NOTES TO FINANCIAL STATEMENTS (Unaudited)

(Dollars in millions except where noted)

1.  Summary of Significant Accounting Policies

General

In response to a request by President Franklin D. Roosevelt, the U.S. Congress in 1933 enacted legislation creating the Tennessee Valley Authority (“TVA”), a corporate agency and instrumentality of the United States.  TVA was initially created to, among other things, improve navigation on the Tennessee River, reduce the damage from destructive flood waters within the Tennessee River system and downstream on the lower Ohio and Mississippi Rivers, further the economic development of TVA's service area in the southeastern United States, and sell the electricity generated at the facilities TVA operates.

Today, TVA operates the nation's largest public power system and supplies power in most of Tennessee, northern Alabama, northeastern Mississippi, and southwestern Kentucky and in portions of northern Georgia, western North Carolina, and southwestern Virginia to a population of over nine million people.

TVA also manages the Tennessee River, its tributaries, and certain shorelines to provide, among other things, year-round navigation, flood damage reduction, and affordable and reliable electricity.  Consistent with these primary purposes, TVA also manages the river system to provide recreational opportunities, adequate water supply, improved water quality, natural resource protection, and economic development.

The power program has historically been separate and distinct from the stewardship programs.  It is required to be self-supporting from power revenues and proceeds from power financings, such as proceeds from the issuance of bonds, notes, and other evidences of indebtedness (“Bonds”).  Although TVA does not currently receive congressional appropriations, it is required to make annual payments to the U.S. Treasury in repayment of, and as a return on, the government's appropriation investment in TVA's power facilities (the "Power Program Appropriation Investment").  In the 1998 Energy and Water Development Appropriations Act, Congress directed TVA to fund essential stewardship activities related to its management of the Tennessee River system and nonpower or stewardship properties with power revenues in the event that there were insufficient appropriations or other available funds to pay for such activities in any fiscal year.  Congress has not provided any appropriations to TVA to fund such activities since 1999.  Consequently, during 2000, TVA began paying for essential stewardship activities primarily with power revenues, with the remainder funded with user fees and other forms of revenues derived in connection with those activities.  The activities related to stewardship properties do not meet the criteria of an operating segment under accounting principles generally accepted in the United States of America ("GAAP").  Accordingly, these assets and properties are included as part of the power program, TVA's only operating segment.

Power rates are established by the TVA Board of Directors (“TVA Board”) as authorized by the Tennessee Valley Authority Act of 1933, as amended, 16 U.S.C. §§ 831-831ee (as amended, the “TVA Act”).  The TVA Act requires TVA to charge rates for power that will produce gross revenues sufficient to provide funds for operation, maintenance, and administration of its power system; payments to states and counties in lieu of taxes ("tax equivalents”); debt service on outstanding indebtedness;

payments to the U.S. Treasury in repayment of and as a return on the Power Program Appropriation Investment; and such additional margin as the TVA Board may consider desirable for investment in power system assets, retirement of outstanding Bonds in advance of maturity, additional reduction of the Power Program Appropriation Investment, and other purposes connected with TVA's power business.  In setting TVA's rates, the TVA Board is charged by the TVA Act to have due regard for the primary objectives of the TVA Act, including the objective that power shall be sold at rates as low as are feasible.  Rates set by the TVA Board are not subject to review or approval by any state or federal regulatory body.

Fiscal Year

TVA's fiscal year ends September 30.  Years (2012, 2011, etc.) refer to TVA's fiscal years unless they are proceeded by “CY,” in which case the references are to calendar years.

Cost-Based Regulation

Since the TVA Board is authorized by the TVA Act to set rates for power sold to its customers, TVA is “self regulated.”  Additionally, TVA's regulated rates are designed to recover its costs of providing electricity.  In view of demand for electricity and the level of competition, TVA assumes that rates, set at levels that will recover TVA's costs, can be charged and collected.  As a result of these factors, TVA records certain 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 such costs 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 or deferral of gains that will be credited to customers in future periods.  TVA assesses whether the regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes, potential legislation, and changes in technology.  Based on these assessments, TVA believes the existing regulatory assets are probable of recovery.  This determination reflects the current regulatory and political environment and is subject to change in the future.  If future recovery of regulatory assets ceases to be probable, or any of the other factors described above cease to be applicable, TVA would no longer be considered to be a regulated entity and would be required to write off these costs.  Most regulatory asset write-offs would be required to be recognized in earnings in the period in which future recovery ceases to be probable.

