The selection and application of accounting policies is an important process that has developed as Duke Energy’s operations change and accounting guidance evolves. Duke Energy has identified a number of critical accounting policies that require the use of significant estimates and judgments and have a material impact on its consolidated financial position and results of operations. Management bases its estimates and judgments on historical experience and on other various assumptions that they believe are reasonable at the time of application. The estimates and judgments may change as time passes and more information about Duke Energy’s environment becomes available. If estimates and judgments are different than the actual amounts recorded, adjustments are made in subsequent periods to take into consideration the new information. Duke Energy discusses each of its critical accounting policies, in addition to certain less significant accounting policies, with senior members of management and the audit committee, as appropriate. Duke Energy’s critical accounting policies are listed below.

Risk Management Activities

Duke Energy uses two comprehensive accounting models for its risk management activities in reporting its consolidated financial position and results of operations as required by GAAP: a fair value model and an accrual model. For the three years ended December 31, 2002, the determination as to which model was appropriate was primarily based on accounting guidance issued by the Financial Accounting Standards Board (FASB) and the Emerging Issues Task Force (EITF). Effective January 1, 2003, Duke Energy adopted EITF Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and for Contracts Involved in Energy Trading and Risk Management Activities.” While the implementation of such guidance will change which accounting model is used for certain of Duke Energy’s transactions, the overall application of the model remains the same.

The fair value model incorporates the use of mark-to-market (MTM) accounting. Under this method, an asset or liability is recognized at fair value on the Consolidated Balance Sheets and the change in the fair value of that asset or liability is recognized in Trading and Marketing Net Margin in the Consolidated Statements of Income during the current period. While DENA is the primary business segment that uses this accounting model, International Energy, Field Services, Other Energy Services and Franchised Electric also have certain transactions subject to this model. Through December 31, 2002, Duke Energy applied MTM accounting to its derivatives, unless subject to hedge accounting or the normal purchase and normal sale exemption (as described below) and energy trading contracts, as defined by EITF Issue No. 98-10, “Accounting for Contracts Involved in Energy Trading and Risk Management Activities.”

MTM accounting is applied within the context of an overall valuation framework. When available, quoted market prices are used to record a contract’s fair value. However, market values for energy trading contracts may not be readily determinable because the duration of a contract exceeds the liquid activity in a particular market. If no active trading market exists for a commodity or for a contract’s duration, holders of these contracts must calculate fair value using internally developed valuation techniques or models. Key components used in these valuation techniques include price curves, volatility, correlation, interest rates and tenor. Of these components, volatility and correlation are the most subjective. Internally developed valuation techniques include the use of interpolation, extrapolation and fundamental analysis in the calculation of a contract’s fair value. All new and existing transactions are valued using approved valuation techniques and market data, and discounted using a London Interbank Offered Rate (LIBOR) based interest rate. Valuation adjustments for performance and market risk, and administration costs are used to arrive at the fair value of the contract and the gain or loss ultimately recognized in the Consolidated Statements of Income. While Duke Energy uses common industry practices to develop its valuation techniques, changes in Duke Energy’s pricing methodologies or the underlying assumptions could result in significantly different fair values and income recognition.

Validation of a contract’s calculated fair value is performed by the Risk Management Group. This group performs pricing model validation, back testing and stress testing of valuation techniques, and variables and price forecasts. Validation of a contract’s fair value may be done by comparison to actual market activity and negotiation of collateral requirements with third parties.

Often for a derivative instrument that is initially subject to MTM accounting, Duke Energy applies either hedge accounting or the normal purchase and normal sales exemption in accordance with SFAS No. 133. The use of hedge accounting and the normal purchase and normal sales exemption provide effectively for the use of the accrual model. Under this model, there is no recognition in the Consolidated Statements of Income for changes in the fair value of a contract until the service is provided or the associated delivery period occurs.

Hedge accounting treatment is used when Duke Energy contracts to buy or sell a commodity such as natural gas at a fixed price for future delivery corresponding with anticipated physical sales or purchase of natural gas (cash flow hedge). In addition, hedge accounting treatment is used when Duke Energy holds firm commitments or asset positions and enters into transactions that “hedge” the risk that the price of natural gas or electricity may change between the contract’s inception and the physical delivery date of the commodity (fair value hedge). To the extent that the fair value of the hedge instrument offsets the transaction being hedged, there is no impact to the Consolidated Statements of Income prior to settlement of the hedge. However, as not all of Duke Energy’s hedges relate to the exact location being hedged a certain degree of hedge ineffectiveness may be realized in the Consolidated Statements of Income.

