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Note 7 - Commitments and Contingencies

Operating Leases

We lease our corporate office space as well as certain office equipment under operating lease
agreements. Total rent expense was approximately $307,000 and $315,000 for the years
ended December 31, 2015 and 2014, respectively.

Our remaining non-cancelable lease commitments for our corporate office space and leased
equipment as of December 31, 2015 were as follows:

(in thousands) Amount
2016 $ 301
2017 176
2018 9
2019 and thereafter -
Total $ 486

—_
SS

Note 8 — Financial Measurement and Fair Value of Financial Instruments

Management uses its best judgment in estimating the fair value of its financial instruments.
However, there are inherent weaknesses in any estimation technique. Therefore, for substan-
tially all financial instruments, the fair value estimates herein are not necessarily indicative of
the amounts that we could realize in a sales transaction for these instruments. The estimated
fair value amounts have been measured as of the period end and have not been reevaluated or
updated for purposes of these consolidated financial statements subsequent to those

respective dates.

We use a fair value hierarchy which prioritizes the inputs to valuation methods used to measure
fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets
for identical assets or liabilities (Level | measurements) and the lowest priority to unobservable
inputs (Level 3 measurements). The three levels of fair value hierarchy are as follows:

Level 1: Based on quoted prices in active markets for identical assets.

Level 2: Based on significant observable inputs.

Level 3: Based on significant unobservable inputs.

An asset or liability’s level within the fair value hierarchy is based on the lowest level of
input that is significant to the fair value measurement.

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For assets and liabilities measured at fair value on a recurring basis, the fair value measure-
ment by levels within the fair value hierarchy used as of December 31, 2015 and 2014 were

as follows:

December 31, 2015
(in thousands) Total Level 1 Level 2 Level 3
Assets:
U.S. government bonds $ 17,210 $ 17,210 § - $ -
Liabilities:
Interest rate swap $ (548) § - $ (548) $ -
December 31, 2014
(in thousands) Total Level 1 Level 2 Level 3
Liabilities:
Interest rate swap $ (583) $ - $ (583) § -

The carrying value of certain financial instruments included in the accompanying Consoli-
dated Balance Sheets, along with the related fair value, as of December 31, 2015 and 2014
was as follows:

2015 2014
Carrying Fair Carrying Fair

(in thousands) Value Value Value Value
Assets:

U.S. government bonds $ 17,237, $ 17,210 §$ - $ -
Liabilities:

Long-term debt (210,172) (211,962) (224,307) (270,191)

Interest rate swap liability (548) (548) (583) (583)

The fair value of long-term debt has been determined by discounting the future cash flows
using current market interest rates for similar financial instruments of the same duration. The
fair value for long-term debt shown above does not purport to represent the amounts at which
those debt obligations would be settled. The fair market value of our interest rate swap
represents the estimated cost to terminate this agreement as of December 31, 2015 and 2014
based upon the then-current interest rates and the related credit risk.

The carrying values of our Cash and Cash Equivalents, Accounts Receivable and Accounts
Payable approximate their fair values because of their short maturity dates. The carrying
value of our CIAC approximates its fair value because it is expected that this is the amount
that will be recovered in future rates.

Note 9 — Income Taxes

The components of the federal and state income tax provision (benefit) as of December 31,
2015 and 2014 were as follows:

(in thousands) 2015 2014
Federal $ (79) $ 343
State 420 24]
Amortization of investment tax credits G3} (33)
Total $ 308 $ 551
Current $ (1) $ (33)
Deferred 309 584
Total $ 308 $ 551

The following is a reconciliation between the statutory federal income tax rate and the
effective income tax rate for 2015 and 2014:

2015 2014
Statutory federal rate 34.0% 34.0%
State tax rate, net of federal benefits 5.6% 5.6%
Permanent differences 56.8% -87.3%
Amortization of investment tax credits 1.7% 2.7%
Effective tax rate -15.5% 45.0%

The temporary items that give rise to the net deferred tax liability as of December 31, 2015
and 2014 were as follows:

{in thousands) 2015 2014
Liabilities:
Property-related, net $ 26,890 $ 25,626
Pension deferred asset - 2,641
Other 443 1,061
Total liabilities 27,333 29,328
Assets:
Pension accrued liability 1,426 3,176
Net operating loss carry forward 3,884 2,399
Altemative minimum tax credit 476 476
NH Business Enterprise Tax credits 369 369
Other 905 2,574
7,060 8,994
Less valuation allowance (369) -
Total assets 6,691 8,994
Net non-current deferred income tax liability $ 20,642 $ 20,334

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We had a federal net operating loss in 2015 and 2014 in the amounts of approximately $3.5
and $1.8 million, respectively. The federal tax benefit of the cumulative net operating loss is
approximately $3.3 million which begins to expire in 2032, and is included in deferred
income taxes in the Consolidated Balance Sheet as of December 31, 2015.

