ITEM 1. BUSINESS
a. GENERAL DEVELOPMENT OF BUSINESS
The Registrant, Connecticut Water Service, Inc. (the Company), is the parent company of The Connecticut Water Company (CWC) which supplies water for residential, commercial, industrial and municipal purposes in various areas in the State of Connecticut through three operating regions. The Company and CWC represent the second largest investor-owned water system in Connecticut in terms of operating revenue and utility plant investment.
The Company was organized in 1956 under the General Statutes of Connecticut as Suburban Water Service, Inc. and has been engaged in the business of acquiring and operating water companies through controlling stock ownership. In addition to operating its core business, CWC offers related services on a contract basis to other water utilities, communities, and businesses. These services range from one-time contracts for a particular service to long-term assignments for system operations and management. In 1975, the Company changed its name to Connecticut Water Service, Inc. after acquiring all of the outstanding Common Stock of CWC. CWC's First Mortgage Bonds are held primarily by institutional investors. The Company is a non-operating company whose income is derived from the earnings on the Common Stock of CWC.
The profitability of the operations of the water utility industry generally and of CWC (and hence the Company) is largely dependent on the timeliness and adequacy of the rates allowed by utility regulatory commissions. In addition, profitability is dependent on numerous factors over which CWC has little or no control, such as the quantity of rainfall and temperature in a given period of time, industrial demand, prevailing rates of interest for short and long-term borrowings, energy rates, and compliance with environmental and water quality regulations. In addition, inflation and other factors beyond the Company's or CWC's control impact the cost of construction, materials and employee costs. See "Business - Financing", "Business - Rates", and "Business - -Regulation".
b. GENERAL DESCRIPTION OF BUSINESS
The Company, a Connecticut corporation, owns all of the outstanding Common Stock of CWC. Substantially all of the Company's revenues and net income are attributable to the sale and distribution of water by the operating regions of CWC. See "Business - Consolidated Operating Statistics".
CWC is specially chartered by the General Assembly of the State of Connecticut as a public service company, and the rates and operations of CWC are regulated by the Connecticut Department of Public Utility Control (DPUC). The Company is specifically prohibited from engaging in business or activities which are not regulated by the DPUC. See "Business - Rates" and "Business Regulation". CWC has one subsidiary organized in 1969 to assist in the acquisition of real estate. The assets and operations of this subsidiary are not significant.
CWC supplies water and, in most instances, provides fire protection through three separate operating regions in all or portions of 32 towns in Connecticut. The service areas have an estimated total population of approximately 216,000 based on DPUC population estimates of 3.5 people per average household. During the twelve months ended December 31, 1996, approximately 64% of the Company's consolidated operating revenues were received from residential customers, 12% from commercial customers, 5% from industrial customers, 3% from public authority customers, and 16% from public fire protection and other customers.
Each of the operating regions serves a separate franchise area. Rates are the same for all regions. The systems of the three operating regions are not physically interconnected.
The following table sets forth the percentage of the Company's utility plant in service at each of CWC's operating regions as of December 31, 1996:
At December 31, 1996, 61,813 customers were served by CWC. At that date, all customers were metered except fire protection customers and 380 customers of the Sound View Water System, acquired in 1995. The Company requires all applicants for new service, other than fire protection, to be metered.
The Company's principal office is located at 93 West Main Street, Clinton, Connecticut 06413 and its telephone number is 860-669-8636.
The business of CWC is subject to seasonal fluctuations. The demand for water during the warmer months is generally greater than during the cooler months due primarily to additional requirements for water in connection with cooling systems, private and public swimming pools and lawn sprinklers. Throughout the year, and particularly during the warmer months, demand will vary with rainfall and temperature levels. WATER SUPPLY
The estimated minimum dependable yields of sources of water supply for each of the operating regions' transmission and distribution systems, as set forth under "Business - CWC Production Facilities as of December 31, 1996" are in excess of present average daily consumption. Except for requests for voluntary conservation in the summers of 1988 and, in the Shoreline Region only, 1995, no restrictions on water use have been required in over 25 years.
Water is secured from both surface and subsurface supplies and supplied through interconnections with other water systems. In 1996, surface sources provided approximately 57% of the supply, well supplies provided approximately 41%, and interconnections with other systems supplied 2%. Studies are made periodically to determine the supply and distribution needs of the regions. A major study, covering a fifty year planning period required of all water companies supplying 1,000 or more persons, was completed in 1987 and submitted to the Connecticut Department of Public Health (DPH) for approval. An updated plan must be prepared every five years or as requested by the DPH. Updated plans for each of CWC's water systems have been prepared and approved by DPH.
See "Business - Construction Program", "Business - Rates" and "Business - - Regulation".