Basis of Presentation

TVA prepares its interim financial statements in conformity with GAAP for interim financial information. Accordingly, TVA's interim financial statements do not include all of the information and notes required by GAAP for annual financial statements. As such, they should be read in conjunction with the audited financial statements for the year ended September 30, 2011 , and the notes thereto, which are contained in TVA's Annual Report on Form 10-K for the year ended September 30, 2011 (the “Annual Report”). In the opinion of management, all adjustments (consisting of items of a normal recurring nature) considered necessary for fair presentation are included.

Use of Estimates

The preparation of financial statements requires TVA to estimate the effects of various matters that are inherently uncertain as of the date of the financial statements.  Although the financial statements are prepared in conformity with GAAP, TVA is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the amounts of revenues and expenses reported during the reporting period.  Each of these estimates varies in regard to the level of judgment involved and its potential impact on TVA's financial results.  Estimates are deemed critical either when a different estimate could have reasonably been used, or where changes in the estimate are reasonably likely to occur from period to period, and such use or change would materially impact TVA's financial conditions, results of operations, or cash flows.

Reclassifications

                Certain reclassifications have been made to the 2011 financial statement to conform to the 2012 presentation.  In the Cash flows from operating activities section of the Statements of Cash Flows, $17 million previously reported as changes in Accounts payable and accrued liabilities for the three months ended December 31, 2010 , was reclassified as Fuel cost tax equivalents.

                Sales of electricity for the three months ended December 31, 2010 previously reported in the Statement of Operations as Sales of electricity to Municipalities and cooperatives of $2,386 million,  Industries directly served of $382 million, and Federal agencies and other of $32 million have been combined and reported as Sales of electricity of $2,800 million.

       

Operating expense of $1,098 million for the three months ended December 31, 2010 , previously reported as Fuel and purchased power expense on the Statement of Operations, have been reclassified as Fuel expense of $738 million and Purchased power expense of $360 million.

     

        Interest on debt and leaseback obligations and Amortization of debt discount, issue, and reacquisition costs, net have

been combined for the three months ended December 31, 2010 , and are shown as Interest expense in the Statements of Operations.  Interest expense for the three months ended December 31, 2010 , was $353 million and Amortization of debt discount, issue, and reacquisition costs, net was $5 million.

Allowance for Uncollectible Accounts

The allowance for uncollectible accounts reflects TVA's estimate of probable losses inherent in its accounts and loans receivable balances.  TVA determines the allowance based on known accounts, historical experience, and other currently available information including events such as customer bankruptcy and/or a customer failing to fulfill payment arrangements after 90 days.  It also reflects TVA's corporate credit department's assessment of the financial condition of customers and the credit quality of the receivables.

2.  Impact of New Accounting Standards and Interpretations

There were no accounting standards and interpretations that became effective for TVA during the quarter ended December 31, 2011 that, if adopted, would have materially affected  its financial condition, results of operations, or cash flows.

            The following accounting standards have been issued, but as of December 31, 2011 , were not effective and had not been adopted by TVA.

Fair Value Measurement.  In May 2011, the Financial Accounting Standards Board ("FASB") issued amendments to achieve common fair value measurement and disclosure requirements to create consistency between GAAP and International Financial Reporting Standards ("IFRS”).  TVA does not expect the adoption of this guidance will materially affect its financial condition, results of operations, or cash flows.  These changes bec a me effective for TVA on January 1, 2012.

Comprehensive Income.  In June 2011, the FASB issued guidance that will require adjustments to the presentation of TVA's financial information.  The guidance eliminates the current option to report comprehensive income and its components in the statement of changes in proprietary capital. The guidance allows for presentation of net income and other comprehensive income in one continuous statement or in two separated, but consecutive statements. These changes become effective for TVA on October 1, 2012. 

Balance Sheet . In December 2011, the FASB issued guidance that requires disclosure about balances presented on a net basis in the financial statements, derivative assets and derivative liabilities, repurchase agreements, and financial assets and

financial liabilities executed under a master netting or similar arrangement. These changes become effective for TVA on October 1, 2013.  TVA is currently evaluating the potential impact of these changes on its financial statements and related disclosures.

3.  Accounts Receivable, Net

Accounts receivable primarily consist of amounts due from customers for power sales.  The table below summarizes the types and amounts of TVA’s accounts receivable:

 

4.  Inventories, Net

The table below summarizes the types and amounts of TVA’s inventories:

5.  Other Long-Term Assets

The table below summarizes the types and amounts of TVA’s other long-term assets:

6.  Regulatory Assets and Liabilities

Regulatory assets generally represent incurred costs that have been deferred because such costs 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 or deferral of gains that will be credited to customers in future periods.  Components of regulatory assets and regulatory liabilities are summarized in the table below.