We had a New Hampshire net operating loss in 2015 and 2014 in the amounts of
approximately $4.4 million and $2.9 million, respectively. The New Hampshire tax benefit of
the cumulative net operating loss is approximately $500,000 which begins to expire in 2022,
and is included in deferred income taxes in the Consolidated Balance Sheet as of December

31, 2015.

As of December 31, 2015 and 2014, we estimated approximately $476,000 and $476,000 of
cumulative federal alternative minimum tax credits that may be carried forward indefinitely
as a credit against our regular tax liability.

As of December 31, 2015 and 2014, we had New Hampshire Business Enterprise Tax
(“NHBET”) credits of approximately $369,000 and $369,000, respectively. NHBET credits
begin to expire in 2017. We anticipate that we will not fully utilize these NHBET credits
before they expire; therefore, we have recorded a valuation allowance related to these credits.
The valuation allowance increased by $369,000 in the year ended December 31, 2015.

Investment tax credits resulting from utility plant additions are deferred and amortized. The
unamortized investment tax credits are being amortized through the year 2033.

We had a regulatory liability related to income taxes of approximately $781,000 and
$803,000 as of December 31, 2015 and 2014, respectively. This represents the estimated
future reduction in revenues associated with deferred taxes which were collected at rates
higher than the currently enacted rates and the amortization of deferred investment tax

credits.

We made a review of our portfolio of uncertain tax positions. In this regard, an uncertain tax
position represents our expected treatment of a tax position taken in a filed tax return, or
planned to be taken in a future tax return, that has not been reflected in measuring income tax
expense for financial reporting purposes. As a result of this review, we determined that we
had no material uncertain tax positions. We will use tax planning strategies, if required, and
when possible, to avoid the expiration of any future net operating loss and/or tax credits.

We file income tax returns in the U.S. federal jurisdiction, the State of New Hampshire, and
the Commonwealth of Massachusetts. Our 2011 through 2014 tax years remain subject to
examination by the Internal Revenue Service. Our tax year 2009 was audited by the Internal
Revenue Service and the year was closed with no changes. Our 2009 through 2014 tax years
remain subject to examination by one or more state jurisdictions.

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Our practice is to recognize interest and/or penalties related to income tax matters in “Other,
Net” in the Consolidated Statements of Income. We incurred no interest in 2015 and 2014.
We incurred $3,000 and $0 of penalties during the years ended December 31, 2015 and 2014,

respectively.

Note 10 — Debt

Long-term debt as of December 31, 2015 and 2014 consisted of the following:

(in thousands) 2015 2014
Unsecured note payable to City of Nashua, 5.75%,
due 12/25/2041 $ 112,864 $ 114,651
Unsecured senior note payable due to an insurance company
7.40%, due March 1, 2021 4,400 4,800
Unsecured Business Finance Authority:
Revenue Bonds (Series 2015A), interest rates from 4.00% to 5.00%, 20,555 -
due January i, 2046
Revenue Bonds (Series 2015B), 5.00%, due January 1, 2046 2,035 -
Revenue Bonds (Series 2014A), interest rates from 3.00% to 4.125%,
due January 1, 2045 41,885 41,885
Revenue Bonds (Series 2014B), 4.50%, due January 1, 2045 5,300 5,300
Revenue Bonds (2005 Series BC-4), 5.375%, due October 1, 2035 - 12,125
Revenue Bonds (2005 Series BC-3), 5.00%, due April 1, 2018 - 7,475
Revenue Bonds (2005 Series A), 4.70%, due October [, 2035 - 12,100
Revenue Bonds (Series 2005A), 4.70%, due January 1, 2035 - 1,765
Revenue Bonds (Series 2005B), 4.60%, due January 1, 2030 - 2,310
Revenue Bonds (Series 2005C), 4.50%, due January 1, 2025 - 1,175
Revenue Bonds, 1997, 6.30%, due May 1, 2022 - 2,600
Unsecured notes payable to bank, floating-rate, due March i, 2030 3,523 3,708
Unsecured notes payable to bank, 3.62%, due June 20, 2023 1,570 1,633
Unsecured notes payable to bank, 4.25%, due June 20, 2033 848 880
Unsecured notes payable to bank, 4.90%, due March 6, 2040 616 -
Unsecured New Hampshire State Revolving Fund (“SRF”) notes (1) 16,576 12,152
Total long-term debt 210,172 224,559
Less current portion (4,120) (26,275)
Less original issue discount - (252)
Total long-term debt, net of current portion $ 206,052 $ 198,032