OPERATING REGIONS
NORTHERN
The Northern Region is composed of eight separate systems, not interconnected, as listed below:
The territory served is primarily residential and commercial with some industry. CWC has entered into an agreement with the State of Connecticut, Department of Transportation, pursuant to which CWC operates and maintains, as part of its Western System, the State's water distribution system for Bradley International Airport located in Windsor Locks, Suffield and East Granby, Connecticut.
The Western System has three emergency standby interconnections with the water system of the Metropolitan District Commission (MDC) (a public water and sewer authority presently serving the City of Hartford and portions of surrounding towns), one in South Windsor and two in Windsor Locks. The Western System also has an emergency interconnection with the water system of the Hazardville Water Company in Enfield. During 1995 an interconnection was completed between the Somers System and the water system of the Hazardville Water Company in Somers to provide water to the Hazardville Water Company.
See "Business - Franchises" with respect to proposals that the MDC expand its operations into the Northern Region and that MDC take over CWC's operations in South Windsor.
SHORELINE
The Shoreline Region is composed of four separate systems, not interconnected, as listed below:
The territory served is primarily residential with some commercial and industry. In 1996 CWC successfully negotiated the purchase of three small water companies, all in southeastern Connecticut. CWC expects these acquisitions to be approved by the DPUC in 1997. These systems will increase revenue approximately $200,000 and increase the customer base by 525.
NAUGATUCK
The Naugatuck Region is composed of four separate systems, not interconnected, as listed below:
The territory served is residential and industrial including a municipality which represented approximately 7.4% of the region's 1996 revenues.
Water for the Collinsville System is supplied under an agreement with the MDC from treatment facilities drawing from a large surface water reservoir owned by the MDC. See "Item 2.

ITEM 2. PROPERTIES
The properties of CWC consist of land, easements, rights (including water rights), buildings, reservoirs, standpipes, dams, wells, supply lines, treatment plants, pumping plants, transmission and distribution mains and conduits, mains and other facilities and equipment used for the collection, purification, storage and distribution of water. CWC owns its principal properties in fee, except that the Collinsville System's principal source of water supply is a water supply contract with the MDC. (See below for description of this contract.) The Company believes that CWC's properties are in good operating condition. Water mains are located, for the most part, in public streets and, in a few instances, are located on land owned by CWC in fee and land occupied under easements, most of which are perpetual and valid and sufficient for the purpose for which they are held. Although it is impractical to investigate the validity of the title to some of the easements held by CWC for distribution mains or to clear title in the cases where such distribution easement titles have been found defective, any such irregularities or defects in title which may exist do not materially impair the use of such properties in the business of CWC. Substantially all of CWC's property is subject to the lien of its Mortgage Indenture to secure CWC's First Mortgage Bonds.
CWC owns ten water filtration treatment plants. Information about these facilities is contained in the following table.
CWC has an agreement with the MDC, to provide, among other things, the operation and maintenance by MDC of a filtration plant (completed in 1990) to supply treated water for substantially all of CWC's Collinsville System, with a capacity of 650,000 gallons per day, and the provision by MDC to CWC's Collinsville System of up to 650,000 gallons per day of water from this plant meeting all applicable Federal and State requirements. CWC has paid 40% of the cost of construction of this plant and pays MDC an appropriate rate for water used by CWC in excess of 400,000 gallons per day.
As of December 31, 1996, the transmission and distribution systems of CWC consisted of approximately 980 miles of main, of which approximately 40 miles have been laid in the past five years. On that date, approximately 75% of CWC's mains were eight-inch diameter or larger. Substantially all new main installations are cement-lined ductile iron pipe of eight-inch diameter or larger. Approximately 100 miles of the Company's pipelines are asbestos cement.
From January 1, 1992 through December 31, 1996, CWC added $36,643,000 of gross plant additions (including plant financed by customer advances and contributions in aid of construction, allowance for funds used during construction and expenditures by CWC reimbursed by any other sources), and retired or sold property having a book value of $2,137,000, resulting in net additions during the period of $34,506,000.
CWC PRODUCTION FACILITIES AS OF DECEMBER 31, 1996
CWC PRODUCTION FACILITIES AS OF DECEMBER 31, 1996
(1) Dependable yield is the maximum continuous rate of withdrawal available from a source of supply without seriously depleting the source. Dependable yield is based on long-term (99% dry year) rainfall records, storage capacity and watershed area.
(2) Occurred in 1988.
(3) Occurred in 1989.
(4) Supplied by water purchased from the Town of East Longmeadow, Massachusetts.
(5) Occurred in 1994.
(6) Supplied by water purchased from the Town of Manchester.
(7) Occurred in 1995
(8) Occurred in 1990.
(9) Occurred in 1987.
(10) Occurred in 1969.
(11) Reservoir held in reserve and used for emergencies only.
(12) Generally used for emergencies. However, see "Item 3.