The normal purchases and normal sales exemption, as provided in SFAS No. 133 and interpreted by Derivative Implementation Group (DIG) Issue C15, indicates that no recognition of the contract’s fair value in the consolidated financial statements is required until settlement of the contract (in Duke Energy’s case, the delivery of power). Duke Energy has applied this exemption for certain contracts involving the purchase and sale of power in future periods.

Regulatory Accounting

Duke Energy accounts for its regulated operations under the provisions of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation.” As a result, Duke Energy records assets and liabilities that result from the regulated ratemaking process that would not be recorded under GAAP for non-regulated entities. Regulatory assets generally represent incurred costs that have been deferred because they are probable of future recovery in customer rates. Regulatory liabilities generally represent obligations to make refunds to customers for previous collections for costs that are not likely to be incurred. Management continually assesses whether the regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes, recent rate orders to other regulated entities and the status of any pending or potential deregulation legislation. Management believes the existing regulatory assets are probable of recovery. This determination reflects the current political and regulatory climate at the state, provincial and federal levels, and is subject to change in the future. If future recovery of costs ceases to be probable, the asset write-offs would be required to be recognized in current period earnings. Total regulatory assets were $1,662 million as of December 31, 2002 and $1,368 million as of December 31, 2001. (See Note 4 to the Consolidated Financial Statements.)

Depreciation Expense and Cost Capitalization Policies

Duke Energy has a significant investment in electric generation assets, as well as electric and natural gas transmission and distribution assets, including gathering and processing facilities. Duke Energy capitalizes all construction-related direct labor and material costs, as well as indirect construction costs. Indirect costs include general engineering, taxes and the costs of certain funds used in construction. The cost of funds used in construction represents estimated debt and equity costs of capital funds necessary to finance the construction of new regulated facilities and interest on debt for new unregulated facilities. After construction is completed, Duke Energy is permitted to recover these costs for regulated facilities, plus a defined return, by including them in the rate base and in the depreciation provision.

As discussed in the Notes to the Consolidated Financial Statements, depreciation on Duke Energy’s assets is generally computed using the straight-line method over the estimated useful life of the assets. The costs of renewals and betterments that extend the useful life of property, plant and equipment are also capitalized. The cost of repairs, replacements and major maintenance projects is expensed as it is incurred.

Depreciation of regulatory assets is provided over the recovery period specified in the related legislation or regulatory agreements. Depreciation of non-regulatory assets is provided over the estimated useful life as determined by periodic studies and the technical expertise of internal consultants. The recovery period for non-regulatory assets ranges from 5 to 40 years.

The computation of depreciation expense requires judgment regarding the estimated useful lives and salvage value of assets. As circumstances warrant, depreciation estimates are reviewed to determine if any changes are needed. Such changes could involve an increase or decrease in estimated useful lives or salvage values which would impact future depreciation expense.

Impairment of Long-lived Assets

Duke Energy evaluates the carrying value of long-lived assets, excluding goodwill, when circumstances indicate the carrying value of those assets may not be recoverable under the guidance of SFAS No. 144. For long-lived assets Duke Energy determines the carrying amount is not recoverable if it exceeds the sum of estimates of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Duke Energy considers various factors when determining if impairment tests are warranted, including but not limited to:

• Significant adverse changes in legal factors or in the business climate;
• A current-period operating or cash flow loss combined with a history of operating or cash flow losses, or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset;
• An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;
• Significant adverse changes in the extent or manner in which an asset is used or in its physical condition;
• A significant change in the market value of an asset; and
• A current expectation that, more likely than not, an asset will be sold or otherwise disposed of before the end of its estimated useful life.

In 2002, the merchant energy portion of Duke Energy’s business portfolio suffered from oversupply of merchant generation, low commodity pricing and volatility, and a steep decline in trading and marketing activity. These market challenges are continuing in 2003. As a result of the 2002 market conditions, Duke Energy suspended certain projects and abandoned other projects in this sector. The culmination of these events caused Duke Energy to evaluate the carrying values of its long-lived assets at DENA and International Energy. This analysis resulted in a $31 million impairment charge at one of DENA’s merchant power facilities. Additionally, charges of approximately $242 million were also recorded in 2002 to write-off site development costs in California and Brazil and to partially write-down uninstalled turbines, as well as the termination of other turbines on order. Also in 2002, a decision was made to abandon an information technology system at DENA resulting in the write-off of approximately $24 million of previously capitalized software and related costs.

