II. Shared Asset Methodology

Proposed Accounting Method

In addition to requesting approval of the leasing and licensing agreements, Verizon in this application makes a novel proposal for tracking the use of Verizon office space and office equipment by three affiliates that provide administrative services for Verizon and other Verizon Communications businesses. Verizon asks the Commission to approve a shared asset methodology for computing payment to Verizon for such uses of its space and office equipment, and that this methodology take the place of Section 851 filings for the routine use of space and office equipment by the three affiliate service organizations.

Verizon states that, as part of its restructuring, many functions have been consolidated, and corresponding employees have been transferred. Two Verizon corporate entities, Service Corp and Consolidated Services Incorporated (CSI), provide administrative functions to all Verizon business units. These functions include product marketing, finance, data processing, human resources, legal services, regulatory and legislative affairs, billing and network integration services.

As part of these services, Service Corp and CSI employees are located in Verizon facilities and use office equipment owned by Verizon. Based on the shared asset arrangement, a fully allocated cost of the shared uses is compared to a market price, and the higher amount is used to allocate expenses to Service Corp and CSI. This arrangement, according to Verizon, allows Verizon to recover operating expenses and earn a return on investment for assets being used by Service Corp and CSI.

Under the methodology, the total Verizon investment in a facility is multiplied by the ratio of Service Corp/CSI employees to total employees at the location. The result is the amount of gross investment allocated to Service Corp/CSI. The gross investment is reduced by accumulated depreciation and deferred taxes to compute the net investment. A return on investment (ROI) is computed based on net investment multiplied by the allowable rate of return for the facility. The ROI is booked as revenue to Verizon's Account 5240, and ultimately results in a reduction to expense on Verizon's books. A similar calculation divides the facility's maintenance expenses, depreciation and property taxes. The final result is compared to market rates so that the amount charged to Service Corp/CSI is at the higher of cost or market, in compliance with the Commission's affiliate transaction rules.

In its amendment to the application on October 15, 2002, Verizon adopted ORA's recommendation to add VDSI as a third subsidiary for which approval of the shared asset methodology is sought. As noted earlier, VDSI provides data processing services to Verizon Communications entities, including Verizon California, and the employees of the affiliate locate on-site at a client company for varying periods of time.

Remaining Issues

In a Prehearing Conference last year, the parties agreed that an evidentiary hearing on remaining issues in this proceeding was unnecessary. Instead, they agreed to submit written position statements by June 14, 2003, addressing two questions:

1. Should the Commission approve the applicant's proposed shared asset methodology in place of Section 851 applications for dealing with the use of space and office equipment by service affiliates of Verizon?

2. Is further investigation warranted as to applicant's transfer of certain business units without prior approval under Pub. Util. Code § 851?

ORA Recommendations on Shared Asset Methodology

In its comments, ORA recommends that the Commission disapprove use of the shared asset methodology as a substitute for 851 filings or, alternatively, require substantial changes in the methodology process. ORA argues that, otherwise, Verizon will not be getting advance approval of these affiliates' use of Verizon space and equipment when required by Pub. Util. Code § 851.

On the other hand, ORA states that it is sympathetic to Verizon's concern that unless a shared asset methodology is used, Verizon will be compelled to enter into leases and licenses with the three service entities and then make numerous Section 851 applications for approval of the transactions. (At the time the application was filed, Verizon had more than 30 such shared-use arrangements, most of which were likely to be amended from time to time as service personnel moved from place to place.) ORA states that, like Verizon, Commission resources are limited, and the Commission may not be able to review frequent 851 filings thoroughly. With that in mind, ORA states that if the Commission approves the shared asset methodology as a substitute for 851 applications, it should make the following modifications to Verizon's practices:

· Verizon should be required to file an 851 application every three years (or file the information as part of the triennial NRF review) to estimate upcoming use of space and property by affiliates.

· Verizon should be required to file an advice letter annually to update use of shared assets. If actual usage exceeds the estimates in the earlier 851 filing, there should be a true-up of the cost allocation plus a late charge payment of 18% so that the regulated utility is not disadvantaged by allowing affiliates to share its resources.

· The shared assets should be reviewed as part of regular audits of Verizon.

· To ensure that ratepayers benefit from the sharing arrangement, there should be a direct flow-through surcredit based on 10% of fully allocated cost if cost is higher than market value, or the difference between the market and cost if market cost is higher.

· All gain on sale from shared assets, if any of them are sold, should be a direct flow-through to ratepayers because ratepayers have borne the risk of these assets.

· While affiliate services should continue to follow affiliate transfer pricing rules, services provided by affiliates to the regulated utility should be based on the lower of cost or market in order to mimic an arm's-length transaction.

ORA also recommends that the Commission reject the use of headcount as an allocator in the shared asset methodology, substituting a formula developed by ORA that adopts the square footage used by affiliates as the allocator. Verizon would be required to update square footage usage in each of its three-year 851 filings.

Verizon's Response to ORA Recommendations

Verizon argues that its shared asset methodology streamlines Section 851 compliance through a self-executing mechanism that appropriately charges the service affiliates for their shared asset usage while avoiding the need for formal leases and redundant 851 applications. It denies ORA's assessment of "risk" to ratepayers from affiliates' use of excess office space and office equipment. Consolidation of administrative-support functions benefits ratepayers, according to Verizon, because otherwise Verizon would have to bear these costs alone.

Verizon states that its use of headcount as an allocator produces a more accurate estimate of costs than ORA's square footage formula. For example, it states, one building (115 E. Lime Ave.) has 90,200 square feet and a total employee headcount of 18, which under ORA's formula would mean assigning 5,011 square feet of that building to each employee, an overstatement of use that skews ORA results. Verizon states that its average of 368 square feet of space per affiliate employee under the shared asset methodology more closely resembles a typical office with standard cubicles and is more reasonable than the weighted average under the ORA approach of 719 square feet, an amount that exceeds the square footage of many one-bedroom apartments.

Verizon argues that its shared asset methodology was developed as a practical accounting approach in the area of administrative consolidation, which has become a fact of life in the telecommunications industry. It states that ORA's proposal to require speculative triennial 851 applications and annual advice letters would defeat this purpose and would be more cumbersome than separate 851 lease applications.

Verizon claims that ORA's proposal to change affiliate pricing rules to reflect a 10% markup on costs charged to the affiliates repeats a proposal that was rejected in the decision leading to this docket. (See D.99-06-092, at 9.) Verizon's existing affiliate pricing rules are set forth in Verizon's Cost Allocation Manual, which the Commission approved in Resolution T-15950 (December 9, 1996).