ITEM 3. LEGAL PROCEEDINGS
During the latter part of 1992 it was discovered that the CWC's Reynolds Bridge well field in Thomaston, Connecticut, was contaminated with methyl tertiary butyl ether ("MTBE"), a gasoline additive. At this time CWC and a responsible party are implementing an appropriate remediation program to clean up the well site. In 1994 legal action was initiated against the two parties deemed responsible for such contamination in order to obtain recovery of CWC's investigation, clean-up and water treatment and supply costs. The lawsuit is still in the discovery stage. The magnitude of such costs is presently estimated to be $5,400,000, or more, of which approximately $2,350,000 has been incurred at December 31, 1996, and $300,000 is expected to be incurred in 1997. The clean-up process may take ten years or more to complete. The Company has reflected the total estimated clean-up costs as a deferred asset in the accompanying consolidated balance sheets representing costs which management believes will be recoverable from third parties or future rates. A related liability has been recorded representing expected future clean-up costs. CWC is presently purchasing water from a public water supply system to provide service to its customers at normal levels. Based upon existing DPUC precedent, the Company and its legal counsel presently believe that any such costs which are not recovered from third parties should be allowed to be recovered through rates charged for water service and that the ultimate resolution of this matter will not have a material impact on the results of operations or financial condition of the Company.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4.1 EXECUTIVE OFFICERS OF THE COMPANY
There are no family relationships between any of the Directors and Executive Officers of the Company.
Part II
ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded in the over-the-counter market under the symbol CTWS and is included in the NASDAQ National Market System. The following table sets forth, for the periods indicated, the high and low last sale prices of the Company's Common Stock in the over-the-counter market and the dividends paid by the Company during the two most recent calendar years. The quotations represent actual sales prices, but the sales reflected may be inter-dealer transactions which do not reflect retail mark-up, mark-down or commission. NASDAQ is the source of the quotations for all periods. Since its affiliation with CWC in 1975, the Company has paid quarterly cash dividends on its Common Stock.
As of March 1, 1997 there were approximately 5,600 holders of record of the Company's Common Stock.
Holders of Common Stock are entitled to receive such dividends as may be declared by the Board of Directors from funds legally available therefor. Future dividends of the Company will be dependent upon timely and adequate rate relief, consolidated and parent company net income, availability of cash to the Company and CWC, the financial condition of the Company and CWC, the ability of the Company and CWC to sell their securities, the requirements of the construction program of CWC and other conditions existing at the time.
The Company is not permitted to pay any dividends on its Common Stock unless full cumulative dividends to the last preceding dividend date for all outstanding shares of Cumulative Preferred Stock of the Company have been paid or set aside for payment.
The income of the Company is derived mainly from earnings on its equity investment in CWC. At December 31, 1996, the retained earnings of CWC aggregated $12,339,000. As a result of dividend restrictions contained in CWC's mortgage indenture and Preferred Stock provisions, the amount of cash dividends payable on CWC's common equity capital out of CWC's retained earnings was limited to $12,089,000.
The Company has a Dividend Reinvestment and Common Stock Purchase Plan. Under the plan, customers and employees of CWC and holders of Common Stock who elect to participate may automatically reinvest all or specified percentages of their dividends in additional shares of Common Stock and may also make optional cash payments of up to $1,000 per month to purchase additional shares of Common Stock. The Company may issue authorized but unissued shares of Common Stock to meet the requirements of the plan, or buy the shares on the open market at its discretion. 1,500,000 shares have been registered with the Securities and Exchange Commission for that purpose. Under the plan, approximately 780,000 shares had been issued by the Company as of December 31, 1996.
The Company has a Performance Stock Program that provides for an aggregate maximum of up to 50,000 shares of Common Stock of the Company to be issued as awards of restricted stock to eligible employees of CWC, conditioned on the attainment of performance goals established by the Salary Committee. Under the plan approximately 20,750 shares, 6,350 of which are restricted, had been issued by the Company as of December 31, 1996.
The Company has an Employee Savings 401-K Match Plan. Under the Plan approximately 9,750 shares of Common Stock had been issued by the Company as of December 31, 1996.
CONNECTICUT WATER SERVICE, INC. AND SUBSIDIARY
SUPPLEMENTAL INFORMATION (UNAUDITED)
* 1987 includes $1,004 net income, $.48 per average common share, related to cumulative effect of Change in Method of Accounting for unbilled revenues.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto.
LIQUIDITY AND CAPITAL RESOURCES - During the first two quarters of 1996 the Dividend Reinvestment and Common Stock Purchase Plan (DRIP) provided over $900,000 of new equity capital, increasing the common stock equity component of the Company's capitalization to 50%, up from 48% in 1995. To assist the Company in maintaining a 50/50 Equity to Debt ratio, the Company modified its DRIP to give the Company increased financial flexibility through the option of being able to provide DRIP shares through open market purchases and negotiated transactions, in addition to the previous method of issuing new shares. To meet the DRIP requirements in the second half of 1996 the Company chose to purchase shares on the open market. These purchases allowed the Company to maintain the 50/50 Equity to Debt ratio, and have been financed with short-term debt, a less expensive form of financing than issuance of equity for the Company at this time.