Judgment is exercised to estimate the future cash flows and the useful lives of these long-lived assets and to determine management’s intent to use the assets. The sum of undiscounted cash flows is primarily dependent on forecasted commodity prices for sales of power and costs of fuel. Duke Energy incorporates current market information as well as historical, fundamental analysis and other factors into its forecasted commodity prices. While commodity prices vary from time to time, the methodology used by Duke Energy provides the best estimate of undiscounted cash flows over the long-lived asset’s life. Revenues from merchant generation facilities are generally estimated by using probabilistic models that calculate the operating margin on the spread between the forward power prices and the marginal cost to dispatch the facility. Other operating expenses, including future escalation provisions, are factored into the calculation as well. Duke Energy used a probability-weighted approach for developing estimates of future cash flows to test the recoverability of its merchant generation long-lived assets. The probability-weighted approach, as introduced by FASB Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements” and encouraged by SFAS No. 144, considers the likelihood of possible outcomes. Under the probability-weighted approach, alternate courses of action being considered are assigned a probability assessment with the most likely scenarios weighted higher. Alternatives include potential disposal or operation for their remaining useful lives. A change in Duke Energy’s probability assessment for each scenario could have a significant impact on the estimated future cash flows. If the carrying value of the long-lived assets is not recoverable based on these estimated future cash flows, the impairment loss is measured as the excess of the asset’s carrying value over its fair value. Management assesses the fair value of the long-lived assets using commonly accepted techniques including, but not limited to, recent third party comparable sales and discounted cash flow analysis.

Additionally, Duke Energy evaluated the long-lived assets at Field Services as a result of challenging market conditions, primarily lower NGL pricing in 2002. As a result, Field Services recorded $40 million in impairment charges ($28 million at Duke Energy’s 70% share) in the fourth quarter of 2002 related to certain operating assets.

Impairment of Goodwill

Duke Energy evaluates the impairment of goodwill under SFAS No. 142. The majority of Duke Energy’s goodwill relates to the acquisition of Westcoast in March 2002 and was not impaired as of December 31, 2002. As required by SFAS No. 142, Duke Energy performs an annual goodwill impairment test and updates the test if events or circumstances occur that would more likely than not reduce the fair value of a reporting unit below its carrying amount. As described above, certain sectors of Duke Energy, primarily merchant energy and Field Services, are operating in challenging market conditions. In 2002 Duke Energy recorded a goodwill impairment loss of $194 million related to International Energy’s European trading and marketing business. Significant changes in the European market and recent operating results have adversely affected Duke Energy’s outlook for this business unit. The exit of key market participants and a tightening of credit requirements are the primary drivers of this revised outlook. To determine the amount of the impairment, management estimated the fair value of the assets and operations using the present value of expected future cash flows of the reporting unit in comparison to its carrying value. As a result, substantially all of the goodwill related to the European operations was written-off. There were no other goodwill impairments recorded in 2002. As the challenging market conditions continue into 2003, in addition to performing the annual goodwill impairment analysis required by SFAS No. 142, management will continue to remain alert for any indicators that the fair value of a reporting unit could be below book value and assess goodwill for impairment as appropriate.

As of the acquisition date, Duke Energy allocates goodwill to a reporting unit. Duke Energy defines a reporting unit as an operating segment or one level below. (See Note 3 to the Consolidated Financial Statements.)

Revenue Recognition

Unbilled and Estimated Revenues.    Revenues on sales of electricity are recognized when the service is provided. Revenues from electric service provided but not yet billed are estimated each month based on the difference between territorial load and the amount billed.

Revenues on sales of natural gas, natural gas transportation, storage and distribution as well as sales of petroleum products are recognized when the service is provided. Revenues related to these services provided but not yet billed are estimated each month. These estimates are generally based on contract data, regulatory information, preliminary measurements and allocations, estimated distribution usage based on historical data adjusted for heating degree days, commodity prices and preliminary throughput measurements. Final bills for the current month are billed and collected in the following month.

