods, is summarized as follows
(amounts in millions):
|
Three Months
|
Three Months
|
Six Months
|
Three Months
|
|||||||||||||||||
|
2007
|
3/31/2008
|
6/30/2008
|
6/30/2008
|
9/30/2008
|
||||||||||||||||
|
As
reported:
|
||||||||||||||||||||
|
Operating
income
|
$ | 705 | $ | (82 | ) | $ | 433 | $ | 351 | $ | 272 | |||||||||
|
Income
(loss) before income taxes
|
2,147 | (219 | ) | 222 | 3 | 56 | ||||||||||||||
|
Adjusted
EBITDA
|
1,412 | 294 | 474 | 768 | 593 | |||||||||||||||
|
Total
comprehensive income (loss)
|
2,508 | (614 | ) | 37 | (577 | ) | 900 | |||||||||||||
|
As
adjusted:
|
||||||||||||||||||||
|
Operating
income
|
$ | 704 | $ | (108 | ) | $ | 417 | $ | 309 | $ | 314 | |||||||||
|
Income
(loss) before income taxes
|
2,146 | (248 | ) | 212 | (36 | ) | 95 | |||||||||||||
|
Adjusted
EBITDA
|
1,412 | 294 | 473 | 767 | 594 | |||||||||||||||
|
Total
comprehensive income (loss)
|
2,603 | (576 | ) | (16 | ) | (592 | ) | 820 | ||||||||||||
|
Percentage
impact:
|
(0.1 | )% | 31.7 | % | (3.7 | )% | (12.0 | )% | 15.4 | % | ||||||||||
|
Operating
income
|
(0.0 | )% | 13.2 | % | (4.5 | )% | (1300.0 | )% | 69.6 | % | ||||||||||
|
Income
(loss) before income taxes
|
0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | ||||||||||
|
Adjusted
EBITDA
|
3.7 | % | 6.2 | % | 143.2 | % | (2.6 | )% | (8.9 | )% | ||||||||||
|
Total
comprehensive income (loss)
|
||||||||||||||||||||
SAB
99 Analysis
In
addition, the impact of the adjustments was less than 5% on all significant
balance sheet captions, except for accumulated other comprehensive income (see
discussion below). See balance sheet detail as follows (amounts in
millions):
|
12/31/2007
|
3/31/2008
|
6/30/2008
|
||||||||||
|
As
reported:
|
||||||||||||
|
Total
assets
|
$ | 18,482 | $ | 18,991 | $ | 22,621 | ||||||
|
Total
liabilities (not subject to compromise)
|
(14,343 | ) | (15,367 | ) | (18,947 | ) | ||||||
|
Accumulated
other comprehensive loss
|
231 | 631 | 791 | |||||||||
|
Total
stockholders’ (equity) deficit
|
(4,652 | ) | (3,621 | ) | 3,671 | |||||||
|
As
adjusted:
|
||||||||||||
|
Total
assets
|
$ | 18,604 | $ | 19,198 | $ | 22,790 | ||||||
|
Total
liabilities (not subject to compromise)
|
(14,371 | ) | (15,470 | ) | (19,076 | ) | ||||||
|
Accumulated
other comprehensive income
|
136 | 498 | 711 | |||||||||
|
Total
stockholders’ (equity) deficit
|
(4,558 | ) | (3,725 | ) | (3,711 | ) | ||||||
|
Percentage
impact:
|
||||||||||||
|
Total
assets
|
0.7 | % | 1.1 | % | 0.7 | % | ||||||
|
Total
liabilities (not subject to compromise)
|
0.2 | % | 0.7 | % | 0.7 | % | ||||||
|
Accumulated
other comprehensive income
|
(41.1 | )% | (21.1 | )% | (10.1 | )% | ||||||
|
Total
stockholders’ (equity) deficit
|
(2.0 | )% | 2.9 | % | 1.1 | % | ||||||
There is
no impact on total cash from operating, investing or financing activities. See
also more detailed analysis of the impact of the adjustments on the full balance
sheet and income statement included in Appendix A.