Utility plant additions were financed through cash provided by operating activities, funds received from others, funds provided by the DRIP, and through interim bank borrowings. Seasonal cash requirements were provided through interim bank borrowings.
Interim bank loans payable at year end were $5,795,000, approximately $3,000,000 higher than the same time the prior year. This increase is due to the changes to the DRIP, as well as the decrease in cash flows from operations stemming primarily from the extreme weather differences between 1996 and 1995. Management considers the current $12,000,000 line of credit with four banks adequate to finance expected short-term borrowing requirements that may arise from operations during 1997. Interest expense charged on interim bank loans will fluctuate subject to financial market conditions experienced during the year.
1996 was the fourth consecutive year that interest coverage, the ratio of utility operating income plus Federal and State income taxes to annualized interest expense on outstanding long-term debt, exceeded 4.0 times coverage.
The Board of Directors has approved a $11,400,000 construction budget for 1997. Funds provided by operating activities, given normal weather patterns and related operating revenue billings and contributions from developers and others, are expected to finance approximately 70% of this construction program. Refer to Note 10, Utility Plant and Construction Program, in Notes to Consolidated Financial Statements for additional discussion of the Subsidiary's future construction program. The remainder of the construction program is expected to be financed through interim bank loans.
REGULATORY MATTERS AND INFLATION - The Subsidiary's last rate increase was effective March 25, 1991. That rate decision included a 12.7% allowed return on common equity and a 10.74% allowed return on rate base. Future economic and financial market conditions, coupled with governmental regulations and fiscal policy, plus other factors which are unpredictable and often beyond the control of the Subsidiary, will influence when the Subsidiary requests a revised schedule of rates from the DPUC. Construction expenditures mandated to comply with the amendments to the Safe Drinking Water Act (SDWA) will, when and if required, also affect water rates charged to customers.
The Company, like all other businesses, is affected by inflation, most notably by the continually increasing costs required to maintain, improve, and expand its service capability. The cumulative effect of inflation results in significantly higher facility replacement costs which must be recovered from future cash flow. The ability of the Subsidiary to recover this increased investment in facilities is dependent upon future revenue increases which are subject to approval by the Connecticut Department of Public Utility Control (DPUC).
Management does not presently plan to petition the DPUC for an increase in permanent rates in 1997.
OUTLOOK FOR 1997 - The Company's profitability is primarily attributable to the sale and distribution of water, the amount of which is dependent on seasonal weather fluctuations, particularly during the summer months when water demand will vary with rainfall and temperature levels.
Through December 31, 1996, the Company has expended approximately $2,350,000 in its effort to remediate the Reynolds Bridge Well Field (RBWF) contaminated with MTBE, a gasoline additive. These costs have been deferred. Additional expenditures of approximately $300,000 related to this remediation effort are expected to be incurred in 1997, and will also be deferred as management expects that these costs and future related costs will be recovered from the responsible parties, or through rates charged to customers. Refer to Note 9, Recoverable Clean-Up Costs, for additional discussion of RBWF clean-up costs.
RESULTS OF OPERATIONS -
1996 COMPARED WITH 1995
Net income applicable to common stock for 1996 increased from that of 1995 by $240,000, or $0.02 per average common share, on an increased number of common shares outstanding due primarily to the following:
- - Operating income increased $106,000 as a result of a $758,000 decrease in operating revenues offset by a $864,000 decrease in operating expense.
- - The 1.9% decrease in operating revenues is primarily due to the extreme differences in the 1996 and 1995 summer weather. The 1996 summer was wet and cool causing customer water usage to decline, as opposed to the 1995 summer that was extraordinarily hot and dry.
- - The 2.9% decrease in operating expenses is primarily due to the following:
- a reduction in operation expense due to lower production, treatment, and distribution expenses associated with the decline in the volume of water sold
- a reduction in administrative expenses and a postponement of non-critical maintenance expenses in response to the decline in revenues due to the wet and cool summer
- a greater percentage of the Subsidiary's overall labor activity being directed to capital-related projects
- a lower effective tax rate in 1996 primarily associated with the flow-through adjustment related to pension costs
- - Other income increased $155,000 due primarily to increased AFUDC on the Subsidiary's continuing investment in utility plant.
1995 COMPARED WITH 1994
1995 net income applicable to common stock increased from that of 1994 by $483,000, or $.09 per average common share, on an increased number of average common shares due primarily to the following:
- - Operating revenues increased by 3.2%, or $1,221,000, primarily due to the higher residential, commercial, and public authority consumption in 1995 reflecting the hot and dry summer.