 

 

7.  Kingston Fossil Plant Ash Spill

The Event

In December 2008, one of the dredge cells at the Kingston Fossil Plant ("Kingston") failed, and approximately five million cubic yards of water and coal fly ash flowed out of the cell. TVA is continuing cleanup and recovery efforts in conjunction with federal and state agencies.  TVA completed the removal of time-critical ash from the river during the third quarter of 2010, and removal of the remaining ash is considered to be non-time-critical.  TVA estimates that the physical cleanup work (final removal) will be completed in the last quarter of 2014.  A final assessment, a completion report, and approval by Tennessee and the Environmental Protection Agency ("EPA") is expected to occur by the second quarter of 2015.  Surveillance and monitoring of the site will continue, but this work is beyond the scope of the cleanup project.

Claims and Litigation

See Note 16 — Legal Proceedings Related to the Kingston Ash Spill and — Civil Penalty and Natural Resource Damages for the Kingston Ash Spill .

Financial Impact

Because of the uncertainty at this time of the final costs to complete the work prescribed by the ash disposal plan, a range of reasonable estimates has been developed by cost category.  Known amounts, most likely scenarios, or the low end of the range for each category have been accumulated and evaluated to determine the total estimate.  The range of costs varies from approximately $1.1 billion to approximately $1.2 billion.

TVA recorded an estimate of $1.1 billion for the cost of cleanup related to this event.  In August 2009, TVA began using regulatory accounting treatment to defer all actual costs already incurred and expected future costs related to the ash spill.  The cost is being charged to expense as it is collected in rates over 15 years, beginning October 1, 2009.  As the estimate changes, additional costs may be deferred and charged to expense prospectively as they are collected in future rates.

As work continues to progress and more information is available, TVA will review its estimates and revise them as appropriate.  TVA has accrued a portion of the estimated cost in current liabilities, with the remaining portion shown as a long-term liability on TVA's balance sheets.  Amounts spent since the event through December 31, 2011 , totaled $774 million.  The remaining estimated liability at December 31, 2011 , was $351 million.

TVA has not included the following categories of costs in the above estimate since it has been determined that these costs are currently either not probable or not reasonably estimable: penalties (other than the penalties set out in the June 2010 Tennessee Department of Environment and Conservation ("TDEC") order), regulatory directives, natural resources damages (other than payments required under a memorandum of agreement with TDEC and the U.S. Fish and Wildlife Service establishing a process and a method for resolving the natural resource damages claim), future lawsuits, future claims, long-term environmental impact costs, final long-term disposition of the ash processing area, costs associated with new laws and regulations, or cost of remediating any mixed waste discovered during the ash removal process.  There are certain other costs that will be incurred that have not been included in the estimate as they are appropriately accounted for in other areas of the financial statements.  Associated capital asset purchases are recorded in property, plant, and equipment.  Ash handling and disposition costs from current plant operations are recorded in operating expenses.  A portion of the pond and dredge cell closure costs is also not included in the estimate as it is included in the non-nuclear Asset retirement obligation ("ARO") liability.

Insurance

TVA had property and excess liability insurance programs in place at the time of the Kingston ash spill.  TVA pursued claims under both the property and excess liability programs and has settled all of its property insurance claims and some of its excess liability insurance claims.  Through December 31, 2011 , TVA received proceeds of $40 million.  TVA continues to provide information about the nature and extent of TVA's claims under the policies to the remaining excess liability insurance companies. It is unclear at this time whether the parties will be able to resolve the outstanding claims without resorting to the policies' dispute resolution procedures.  Any amounts received related to insurance settlements are being recorded as reductions to the regulatory asset and will reduce amounts collected in future rates.

8.  Other Long-Term Liabilities

Other long-term liabilities consist primarily of liabilities related to certain derivative agreements as well as liabilities under agreements in respect of compliance with certain environmental regulations (see Note 16 — Environmental Agreements ). The table below summarizes the types and amounts of liabilities:

9.  Asset Retirement Obligations

During the three months ended December 31, 2011 , TVA's total ARO liability increased $37 million due to normal accretion. The increase in the liability was partially offset by ash area settlement projects that were conducted during the three months ended December 31, 2011 . The nuclear and non-nuclear accretion were deferred as regulatory assets, and $14 million of the related regulatory assets were amortized into expense since these amounts were collected in rates.