Income
Statement Impact
As noted
in the table above, the derivative errors resulted in minimal (approximately $1
million) impact to operating income for the year ended December 31, 2007, a
$26 million understatement of the operating loss in the first quarter and a $16
million overstatement of the operating income in the second quarter. If the
errors are not corrected, the impact on the third quarter operating income will
total approximately $42 million (including the impact of one item from our SUD)
which is approximately equal to annual materiality. However, substantially all
of the income statement-related errors occurred during 2008. Therefore, although
there is a misstatement of information among quarters, the errors will not
impact the annual results of operations.
In
addition, the errors all relate to the fair value estimates recorded for
Calpine’s derivative portfolio. Due to the nature of its business, Calpine has a
significant portfolio of derivative commodity instruments which is primarily
comprised of physical and financial gas purchases, physical power purchases and
sales, gas and power options. The accounting for these instruments is complex
and inherently involves significant judgment. As of June 30, 2008, the
total reported amounts of commodity derivative assets and liabilities were as
follows:
Total
derivative assets - $5.747 billion
Total
derivative liabilities - $6.515 billion
Total
commodity mark to market activity - $131 million (six months ended June 30,
2008)
Derivative
fair value measurements are inherently estimates. Due to the volatility of gas
and power prices, the valuation of these instruments varies significantly from
quarter to quarter. The Company should have recognized additional losses of $37
million through June 30, 2008. However, the valuation of these positions
changes daily and the losses have reversed during the third quarter due to
underlying market changes. Therefore, the adjustments, if recorded, would result
in additional losses in prior periods (Q1 and Q2) and larger gains in the
current period with minimal net change in value of these positions (based on
market movements through the end of September).
Furthermore,
consistent with industry patterns, the Company has historically had its lowest
income in the first quarter, when the largest error occurred. As a result,
although the absolute value of the error amount is below our annual materiality
threshold, the percentage impact of the error is quantitatively significant. As
a result, we have focused on the impact of these
SAB
99 Analysis
errors on
the overall trend of earnings. The Company’s income from continuing operations
fluctuated significantly between the first, second and third quarters and these
adjustments would not have impacted that overall trend. See further trend
discussion below.
Impact on Trend of
Earnings
As
discussed above, Calpine just emerged from bankruptcy in January 31, 2008.
As such, the prior three year periods were significantly impacted by
reorganization and other unusual charges and there is no clear trend of
earnings. These adjustments will not impact the overall quarterly trend in 2008.
Typical for this business, earnings are low in first quarter, improving in the
second quarter, peaking in the third quarter and declining again during the
fourth quarter.
The
following charts depict the trends associated with some of the major financial
statement measures (note - third quarter 2008 amounts are
projected):
The table
above illustrates that the earning trends do not change as a result of the
misstatements (note that the 2008 Q3 forecasted results for both restatement and
no restatement are less than prior years due to a $179 million impairment on our
Auburndale assets).
Balance
Sheet Impact
As noted
in the table above, the impact of the adjustments is less than 5% of all
significant balance sheet amounts except for accumulated other comprehensive
income (see separate discussion of accumulated other comprehensive income and
comprehensive income below). Furthermore, the adjustments are less than the
established balance sheet measure of materiality of $113 million, except with
respect to total assets and total liabilities and stockholders equity. However,
because the percentage impact on these captions is so small (less than 1% of the
total) at both December 31, 2007 and June 30, 2008, management
believes that a reasonable investor would not be impacted by these adjustments.
No further analysis of the balance sheet impact considered
necessary.