- - Operating expenses increased by 3.0% primarily due to the following:
- increased gross earnings and income taxes related to the higher revenues and taxable income
- increased operation costs due to higher production, treatment, and distribution expenses associated with the higher volume of water sold
- Increased depreciation expense relating to increased plant in service
- increased maintenance expense
- increased employee fringe benefit costs
- - Other income increased $122,000 due primarily to a reduction in preferred stock dividends accomplished by the refinancing of the 9.5% Series Cumulative Preferred Stock of the Subsidiary in March, 1994.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Connecticut Water Service, Inc.:
We have audited the accompanying consolidated balance sheets of Connecticut Water Service, Inc. (a Connecticut corporation) and Subsidiary as of December 31, 1996 and 1995, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Connecticut Water Service, Inc. and Subsidiary as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Hartford, Connecticut February 14, 1997
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION - Connecticut Water Service, Inc. (the Company) is the parent company of The Connecticut Water Company (the Subsidiary). Intercompany accounts and transactions have been eliminated in the accompanying consolidated financial statements.
PUBLIC UTILITY REGULATION - The Subsidiary is subject to regulation for rates and other matters by the Connecticut Department of Public Utility Control (DPUC) and follows accounting policies prescribed by the DPUC. The Company prepares its financial statements in accordance with generally accepted accounting principles which includes the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation," (FAS 71). FAS 71 requires a cost-based, rate-regulated enterprise such as the Subsidiary to reflect the impact of regulatory decisions in its financial statements. The DPUC, through the rate regulation process, can create regulatory assets that result when costs are allowed for ratemaking purposes in a period other than the period in which the costs would be charged to expense by an unregulated enterprise.
In accordance with FAS 71, the Subsidiary has recorded regulatory assets or liabilities as appropriate primarily related to income taxes and postretirement benefits costs. The specific amounts related to these items are disclosed in the consolidated balance sheets.
The Subsidiary continues to be subject to cost-of-service based rate regulation by the DPUC. Based upon current regulation and recent regulatory decisions, the Company believes that its use of regulatory accounting is appropriate and in accordance with the provisions of FAS 71.
FAS 121, which became effective for 1996, establishes accounting standards for the impairment of long-lived assets. FAS 121 also requires that regulatory assets which are no longer probable of recovery through future revenues be charged to earnings. The adoption of FAS 121 did not have an impact on the financial position or results of operations.
USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.
REVENUES - The Subsidiary accrues an estimate for the amount of revenues relating to sales unbilled at the end of each quarter. Generally, all customers are billed quarterly, except larger commercial and industrial customers, and public fire protection customers, who are billed monthly. Substantially all customers, except fire protection customers, are metered. Public fire protection charges are based on the length and diameter of the water main and number of hydrants in service. Private fire protection charges are based on the diameter of the connection to the water main.
UTILITY PLANT - Utility plant is stated at original cost of such property when first devoted to public service. The difference between the original cost and the cost to the Subsidiary is charged or credited to utility plant acquisition adjustments. Utility plant accounts are charged with the cost of improvements and replacements of property including an allowance for funds used during construction. Retired or disposed of depreciable plant is charged to accumulated provision for depreciation together with any costs applicable to retirement, less any salvage received. Maintenance of utility plant is charged to expense.
ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION - Allowance for funds used during construction (AFUDC) generally represents the cost of funds used to finance the construction of the Subsidiary's utility plant. Generally, utility plant under construction is not recognized as part of the Subsidiary's rate base for ratemaking purposes until facilities are placed into service, and accordingly, the Subsidiary charges AFUDC to the construction cost of utility plant. Capitalized AFUDC, which does not represent current cash income, is recovered through rates over the service lives of the facilities.
In order for certain acquisitions of failing water systems not to degrade the Subsidiary's earnings, the Subsidiary has requested that the DPUC allow it to record AFUDC on its investments in these systems. The 1995 DPUC decision which approved the Subsidiary's acquisition of the Sound View Water System allowed the Subsidiary to capitalize financing costs, amounting to $155,000 in 1996, until its next general rate proceeding.
The Subsidiary's allowed rate of return on rate base is used to calculate AFUDC.
DEPRECIATION - Depreciation is computed on a straight line basis at various rates, approved by the DPUC, estimated to be sufficient to provide for the recovery of the investment in utility plant over its useful life. Water treatment facilities are depreciated using a 2.5% composite rate, while most other utility plant is depreciated at a composite rate of 1.6%. The depreciation rates, based on the average balance of depreciable property, were 1.9% for 1996, 1995 and 1994.
CUSTOMERS' ADVANCES FOR CONSTRUCTION AND CONTRIBUTIONS IN AID OF CONSTRUCTION - Under the terms of construction contracts with real estate developers and others, the Subsidiary receives advances for the costs of new main installations. Refunds are made, without interest, as services are connected to the main, over periods not exceeding fifteen years and not in excess of the original advance. Unrefunded balances, at the end of the contract period, are credited to contributions in aid of construction (CIAC) and are no longer refundable.