Percentage of Completion Contracts.    Long-term contracts, primarily in Other Energy Services, are accounted for using the percentage-of-completion method. Under the percentage-of-completion method, sales and gross profit are recognized as the work is performed based on the relationship between costs incurred and total estimated costs at completion. Sales and gross profit are adjusted prospectively for revisions in estimated total contract costs and contract values. When the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract is recorded in that period. The provision for the loss arises because estimated cost for the contract exceeds estimated revenue.

Trading and Marketing Revenues.    Duke Energy is exposed to market risks associated with commodity prices and it engages in certain transactions to mitigate this exposure. Transactions that are carried out in connection with trading activities are currently accounted for under the MTM accounting method as required by EITF Issue No. 98-10. Under this method, Duke Energy’s trading contracts are recorded at fair value. Prior to settlement of any energy contract held for trading purposes, a favorable or unfavorable price movement is reported as Trading and Marketing Net Margin in the Consolidated Statements of Income. An offsetting amount is recorded as Unrealized Gains or Unrealized Losses on Mark-to-Market and Hedging Transactions in the Consolidated Balance Sheets. Prices used to determine fair value reflect management’s best estimates considering various factors, including quoted market prices, when available, and modeling techniques. When a contract to sell or buy is physically settled, the fair value entries are reversed and the gross amounts invoiced to the customer or due to the counterparty are included as Trading and Marketing Net Margin in the Consolidated Statements of Income. For financial settlement, the effect on the Consolidated Statements of Income is the same as physical transactions. For all contracts, the unrealized gain or loss in the Consolidated Balance Sheets is reversed and classified as a receivable or payable account until collected.

In June 2002, the EITF reached a partial consensus on Issue No. 02-03. The EITF concluded that, effective for periods ending after July 15, 2002, mark-to-market gains and losses on energy trading contracts (including those to be physically settled) must be shown on a net basis in the Consolidated Statements of Income. Duke Energy had previously chosen to report certain of its energy trading contracts on a gross basis, as sales in operating revenues and to record the associated costs in operating expenses, in accordance with prevailing industry practice. The amounts in the Consolidated Statements of Income have been reclassified to conform to the 2002 presentation of recording all amounts on a net basis in operating revenues. In the calculation of net revenues, Duke Energy has continued to enhance its methodologies around the application of this complex accounting literature since the third quarter 2002 when these trading revenues were first reported on a net basis. (See Note 1 to the Consolidated Financial Statements for further discussion.)

In October 2002, the EITF, as part of their further deliberations on Issue No. 02-03, rescinded the consensus reached on Issue No. 98-10. As a result, all energy trading contracts that do not meet the definition of a derivative under SFAS No. 133, and trading inventories that previously had been recorded at fair values, will be recorded at their historical cost and reported on an accrual basis, resulting in the recognition of earnings or losses at the time of contract settlement or termination. New non-derivative energy trading contracts entered into after October 25, 2002 are accounted for under the accrual accounting basis. Non-derivative energy trading contracts on the Consolidated Balance Sheets as of January 1, 2003 that existed on October 25, 2002 and trading inventories that were recorded at fair values will be adjusted to historical cost via a net-of-tax and minority interest cumulative effect adjustment of $125 million to $175 million recorded as a reduction to first quarter 2003 earnings.

The EITF also reached a consensus in October 2002 on Issue No. 02-03 that, effective for periods beginning after December 15, 2002, gains and losses on all derivative instruments considered to be held for trading purposes should be shown on a net basis in the income statement. Gains and losses on non-derivative energy trading contracts should similarly be presented on a gross or net basis in connection with the guidance in Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” Upon application of this presentation, comparative financial statements for prior periods should be reclassified to conform to the consensus. Duke Energy is currently assessing the new net revenue presentation requirements, which will have no impact on operating income or net income.

Pension

Duke Energy and its subsidiaries maintain a non-contributory defined benefit retirement plan. It covers most U.S. employees using a cash balance formula. Under a cash balance formula, a plan participant accumulates a retirement benefit consisting of pay credits that are based upon a percentage (which may vary with age and years of service) of current eligible earnings and current interest credits. Duke Energy acquired Westcoast, including its retirement plans, on March 14, 2002.