Other
Comprehensive Income / Accumulated Other Comprehensive Income
As noted
in the tables above, the impact on other comprehensive income was less than 5%
for the periods ended December 31, 2007 and March 31, 2008. The errors
had a larger percentage impact for the three-month and six-month periods ended
June 30, 2008, primarily because the company was close to breakeven for
those periods. The total amount of the adjustments was not
SAB
99 Analysis
above the
materiality thresholds. Furthermore, consistent with the discussion above,
because the company was close to breakeven during these periods, we focused on
the trend of earnings. The adjustments did not have an impact on the overall
trend of earnings for any of the periods.
We also
considered the impact of the adjustments on Accumulated other comprehensive
income. As noted in the balance sheet summary above, the errors had a
quantitatively significant impact on accumulated other comprehensive income,
especially with respect to prior year end (approximately 41%). However,
management believes that its investors consider the nature of the items included
in AOCI (unrealized change in fair value on derivatives designated as hedges)
and understand that this amount is subject to significant fluctuation and may
not be realized. Furthermore, AOCI is typically viewed in the context of overall
equity. In this case, the aggregate impact of all adjustments was not
quantitatively significant to overall equity (less than 5% in each period).
Therefore, due to this combination of factors, management does not believe that
its investors and other users of the financial statements would be impacted by
the errors in prior periods.
Other
Considerations
The
misstatements do not impact total cash flows from operating, investing or
financing activities, other financial statement disclosures (presented in
Appendix D) or the calculation of our value at risk and other portfolio risk
metrics. There is no impact to adjusted EBITDA or commodity margin, the primary
measures that investors consider in assessing our financial condition.
Furthermore, the errors relate to a volatile component of the income statement
(unrealized gains / losses on commodity derivative instruments) and the net
losses that would have been recorded through June 30, 2008 have already
reversed due to market changes during the third quarter. Therefore, the effect
of making these adjustments would only increase the volatility of our earnings
among quarters with no impact on the year to date earnings reported through the
end of the third quarter and no impact on our performance metrics.
Appendix
C illustrates the impact of correcting the misstatements in the third quarter.
As noted, the misstatements exceed the materiality threshold on certain
financial statement line items; however, the table above illustrates that
correcting the misstatement in the third quarter does not change the overall
earnings trend.
Accordingly,
management concludes that the qualitative aspects should be considered along
with the quantitative aspects in determining whether a reasonable investor would
be influenced by the misstatements.
B.
Qualitative Analysis
In
assessing the overall impact on the financial statements, management also
considered various qualitative factors as required by SAB 99. As a result of
that assessment, we noted no factors which would suggest that it was likely that
a reasonable investor would have been impacted by these errors. Each of those
factors outlined in SAB 99 was considered as follows:
|
1.
|
Whether
the misstatement arises from an item capable of precise measurement or
whether it arises from an estimate and, if so, the degree of imprecision
inherent in the estimate
|
The
errors all relate to the fair value estimates recorded for Calpine’s derivative
portfolio. Due to the nature of its business, Calpine has a significant
portfolio of derivative commodity instruments which is primarily comprised of
physical and financial gas purchases, physical power purchases and sales, gas
and power options. The accounting for these instruments is complex and
inherently involves significant judgment. As of June 30, 2008, the total
reported amounts of commodity derivative assets and liabilities were as
follows:
Total
derivative assets - $5.747 billion
Total
derivative liabilities - $6.515 billion
Total
commodity mark to market activity - $131 million (six months ended June 30,
2008)
Derivative
fair value measurements are inherently estimates. Due to the volatility of gas
and power prices, the valuation of these instruments varies significantly from
quarter to quarter. The Company should have recognized additional losses of $37
million through June 30, 2008. However, the valuation of these positions
changes daily and the losses have reversed during the third quarter due to
underlying market changes. Therefore, the adjustments, if recorded, would result
in
SAB
99 Analysis
additional
losses in prior periods and larger gains in the current period with minimal net
change in value of these positions (based on market movements through early
September). To further support
this analysis, Appendix E illustrates the historical quarterly volatility in
mark-to-market movements from 2006 to date.