INCOME TAXES - The Company provided deferred taxes for all temporary book-tax differences using the liability method. Under the liability method, deferred income taxes are recognized at currently enacted income tax rates to reflect the tax effect of temporary differences between the financial reporting and tax bases of assets and liabilities. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. To the extent such income taxes increase or decrease future rates, an offsetting regulatory asset and liability have been recorded in the accompanying consolidated balance sheets.
The Company believes that all deferred income tax assets will be realized in the future. Approximately $1,000,000, of the December 31, 1996 and 1995 unfunded future income taxes is related to deferred Federal income taxes. The remaining balance of the unfunded future income taxes is related to deferred State income taxes.
Deferred Federal income taxes consists primarily of amounts that have been provided for accelerated depreciation subsequent to 1981, as required by Federal income tax regulations. Deferred taxes have also been provided for temporary differences in the recognition of certain expenses for tax and financial statement purposes as allowed by DPUC ratemaking policies.
Connecticut Corporation Business Taxes have been reflected primarily using the flow-through method of accounting for temporary differences in accordance with required DPUC ratemaking policies.
MUNICIPAL TAXES - Municipal taxes are expensed over the 12 month period beginning on July 1 following the lien date, corresponding with the period in which the municipal services are provided.
OTHER DEFERRED COSTS - In accordance with DPUC ratemaking procedures, costs which benefit future periods, such as tank painting, are expensed over the periods they benefit.
UNAMORTIZED DEBT ISSUANCE EXPENSE - The issuance costs of long-term debt, including the remaining balance of issuance costs on long-term debt issues that have been refinanced prior to maturity and related call premiums, are amortized over the respective lives of the outstanding debt, as approved by the DPUC.
NOTE 2: INCOME TAX EXPENSE
Income Tax Expense is comprised of the following:
The components of the Federal and State income tax provisions are:
In accordance with required regulatory treatment, deferred income taxes are not provided for certain timing differences. This treatment, along with other items, causes differences between the statutory income tax rate and the effective income tax rate. The differences between the effective income tax rate recorded by the Company and the statutory Federal tax rate are as follows:
NOTE 3: COMMON STOCK
The Company has 7,500,000 authorized shares of common stock, no par value. A summary of the changes in the common stock accounts for the period January 1, 1994 through December 31, 1996, appears below:
(1) Includes 6,346 restricted shares issued through the Performance Stock Program.
In 1988 the Board of Directors authorized a dividend distribution of one right to purchase Common Stock (Right) for each outstanding share of Common Stock. Each Right entitles the registered holder under certain circumstances to purchase from the Company one share of Common Stock (or substitute equity or debt securities) at an exercise price (subject to antidilution adjustments) of $50 per share, or under other circumstances, common stock or other securities or assets of an acquiring entity or of the Company.
The Rights are not currently exercisable or separately transferable apart from the Common Stock. The Rights can be redeemed by the Board of Directors under certain circumstances at a price of $.01 per Right. The agreement pursuant to which the Rights were issued may be amended by the Board of Directors under certain circumstances. The Rights expire on October 11, 1998.
The Company may not pay any dividends on its Common Stock unless full cumulative dividends to the preceding dividend date for all outstanding shares of Preferred Stock of the Company have been paid or set aside for payment. All such preferred stock dividends have been paid.
NOTE 4: ANALYSIS OF RETAINED EARNINGS
The summary of the changes in Retained Earnings for the period January 1, 1994 through December 31, 1996, appears below:
NOTE 5: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each of the following financial instruments.
CASH - The carrying amount approximates fair value.
FIRST MORTGAGE BONDS - The fair value of the Company's fixed rate long-term debt is based upon borrowing rates currently available to the Company. As of December 31, 1996 and 1995, the estimated fair value of the Company's long-term debt was $55,800,000 and $58,400,000, respectively, as compared to the carrying amounts of $54,430,000 and $54,460,000, respectively.
The fair values shown above have been reported to meet the disclosure requirements of Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Values of Financial Instruments" and do not purport to represent the amounts at which those obligations would be settled.
NOTE 6: LONG-TERM DEBT
Long-Term Debt at December 31, consisted of the following:
Substantially all utility plant is pledged as collateral for the Subsidiary's long-term debt.
There are no mandatory sinking fund payments required on the outstanding First Mortgage Bonds at December 31, 1996. However, the Series Q and R First Mortgage Bonds provide for an estate redemption right whereby the estate of deceased bondholders or surviving joint owners may submit bonds to the Trustee for redemption at par subject to a $25,000 per individual holder and a 3% annual aggregate limitation.
Outstanding bonds may be initially called for redemption by the Company at the following dates and prices - Series Q - August 1, 1996 and Series R, September 1, 1997 at 103%; Series S, December 15, 2003 at 102%; Series T, July 1, 2003 and Series U, September 1, 2003 at 100% plus accrued interest to the date of redemption; Series V, January 1, 2004 at 103.5%.