Duke Energy accounts for its defined benefit pension plan using SFAS No. 87, “Employers’ Accounting for Pensions.” Under SFAS No. 87, pension income/expense is recognized on an accrual basis over employees’ approximate service periods. For Duke Energy’s defined benefit pension plans, it recognized income of $27 million in 2002, income of $9 million in 2001, and expense of $3 million in 2000. Duke Energy expects its pension expense to be approximately $2 million in 2003 primarily as a result of the increase in unrecognized net experience loss and the decrease in the expected long-term rate of return on plan assets. The Westcoast retirement plans recognized pension expense of $7 million in 2002.

The fair value of Duke Energy’s plan assets decreased to $2,120 million as of September 30, 2002 from $2,470 million as of September 30, 2001. Lower investment returns, ongoing benefit payments and declining interest rates have increased Duke Energy’s plan’s calculated under-funded status to $551 million as of December 31, 2002 from $58 million as of December 31, 2001. Funding requirements for defined benefit plans are determined by government regulations, not SFAS No. 87. No contributions to the Duke Energy plan were made in 2002, 2001 or 2000. Duke Energy does not anticipate making a contribution in 2003 for the 2002 plan year. Duke Energy anticipates that it will make a contribution to its plan in 2004 of approximately $100 million for the 2003 plan year. Duke Energy anticipates that it will make a contribution of approximately $10 million to the Westcoast pension plans in 2003 for the 2003 plan year. Contributions for the 2004 plan year and beyond may vary based on the actual return on the defined benefit pension plan’s assets, as well as other factors.

The calculation of pension expense and Duke Energy’s pension liability requires the use of assumptions. Changes in these assumptions can result in different expense and reported liability amounts, and future actual experience can differ from the assumptions. Duke Energy believes that the two most critical assumptions are the expected long-term rate of return on plan assets and the assumed discount rate.

Duke Energy assumed that its plan’s assets would generate a long-term rate of return of 9.25% as of December 31, 2002, 2001 and 2000. For 2003, this rate has been lowered to 8.5%. If Duke Energy had used a long-term rate of 8.5% in 2002, its pension income would have been lower by approximately $22 million, before income taxes. Duke Energy developed its expected long-term rate of return assumption by evaluating input from an outside actuary and pension trust consultants. Duke Energy’s expected long-term rate of return on plan assets is based on a target allocation of 65% equities and 35% fixed income securities. Duke Energy’s allocation as of December 31, 2002 approximated its targeted allocation. Duke Energy regularly reviews its actual asset allocation and periodically rebalances its investments to its targeted allocation when considered appropriate. The long-term rate of return for Westcoast is 7.75% for 2002 and 2003. This rate was established using actuarial consultants appropriate for the region and investment strategy.

Duke Energy discounted its future pension obligations using a rate of 6.75% as of September 30, 2002, compared to 7.25% as of September 30, 2001 and 7.5% as of September 30, 2000. Duke Energy determines the appropriate discount based on the current rates earned on long-term bonds that receive one of the two highest ratings given by a recognized rating agency. Lowering the discount rate by 0.25% (from 6.75% to 6.5%) would decrease Duke Energy’s estimated 2003 pension expense by approximately $4 million.

Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in Duke Energy’s pension plans will impact Duke Energy’s future pension expense and liabilities. Management cannot predict with certainty what these factors will be in the future.

Contingencies

Duke Energy follows SFAS No. 5, “Accounting for Contingencies,” to determine accounting and disclosure requirements for contingencies. Duke Energy operates in a highly regulated environment. Governmental bodies such as the FERC, the NCUC, the PSCSC, the SEC, the Internal Revenue Service, the Nuclear Regulatory Commission (NRC), the Department of Labor, the Environmental Protection Agency and others have purview over various aspects of Duke Energy’s business operations and public reporting. Reserves are established when required in management’s judgment and disclosures are made when appropriate regarding litigation, assessments, credit worthiness of customers or counterparties, and self-insurance exposures, among others. (See Note 16 to the Consolidated Financial Statements for discussion of various contingencies.) The evaluation of these contingencies is performed by various specialists inside and outside of Duke Energy. Accounting for contingencies requires significant judgment by management regarding the estimated probabilities and ranges of exposure to potential liability. Management’s assessment of Duke Energy’s exposure to contingencies could change as new developments occur or more information becomes available. The outcome of the contingencies could vary significantly and could materially impact the consolidated results of operations, cash flows and financial position of Duke Energy. Management has applied its best judgment in applying SFAS No. 5 to these matters.