|
2.
|
Whether the misstatement masks a
change in earnings or other
trends
|
The misstatements do not mask a change
in earnings or other trends including changing a net loss to income or vice
versa. See further discussion of the trend of earnings in the quantitative
analysis above.
|
3.
|
Whether
the misstatement hides a failure to meet analysts’ consensus expectations
for the enterprise
|
Calpine had not previously published earnings guidance and analysts
following Calpine’s stock primarily focus on adjusted EBITDA and other measures that exclude
the impact of the derivative mark to market amounts. Analyst’s EPS mean estimates for Q1 and Q2 2008
were $0.01 and $0.10, respectively, versus actual EPS amounts for Q1 and Q2 2008 of $(0.44) and $0.41, respectively. The adjustments would not change the
direction of EPS against analysts’ estimates. As a result, management does not believe
that the errors hide a
failure to meet analysts’ consensus expectations for the company.
|
4.
|
Whether the misstatement changes a
loss into income or vice
versa
|
As noted
under the discussion of trend of earnings above, the aggregate adjustments did
not change a loss into income or vice versa in any of the impacted
periods.
|
5.
|
Whether the
misstatement concerns a segment or other portion of the
registrant’s business
that has been identified as playing a significant role in the
registrant’s operations
or profitability
|
The misstatements relate to unrealized
mark-to-market misstatements that do not impact our key performance indicators
of adjusted EBITDA or commodity margin. Accordingly, our key performance
measures by segment are not impacted by the misstatements.
|
6.
|
Whether the misstatement affects
the registrant’s compliance with regulatory
requirements
|
Not applicable. Calpine is not subject
to any regulatory requirements impacted by earnings.
|
7.
|
Whether the misstatement affects
the registrant’s compliance with loan covenants
or other contractual
requirements
|
The affect of the derivative-related
misstatements did not impact Calpine’s compliance with loan covenants or other
contractual requirements. Note that a key issue in this industry is
that fair value amounts typically drive margin posting, collateral and other
requirements. However, in this case, there was no impact on margin or collateral
requirements, as the fair values were properly recorded in the underlying
trading system, used for determination of these amounts.
|
8.
|
Whether the misstatement has the
effect of increasing management’s compensation - for example, by
satisfying requirements for the award of bonuses or other forms of
incentive compensation
|
The derivative misstatements did not and
will not impact management’s compensation as the unrealized gains and losses are
excluded from adjusted EBITDA which is used in the determination of some bonus
and other compensation amounts. The Company has no other compensation programs
tied to financial performance.
SAB
99 Analysis
|
9.
|
Whether the misstatement involves
concealment of an unlawful
transaction
|
Not
applicable. The misstatements relate to a combination of errors in the
derivative accounting area. There is no suggestion of any illegal acts
associated with these adjustments; the misstatements were inadvertent and
unintentional.
SAB 99
also includes other factors for consideration as follows:
|
o
|
Whether a known
misstatement may result in a significant positive or negative market
reaction
|
As noted
above, management does not believe that the aggregate impact of the adjustments
has had or will have any impact on the market’s reaction to Calpine. As
discussed, in this sector, unrealized mark-to-market gains and losses are
generally excluded by analysts, investors and others in considering Calpine’s
performance - the key performance measure is EBITDA which does not include this
amount.
Management
performed an analysis of the Company’s stock price and did not note any
significant positive or negative reaction to the earnings release in August. In
general, management believes that the stock price is influenced more by the
strategic direction of the Company, overall market trends, and overall stock
price movement in Calpine’s sector. In this context, the errors would not be
expected to influence market reaction.
|
o
|
Whether small
intentional misstatements are pursuant to actions to “manage” earnings.
While intent alone does not render a misstatement material, it may be an
indicator that management believes the misstatement to be significant,
especially when intentionally
made
|
The
adjustments do not represent intentional misstatements intended to manage
earnings. As noted above, the mark-to-market amounts are excluded from the key
performance measures used within the company and by investors and analysts. In
addition, the nature of the adjustments does not suggest deliberate
manipulation.