NOTE 7: PREFERRED STOCK
Preferred Stock at December 31, consisted of the following:
All or any part of any series of either class of the Company's issued Preferred Stock may be called for redemption by the Company at any time. The per share redemption prices of the Series A and Series $.90 Preferred Stock, if called by the Company, are $21.00 and $16.00, respectively.
The Company is authorized to issue 400,000 shares of an additional class of Preferred Stock, $25 par value, the general preferences, voting powers, restrictions and qualifications of which are similar to the Company's existing Preferred Stock. No shares of the $25 par value Preferred Stock have been issued.
The Company is also authorized to issue 1,000,000 shares of $1 par value preference stock, junior to the Company's existing Preferred Stock in rights to dividends and upon liquidation of the Company. No shares of the preference stock have been issued.
NOTE 8: BANK LINES OF CREDIT
A $12,000,000 line of credit is provided by four banks. Bank commitment fees of approximately $15,000, $12,000, and $14,000 were paid in 1996, 1995, and 1994, respectively, on the lines of credit.
At December 31, 1996 and 1995, the weighted average interest rates on short-term borrowings outstanding were 5.85% and 6.02%, respectively.
NOTE 9: RECOVERABLE CLEAN-UP COSTS
During the latter part of 1992 it was discovered that the Subsidiary's Reynolds Bridge well field in Thomaston, Connecticut, was contaminated with methyl tertiary butyl ether (MTBE), a gasoline additive. At this time the Subsidiary and a responsible party are implementing an appropriate remediation program to clean up the well site. In 1994, legal action was initiated by the Company against the two parties deemed responsible for such contamination in order to obtain recovery of the Subsidiary's investigation, clean-up and water treatment and supply costs. The lawsuit is still in the discovery stage. The magnitude of such costs is presently estimated to be $5,400,000, or more, of which approximately $2,350,000 has been incurred at December 31, 1996 and $300,000 is expected to be incurred in 1997. The clean-up process may take ten years or more to complete. The Company has reflected the total estimated clean-up costs as a deferred asset in the accompanying consolidated balance sheets representing costs which management believes will be recoverable from third parties or through future rates. A related liability has been recorded representing expected future clean-up costs. The Subsidiary is presently purchasing water from a public water supply system to provide service to its customers at normal levels. The Company and its legal counsel presently believe that any such costs which are not recovered from third parties should be allowed to be recovered through rates charged for water service and that the ultimate resolution of this matter will not have a material impact on the results of operations or financial condition of the Company.
NOTE 10: UTILITY PLANT AND CONSTRUCTION PROGRAM
The components of utility plant and equipment at December 31, are as follows:
The amounts of depreciable plant at December 31, 1996 and 1995, included in total plant were $180,101,000 and $172,819,000, respectively.
The Subsidiary is engaged in a continuous construction program. The Subsidiary's estimated annual capital expenditures, net of amounts financed by customer advances and contributions in aid of construction, are expected to be $10,400,000 during 1997, $5,500,000 during 1998, and $6,500,000 in 1999. These projections include costs of refurbishing the Rockville Water Treatment Plant of $4,550,000 in 1997 and $1,425,000 in 1998. The projections also include $535,000 in 1997 to make improvements to the Sound View Water System that the Subsidiary acquired in 1995. During the period 2000 to 2001, construction expenditures for routine improvements to the water distribution system are expected to be approximately $5,000,000 each year.
NOTE 11: TAXES OTHER THAN INCOME TAXES
Taxes Other than Income Taxes consist of the following:
NOTE 12: PENSION AND OTHER EMPLOYEE BENEFITS
PENSION - The Subsidiary has a trusteed, non-contributory defined benefit retirement plan (the Pension Plan) which covers all employees who have completed one year of service. Benefits under the Pension Plan are based on credited years of service and "average earnings", as defined in the Pension Plan. The Subsidiary's policy is to fund accrued pension costs as permitted by Federal income tax regulations. Fundings of $153,000 and $396,000 were made for 1996 and 1995 respectively.
The table below sets forth the Pension Plan's funded status and amounts recognized in the Company's year end Balance Sheets.
Net periodic pension cost included the following components:
The actuarial present value of the projected benefit obligation was determined based on the following assumptions:
The weighted average discount rate assumption is based on the return provided by high quality fixed income investments at year end. This rate of return assumption will likely change annually. The wage rate assumption and the rate of return on plan assets are more long-term assumptions which may be revised to reflect changes in economic conditions.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN - The Subsidiary provides additional pension benefits to senior management through a supplemental executive retirement plan. At December 31, 1996 the actuarial present value of the projected benefit obligation was $533,000. Expense associated with this plan was $115,000 for 1996, $181,000 for 1995, and $72,000 for 1994.
