6. Discussion

A. ORA & TURN's Joint Petition to Modify D.02-10-020

Decision 02-10-020 ordered ORA to conduct an audit of Verizon covering the years 1999 through 2002. We grant ORA and TURN's petition to modify D.02-10-020 to add the years 2003 and 2004 to the audit. We conclude that it is appropriate to add recent years to the audit in order to obtain additional audited data with which to make informed decisions regarding NRF and other matters.

We decline to delete older years from the audit as recommended by SBC and Verizon. ORA and TURN correctly note that the recent audits of SBC and Verizon revealed that these companies have in the past submitted monitoring reports that contained inaccurate information. The Commission needs accurate historical information for many purposes, such as identifying trends and serving as a reference point for evaluating current and future performance.

We realize there might be changes to Verizon's regulatory framework in R.05-04-005, but these regulatory changes should not affect the audit through year 2004. Any changes to Verizon's regulatory framework are likely to be applied prospectively, and not retroactively, to the period covered by the audit, but clearly they will affect the relevance of audited material to the regulatory program.

Verizon argues that the audit period should not be expanded because doing so exceeds what is required by § 314.5. SBC and Verizon also contend that expanding the audit period will impose unnecessary costs on Verizon and its ratepayers. We are not persuaded by these arguments. Although § 314.5 requires the Commission to audit Verizon "at least once every three years," there is nothing in § 314.5 that prevents the Commission from exceeding this minimum requirement. We conclude that it is appropriate to audit Verizon for the period of 1999 - 2004 for the reasons stated in D.02-10-020 and today's Decision.⁹ Verizon's out-of-pocket costs for the audit should be minimal, since D.02-10-020 authorized Verizon to seek recovery of the audit costs incurred by ORA to hire CPAs.¹⁰ To ensure that the audit costs borne by ratepayers are reasonable, we will consider in Phase 3 whether to cap the costs incurred by ORA to hire CPAs.

B. Verizon's Petition to Modify D.02-10-020

Verizon's petition asks the Commission to (1) significantly reduce the scope of the audit ordered in D.02-10-020, (2) revise the audit period to include only the most recent three years, and (3) determine the scope of the downsized audit in Phase 3. We address each of Verizon's requests below.

i. Scope of the Audit

We decline to grant Verizon's request to reduce the scope of the audit ordered by D.02-10-020 at this time. In particular, we believe that limiting the scope of the audit by Commission ruling on specific audit issues will result in an inappropriate micromanagement of ORA's investigation by the Commission and we decline to do so. We conclude that the current scope of the audit is appropriate for the reasons stated in D.02-10-020:

Audits are an essential part of NRF. They provide a means for the Commission to monitor utility financial performance, to determine if utilities are complying with Commission rules and statutory requirements, and to assess whether the Commission's goals for NRF are being met...Although NRF has been in effect for more than 12 years, there has yet to be a comprehensive audit of Verizon under NRF. Given the many problems found by ORA's [recent and] relatively narrow audit, it is clear in retrospect that comprehensive audits should have been conducted routinely. But even if no problems had been found, it is prudent for the Commission to maintain continuous, comprehensive, and vigilant oversight of large utilities like Verizon that provide essential services to millions of Californians.

For the preceding reasons, we will direct ORA to conduct a thorough audit of Verizon.... (D.02-10-020, mimeo., p. 56.)

Although we decline to reduce the scope of the audit,¹¹ we will provide guidance regarding some of our expectations for the audit so that ORA can plan and conduct the audit accordingly. First, we do not anticipate that the audit will affect rates. During the period covered by the audit, the earnings sharing mechanism was suspended and prices for Verizon's services were de-linked from costs. Consequently, there is no obvious way that any errors or irregularities discovered by ORA's audit could have affected rates. However, should ORA's audit reveal such actions are necessary, we will address those issues on the merits at the appropriate time.

Second, we do not anticipate that ORA's audit will result in fines or other sanctions. Such actions are appropriate only if ORA discovers a violation of a statute or Commission decision.