Conclusion
Based on the combined
quantitative and
qualitative factors listed
below, Calpine’s management concludes that “a reasonable person’s decision relying on this information
would not have been changed or influenced by the misstatement.” Key
factors in reaching this conclusion include the following:
|
|
·
|
The initial errors and subsequent
correction have no impact on the overall trend of
earnings.
|
|
|
·
|
Management, our investors and
other stakeholders measure performance based on adjusted EBITDA or
commodity margin. Both of these measures exclude unrealized gains and
losses on commodity derivative instruments and were not impacted by the
misstatement.
|
|
|
·
|
The misstatements did not affect
compliance with loan covenants, other contractual requirements (such as
collateral posting requirements) or any regulatory
requirements.
|
|
|
·
|
The misstatements were
unintentional and did not affect management
compensation.
|
Based on the above quantitative and
qualitative factors, management concluded that the December 31, 2007
financial statements and the 2008 first and second quarter financial statements
are materially correct and that no restatement of previously issued information
is necessary.
Q3 2008
Disclosure:
Below is an example of the disclosure we
will consider adding to our Q3 2008 Form 10Q.
During the third quarter of 2008, we
discovered non-cash, unrealized mark-to-market errors of $30 million related to
certain commodity derivative instruments that had not been properly recorded in
prior periods. These errors related to manual errors, valuation and the improper
treatment of the normal purchase or normal sale exclusion. These errors have no
impact to our Consolidated Condensed Statement of Operations for the nine months
ended September 30, 2008, and had no impact on our cash
flows in any period. Additionally, these errors have no impact on any of our
loan covenants. We have evaluated the errors
SAB
99 Analysis
in accordance with the guidance provided
in SAB No. 99, “Materiality,” and we have determined the errors are
not material to any period. If the fair value of the commodity derivative
instruments had been properly recorded in prior periods, net loss would have
increased by $26 million for the three month period
ended March 31, 2008, net income would have decreased
by $4 million for the three months ended
June 30, 3008, and net loss would have
increased by $30 million for the six months ended
June 30, 2008. The correction of these errors
in the third quarter of 2008 resulted in a $30 million reduction in net income for the
three months ended September 30, 2008; however, the errors have no net
impact for the nine months ended September 30, 2008. In addition, we determined that
a portion of a cash flow hedge was not properly recorded at fair value at
December 31, 2007. This error resulted in
accumulated other comprehensive loss being overstated by $95 million and $86
million at December 31, 2007, and June 30, 2008, respectively. The error in
accumulated other income (loss) did not impact our Consolidated Condensed
Statements of Operations and Cash Flows.
Discussion with the Audit
Committee, PWC and Outside SEC Counsel:
We have discussed the above items with
Calpine’s Audit Committee, PWC, the Company’s independent auditor, and outside
SEC counsel.