POSTRETIREMENT BENEFITS OTHER THAN PENSION (PBOP) - In addition to providing pension benefits, the Subsidiary provides certain medical, dental and life insurance benefits to retired employees partially funded by a 501(c)(9) Voluntary Employee Beneficiary Association Trust (VEBA) that has been approved by the DPUC. Substantially all of the Subsidiary's employees may become eligible for these benefits if they retire from the Company on or after age 55 with 10 years of service with the Subsidiary. The contributions for calendar years 1996, 1995, and 1994 were $265,000, $250,000, and $250,000, respectively.
A deferred regulatory asset has been recorded to reflect the amount which represents the future operating revenues expected to be collected in customer rates when the associated liabilities become payable, including appropriate income and gross earnings taxes. The Company believes that the deferred asset recorded from the adoption of this statement will be recovered in the future through the ratemaking process as the DPUC has issued decisions for other water companies authorizing such rate recovery and has allowed the recording of a regulatory asset for the portion of the costs to be recovered through future rates.
The Company has elected to recognize the transition obligation on a delayed basis over a period equal to the plan participants' 21.6 years of average future service.
The table below sets forth the PBOP plans' funded status and unfunded amounts recognized in the Company's 1996 and 1995 year end Balance Sheets.
Net periodic PBOP costs include the following components:
The actuarial present value of the projected benefit obligation was determined based on the following assumptions:
In determining the accumulated postretirement benefit obligation, two sets of medical cost trend rates were used; for retired employees prior to age 65 and for retirees age 65 and over. Health care cost trends of 9% and 8%, respectively, were assumed for 1996, grading down over the years to 5.5% in 1999 and after.
Health care cost trend rates have a significant effect on the accumulated postretirement benefit obligation and net periodic cost. A one-percentage-point increase in the assumed health care cost trend rates would increase the accumulated postretirement benefit obligation at December 31, 1996 by $384,000 and would increase the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $62,000. Accordingly, subsequent changes would increase or decrease the regulatory assets and liabilities discussed above.
SAVINGS PLAN - The Subsidiary maintains an employee savings plan which allows participants to contribute from 1% to 10% of pre-tax compensation. The Subsidiary matches either 25 or 50 cents for each dollar contributed by the employee up to 3% of the employees' compensation depending on the Company's earnings per average common share (EPS). If EPS in the prior year exceeds 110% of dividends paid per common share, the applicable percentage is 50%; otherwise, the match is 25%. The Subsidiary's contribution charged to expense in 1996, 1995 and 1994 was $78,000, $71,000 and $60,000, respectively, in each case based on a 50% match.
PERFORMANCE STOCK PROGRAM - The Company has a Performance Stock Program whereby restricted shares of Common Stock may be awarded annually to Officers of the Subsidiary. When the goals established by the Compensation Committee have been attained, the restrictions on the stock are removed. Amounts charged to expense pursuant to this plan were $100,000, $160,000 and $120,000 for 1996, 1995 and 1994, respectively.
NOTE 13: QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data for the years ended December 31, 1996 and 1995 appears below:
ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction G(3), the information called for by Items 10, (except for information concerning the executive officers of the Company) 11, 12, and 13 is hereby incorporated by reference from the Company's definitive proxy statement filed by EDGAR on or about March 19, 1997. Information concerning the executive officers of the Company is included as Item 4.1 of this report.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(A) Documents filed as part of this report:
(1) Consolidated Financial Statements:
(2) Financial Statement Schedules for the years ended December 31, 1996, 1995 and 1994:
Report of Independent Public Accountants on Schedules
Schedule II - Valuation and Qualifying Accounts
All other schedules provided for in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because of the absence of conditions under which they are required or because the required information is set forth in the financial statements or notes thereto.
(3) Exhibits:
Exhibits heretofore filed with the Securities and Exchange Commission as indicated below are incorporated herein by reference and made a part hereof as if filed herewith. Exhibits marked by asterisk (*) are being filed herewith.
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Note: Exhibits 10.1 through 10.10, 10.21 and 10.22 set forth each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form-10K.
(b) No reports on Form 8-K were filed during the last quarter of 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CONNECTICUT WATER SERVICE, INC. Registrant
By /s/ Marshall T. Chiaraluce ---------------------------- Marshall T. Chiaraluce President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of Connecticut Water Service, Inc. in the capacities and on the dates indicated.
SCHEDULES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE
We have audited, in accordance with generally accepted auditing standards, the financial statements of Connecticut Water Service, Inc. included in this Form 10-K, and have issued our report thereon dated February 14, 1997. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule listed in the accompanying index to financial statements and schedule is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP
Hartford, Connecticut February 14, 1997 CONNECTICUT WATER SERVICE, INC. and SUBSIDIARY
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(1) Amounts charged off as uncollectible after deducting recoveries EXHIBITS
TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR
ENDED DECEMBER 31, 1996
10.9 Savings Plan of The Connecticut Water Company
10.10 The Connecticut Water Company Employees' Retirement Plan
24.1 Consent of Arthur Andersen LLP
27.0 Financial Data Schedule