Third, consistent with D.04-09-061, any errors in Verizon's monitoring reports and accounting records discovered by ORA's audit should be corrected in a manner consistent with generally accepted accounting principles (GAAP).¹² If corrections are required by GAAP, we expect Verizon to (i) file corrected monitoring reports, and (ii) correct errors that extend beyond the audit period. In most situations, GAAP does not require a retrospective restating of financial reports and it is difficult to envision scenarios that would require such a restatement. We note that to the extent GAAP is applicable the FCC has moved there. However, we note that the FCC has not found GAAP sufficient for all regulatory accounting. In particular Part 32 and part 64 cost allocation of the FCC's Uniform System of Accounts will have an increasingly important role as we move toward naked DSL and a review of universal service. To the extent that this decision seeks to unify regulatory accounting with GAAP, it does so only consistent with the FCC's action. We do so to ensure there is a uniform regulatory accounting front at the state and federal level. To that end, it is appropriate for this Commission to modify D.87-12-063 to be consistent with the FCC's modified Uniform System of Accounts modification since the issuance of D.87-12-063.

Fourth, although audited information for every year in the audit period will be valuable, it is likely that information concerning the most recent years will be more useful for Commission decision-making purposes than information from more distant years. Therefore, we encourage ORA to plan to spend a majority of its audit resources on the most recent years of the audit period.

Finally, we are presently considering in A.05-04-020 a proposed merger of Verizon Communications Inc. (VCI) and MCI, Inc. If we approve the merger, an audit of Verizon covering a period of time before and after the merger could help identify and measure the short-term and long-term benefits of the merger, as well as other effects the merger might have on the public interest. If the Commission in A.05-04-020 orders an audit of the merger, ORA should combine the merger audit with the audit ordered by D.02-10-020, as modified by today's Decision and any subsequent decision issued by the Commission related to the merger.

ii. The Years Covered by the Audit

We decline to grant Verizon's request to modify the audit period to include only the most recent three years. Verizon's arguments for doing so mirror its reasons for opposing ORA and TURN's petition. We rejected Verizon's arguments for the reasons described previously, which we will not repeat here.

iii. Revisions to the Audit Scope in Phase 3

In today's Decision, supra, we deny Verizon's request to reduce the scope of the audit ordered by D.02-10-020 at this time. As a result, Verizon's request to establish the scope of a downsized audit in Phase 3 is moot. However, we will consider other revisions to the scope of the audit in Phase 3. First, D.02-10-020, as modified by today's Decision, limits the scope of the audit to the years 1999 through 2004. The next triennial NRF review, if one is held,¹³ will start in 2008 or 2009, assuming the instant proceeding ends in 2005 or 2006. This suggests that the audit could include 2005 through 2007 or 2008, depending on when the next triennial review begins. Therefore, we will consider in Phase 3 whether the audit period should include 2005 and later years.

Second, we may adopt substantial changes to Verizon's regulatory framework in R.05-04-005. If we decide in Phase 3 to expand the scope of the audit to include 2005 and later years, we may also consider the related issues of (1) how to tailor the audit to reflect the regulatory framework in effect during 2005 and later years, and (2) the appropriate proceeding for ORA's next audit report if NRF is replaced by another regulatory framework.

Finally, we may make other revisions to the scope of the audit as we deem appropriate in Phase 3.¹⁴ ORA may modify the scope of the audit, as appropriate, in response to developments in Phase 3.¹⁵

We note that ORA has not yet commenced the audit ordered by D.02-10-020. At this point, we believe it would be more efficient to postpone the audit until after Phase 3 or the merger proceeding, whichever is later. This will enable ORA to plan and conduct one comprehensive audit that takes into account developments in Phase 3 and the VCI-MCI merger proceeding.

⁹ See D.02-10-020, mimeo., p. 56, and today's Decision, Findings of Fact 4 through 10.

¹⁰ Verizon will undoubtedly incur some internal costs for the audit, such as responding to data requests and meeting with auditors. SBC and Verizon's argument that Verizon's internal costs will be unduly burdensome is speculative at this point and ignores the fact that regulatory compliance costs were built into Verizon's start-up revenue requirement.

¹¹ Even if we did reduce the scope of the audit ordered by D.02-10-020, ORA has independent statutory authority to use its own resources to conduct a comprehensive audit of Verizon.

¹² D.04-09-061, mimeo., p. 165 [OP 1].

¹³ There may not be another triennial review if NRF is replaced by another regulatory framework in R.05-04-005.

¹⁴ We will not relitigate the issue of whether to reduce the scope of the audit during 1999 - 2004.

¹⁵ D.02-10-020, mimeo., p. 83 [OP 8].