A UDITED FINANCIAL STATEMENTS Puerto Rico Electric Power Authority (A Component Unit of the Commonwealth of Puerto Rico) Years Ended June 30, 2010 and 2009 With Report of Independent Auditors 1008-1179560 Puerto Rico Electric Power Authority (A Component Unit of the Commonwealth of Puerto Rico) Audited Financial Statements Years Ended June 30, 2010 and 2009 Contents Report of Independent Auditors .............................................................................................. 1 Management’s Discussion and Analysis .................................................................................. 3 Audited Financial Statements Balance Sheets ........................................................................................................................ 16 Statements of Revenues, Expenses and Changes in Net Assets ................................................ 18 Statements of Cash Flows ....................................................................................................... 19 Notes to Audited Financial Statements.. .................................................................................. 21 Report on Internal Control Over Financial Reporting and on Compliance and Other Matters Based on an Audit of the Financial Statements Performed in Accordance with Government Auditing Standards .......................................................................................... 81 Required Supplementary Information Supplementary Schedule of Funding Progress ......................................................................... 83 1008-1179560 Ernst & Young LLP 1000 Scotiabank Plaza 273 Ponce de León Avenue San Juan, PR 00917-1951 Tel: 787 759 8212 Fax: 787 753 0808 www.ey.com Report of Independent Auditors To the Governing Board of the Puerto Rico Electric Power Authority We have audited the accompanying financial statements of the Puerto Rico Electric Power Authority (the Authority), a component unit of the Commonwealth of Puerto Rico, as of and for the years ended June 30, 2010 and 2009, as listed in the table of contents. These financial statements are the responsibility of the Authority's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of PREPA Networks, Inc. (PREPA.Net) (a blended component unit), which financial statements reflect total assets constituting approximately .2% and .3% of total assets as of June 30, 2010 and 2009, and revenues constituting .2% and .2% of total revenues for the years then ended. Those financial statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for PREPA Holdings and PREPA.Net, is based solely on the reports of the other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Authority’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Authority’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the reports of the other auditors, provide a reasonable basis for our opinion. In our opinion, based on our audits, and the reports of the other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of the Authority as of June 30, 2010 and 2009, and the changes in its financial position and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. 1008-1179560 1 A member firm of Ernst & Young Global Limited As discussed in Note 2 to the financial statements, the Authority changed its method of accounting for derivative instruments as a result of the adoption of the Governmental Accounting Standards Board (GASB) Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, effective July 1, 2009. In accordance with Government Auditing Standards, we have also issued our report, dated January 31, 2011, on our consideration of the Authority’s internal control over financial reporting and on our tests of its compliance with certain provisions of laws, regulations, contracts, and grant agreements and other matters. The purpose of that report is to describe the scope of our testing of internal control over financial reporting and compliance and the results of that testing, and not to provide an opinion on the internal control over financial reporting or on compliance. That report is an integral part of an audit performed in accordance with Government Auditing Standards and should be considered in assessing the results of our audits. Management’s Discussion and Analysis on pages 3 through 13 and the required supplementary information disclosed on page 83 are not a required part of the basic financial statements but is supplementary information required by the Governmental Accounting Standards Board (GASB). We have applied certain limited procedures, which consisted principally of inquiries of management regarding the methods of measurement and presentation of the required supplementary information. However, we did not audit the information and express no opinion on it. ey January 31, 2011 Stamp No. 2576794 affixed to original of this report. 1008-1179560 2 A member firm of Ernst & Young Global Limited Puerto Rico Electric Power Authority (A Component Unit of the Commonwealth of Puerto Rico) Management’s Discussion and Analysis Year Ended June 30, 2010 This section of the financial report of Puerto Rico Electric Power Authority (the Authority) presents the analysis of the Authority’s financial performance during the fiscal years ended June 30, 2010, 2009 and 2008. As management of the Authority, we offer readers of the financial statements this narrative overview and analysis of the financial activities. We recommend readers to consider the information herein presented in conjunction with the financial statements that follow this section. Financial Highlights § Operating income for fiscal year ended June 30, 2010 was $359.5 million representing a decrease of .9 percent for the fiscal year ended June 30, 2009. For the fiscal years ended June 30, 2009 and 2008 was $362.6 million and $181.1 million respectively, representing 100 percent increase and 51.1 percent decrease when compared to fiscal years ended June 30, 2008 and 2007, respectively. § Operating expenses increased by $171.9 million or 4.7 percent for the fiscal year ended June 30, 2010; decreased by $541.0 million or 12.9 percent and increased by $871.7 million or 26.3 percent for the fiscal years ended June 30, 2009 and 2008, respectively, when compared to previous fiscal years. § In June 2008, the Government Accounting Standards Board (GASB) issued Statement 53, Accounting and Financial Reporting for Derivative Instruments. GASB 53 addresses the recognition, measurement, and disclosure of information regarding derivative instruments entered into by state and local governments. The Authority adopted GASB statement 53 in Fiscal Year 2010. The effect of applying this statement was reported as a restatement of 2009 financial statements resulting in an increase of deferred outflows and fair value of derivatives instruments of $103.9 million. § The Authority’s Net Utility Plant for the fiscal year ended June 30, 2010 increased by $116.1 million or 1.8 percent. For the fiscal year ended 2009 and 2008 the increase was $236.2 million and $419.4 million or 3.8 percent and 7.3 percent, respectively. § Total assets increased by $195.5 million and decreased by $346.1 million and $989.9 million, or 2.2 percent increase, 3.7 percent decrease and 12.0 percent increase, respectively, for the fiscal years ended June 30, 2010, 2009 and 2008. 1008-1179560 3 Puerto Rico Electric Power Authority (A Component Unit of the Commonwealth of Puerto Rico) Management’s Discussion and Analysis (continued) § For the fiscal year ended June 30, 2010, as compared to the fiscal year ended June 30, 2009 and June 30, 2008, accounts receivable decreased by 3.7 percent, from $1,126.9 million to $1,085.1 million and by 11.5 percent from $1,272.8 million to $1,126.9 million, respectively. The decrease in 2010 was mainly due to a collection of over $120 million from the government sector and the efforts of the Collection and Energy Theft Programs with the private sector. The decrease in 2009 was mainly due to the collection of $136.7 million from insurance companies related to a claim filed as a result of two fires at the Palo Seco Steam Plant and to a decline in the average fuel oil price per barrel of $7.95 (9.4%). § Accounts receivable from the governmental