|
Prepared
by:
|
| /s/ Kenneth Graves |
|
Kenneth
Graves, Interim Corporate Controller
|
|
Approved
by:
|
| /s/ Zamir Rauf |
|
Zamir
Rauf, Interim Executive Vice President
|
|
And
Interim Chief Financial
Officer
|
SAB
99 Analysis
Appendix
A – Quantitative Analysis
|
Six
Months
|
Six
Months
|
|||||||||||||||
|
Ended
6/30/08
|
Ended
6/30/08
|
|||||||||||||||
|
As
Reported
|
If
Restated
|
$
Change(1)
|
%
Change
|
|||||||||||||
|
Operating
revenues
|
$ | 4,779 | $ | 4,721 | $ | (58 | ) | (1.2 | )% | |||||||
|
Fuel and purchased energy
expense
|
(3,613 | ) | (3,596 | ) | 17 | (0.5 | )% | |||||||||
|
Total cost of
revenue
|
(4,332 | ) | (4,321 | ) | 11 | (0.3 | )% | |||||||||
|
Gross
profit
|
447 | 400 | (47 | ) | (10.5 | )% | ||||||||||
|
Income from
operations
|
351 | 309 | (42 | ) | (12.0 | )% | ||||||||||
|
Income (loss) before
reorganization items and income taxes
|
(258 | ) | (298 | ) | (40 | ) | 15.5 | % | ||||||||
|
Reorganization
Items
|
(261 | ) | (260 | ) | 1 | (0.4 | )% | |||||||||
|
Income (loss) before income
taxes
|
3 | (36 | ) | (39 | ) | # | ||||||||||
|
Net income
(loss)
|
(17 | ) | (56 | ) | (39 | ) | # | |||||||||
|
Basic and diluted
EPS
|
(0.04 | ) | (0.12 | ) | (0.08 | ) | ||||||||||
|
Three
Months
|
Three
Months
|
|||||||||||||||
|
Ended
6/30/08
|
Ended
6/30/08
|
|||||||||||||||
|
As Reported
|
If Restated
|
$ Change(1)
|
% Change
|
|||||||||||||
|
Operating
revenues
|
$ | 2,828 | $ | 2,799 | $ | (29 | ) | (1.0 | )% | |||||||
|
Fuel and purchased energy
expense
|
(2,008 | ) | (1,994 | ) | 14 | (0.7 | )% | |||||||||
|
Total cost of
revenue
|
(2,352 | ) | (2,344 | ) | 8 | (0.3 | )% | |||||||||
|
Gross
profit
|
476 | 455 | (21 | ) | (4.4 | )% | ||||||||||
|
Income from
operations
|
433 | 417 | (16 | ) | (3.7 | )% | ||||||||||
|
Income (loss) before
reorganization items and income taxes
|
240 | 228 | (12 | ) | (5.0 | )% | ||||||||||
|
Reorganization
Items
|
18 | 20 | 2 | 11.1 | % | |||||||||||
|
Income (loss) before income
taxes
|
222 | 212 | (10 | ) | (4.5 | )% | ||||||||||
|
Net income
(loss)
|
197 | 187 | (10 | ) | (5.1 | )% | ||||||||||
|
Basic and diluted
EPS
|
0.41 | 0.39 | (0.02 | ) | ||||||||||||
|
Three
Months
|
Three
Months
|
|||||||||||||||
|
Ended
3/31/08
|
Ended
3/31/08
|
|||||||||||||||
|
As Reported
|
If Restated
|
$ Change(1)
|
% Change
|
|||||||||||||
|
Operating
revenues
|
$ | 1,951 | $ | 1,922 | $ | (29 | ) | (1.5 | )% | |||||||
|
Fuel and purchased energy
expense
|
(1,605 | ) | (1,602 | ) | 3 | (0.2 | )% | |||||||||
|
Total cost of
revenue
|
(1,980 | ) | (1,977 | ) | 3 | (0.2 | )% | |||||||||
|
Gross
profit
|
(29 | ) | (55 | ) | (26 | ) | # | |||||||||
|
Income (loss) from
operations
|
(82 | ) | (108 | ) | (26 | ) | 31.7 | % | ||||||||
|
Income (loss) before
reorganization items and income taxes
|
(498 | ) | (526 | ) | (28 | ) | 5.6 | % | ||||||||
|
Reorganization
Items
|
(279 | ) | (280 | ) | (1 | ) | 0.4 | % | ||||||||
|
Income (loss) before income
taxes
|
(219 | ) | (248 | ) | (29 | ) | 13.2 | % | ||||||||
|
Net income
(loss)
|
(214 | ) | (243 | ) | (29 | ) | 13.6 | % | ||||||||
|
Basic and diluted
EPS
|
(0.44 | ) | (0.50 | ) | (0.06 | ) | ||||||||||
__________
# Change
is greater than 100%
(1)
Includes previously identified adjustments on our Q2 2008 SUD listing and
passed.
SAB
99 Analysis
|
6/30/08
|
6/30/08
|
|||||||||||||||
|
As
Reported
|
If
Restated
|
$
Change
|
%
Change
|
|||||||||||||
|
Assets:
|
||||||||||||||||
|
Accounts
receivable
|
$ | 1,443 | $ | 1,439 | $ | (4 | ) | (0.3 | )% | |||||||
|
Current derivative
assets
|
5,053 | 5,157 | 104 | 2.1 | % | |||||||||||
|
Total current
assets
|
8,325 | 8,420 | 95 | 1.1 | % | |||||||||||
|
Long-term derivative
assets
|
694 | 768 | 74 | 10.7 | % | |||||||||||
|
Total
assets
|
22,621 | 22,790 | 169 | 0.7 | % | |||||||||||
|
Liabilities and
stockholders’ equity:
|
||||||||||||||||
|
Current
derivative liabilities
|
$ | 5,486 | $ | 5,572 | $ | 86 | 1.6 | % | ||||||||
|
Total
current liabilities
|
7,452 | 7,550 | 98 | 1.3 | % | |||||||||||
|
Long-term
derivative liabilities
|
1,029 | 1,072 | 43 | 4.2 | % | |||||||||||
|
Total
liabilities not subject to compromise
|
18,947 | 19,076 | 129 | 0.7 | % | |||||||||||
|
Accumulated
deficit
|
(7,724 | ) | (7,763 | ) | (39 | ) | 0.5 | % | ||||||||
|
Accumulated
other comprehensive loss
|
(791 | ) | (712 | ) | 79 | (10.0 | )% | |||||||||
|
Total
stockholders’ equity (deficit)
|
3,671 | 3,711 | 40 | 1.1 | % | |||||||||||
|
Total
liabilities and stockholders’ equity
|
22,621 | 22,790 | 169 | 0.7 | % | |||||||||||
|
12/31/07
|
12/31/07
|
|||||||||||||||
|
As Reported
|
If Restated
|
$ Change
|
% Change
|
|||||||||||||
|
Assets:
|
||||||||||||||||
|
Accounts
receivable
|
$ | 878 | $ | 878 | $ | — | 0.0 | % | ||||||||
|
Current
derivative assets
|
231 | 269 | 38 | 16.5 | % | |||||||||||
|
Total
current assets
|
4,531 | 4,569 | 38 | 0.8 | % | |||||||||||
|
Long-term
derivative assets
|
222 | 306 | 84 | 37.8 | % | |||||||||||
|
Total
assets
|
18,482 | 18,604 | 122 | 0.7 | % | |||||||||||
|
Liabilities
and stockholders’ equity:
|
||||||||||||||||
|
Current
derivative liabilities
|
$ | 306 | $ | 323 | $ | 17 | 5.6 | % | ||||||||
|
Total
current liabilities
|
3,604 | 3,621 | 17 | 0.5 | % | |||||||||||
|
Long-term
derivative liabilities
|
510 | 521 | 11 | 2.2 | % | |||||||||||
|
Total
liabilities not subject to compromise
|
14,343 | 14,371 | 28 | 0.2 | % | |||||||||||
|
Accumulated
deficit
|
(7,685 | ) | (7,686 | ) | (1 | ) | 0.0 | % | ||||||||
|
Accumulated
other comprehensive loss
|
(231 | ) | (136 | ) | 95 | (41.1 | )% | |||||||||
|
Total
stockholders’ equity (deficit)
|
(4,652 | ) | (4,558 | ) | 94 | (2.0 | )% | |||||||||
|
Total
liabilities and stockholders’ equity
|
18,482 | 18,604 | 122 | 0.7 | % | |||||||||||
SAB
99 Analysis
Appendix B - -- Adjusted EBITDA