(1) SRF notes are duc through 2035 at interest rates ranging from 1% to 4.488%. These notes are payable in 120 to 240
consecutive monthly installments of principal and interest. The 1% rate applies to construction projects still in process
until the earlier of (i) the date of substantial completion of the improvements, or (ii) various dates specified in the note
(such earlier date being the interest rate change date). Commencing on the interest rate change date, the interest rate
changes to the lower of (i) the rate as stated in the note or (ii) 80% of the established 11 General Obligations Bond

Index published during the specified time period before the interest rate change date,

The aggregate principal payment requirements subsequent to December 31, 2015 are as
follows:

{in thousands) Amount

2016 $ 4,120
2017 4,952
2018 5,180
2019 5,416
2020 5,680
2021 and thereafter 184,824
Total $ 210,172

Several of Pennichuck Water’s loan agreements contain a covenant that prevents Pennichuck
Water from declaring dividends if Pennichuck Water does not maintain a minimum net
worth of $4.5 million. As of December 31, 2015 and 2014, Pennichuck Water’s net worth
was $124.6 and $127.8 million, respectively.

On December 15, 2014, Pennichuck Water issued tax-exempt Series 2014A (AMT) bonds
and taxable Series 2014B bonds, in the amounts of $41,885,000 and $5,300,000,
respectively. The Series 2014A bonds, which were issued at a premium of approximately
$1.9 million, include money raised to finance capital projects for the years 2014 through
2016 in the amount of $19.5 million, the refinance and refunding of the Series 2005C, Series
BC-3, Series BC-4 and 1997 bonds (collectively the “refinanced bonds”) included in the
table above in the amount of $23.375 million, and the cost of issuance associated with this
new series of debt obligations. The refinanced bonds are offset in total by the amount of cash
held in the Restricted Cash — Bond Refund Escrow account, as fully described in Note 1 to
these financial statements. The associated bond premium for the Series 2014A bonds is being
amortized over the lives of the underlying bond obligations. The Series 2014 bonds, which
were issued at par, includes $5.1 million to reimburse Pennichuck Water for capital projects
completed in calendar year 2013 and January 2014, and originally funded from working
capital or line of credit borrowings from the Company’s bank, as well as the associated cost
of issuance for this series of bonds. The cost of issuance associated with both the Series
2014A and Series 2014B bonds is being amortized over the 30-year life of the debt

obligations.

On October 27, 2015, Pennichuck Water issued tax-exempt Series 2015A (AMT) bonds and
taxable Series 2015B bonds, in the amounts of $20,555,000 and $2,035,000, respectively.
The Series 2015A bonds, which were issued at a premium of approximately $1.3 million,
include money raised to finance capital projects for the years 2015 through 2017 in the
amount of $7.5 million, the refinance and refunding of the Series 2005A, Series 2005B, and
Series A bonds (collectively the “refinanced bonds”) included in the table above in the
amount of $16.2 million, and the cost of issuance associated with this new series of debt
obligations. The refinanced bonds are offset in total by the amount of cash held in the
Restricted Cash - Bonds Refund Escrow account, as fully described in Note 1 to these
financial statements. The associated bond premium for the Series 2015A bonds is being

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amortized over the lives of the underlying bond obligations. The Series 2015A bonds, which
were issued at a premium, include $5.1 million to construct a new operations facility in 2016.
The $222,000 cost of issuance associated with both the Series 2015A and Series 2015B
bonds is being amortized over the 30-year and [5-year life of the debt obligations.

These bonds were issued under a new bond indenture and loan and trust agreement, which
contains certain covenant obligations upon Pennichuck Water, which are as follows:

Debt to Capital Covenant - Pennichuck Water cannot create, issue, incur, assume or
guarantee any short-term debt if (1) the sum of the short-term debt plus its funded
debt (“Debt”) shall exceed 85% of the sum of its short-term debt, funded debt and
capital stock plus surplus accounts (“Capital”), unless the short-term debt issued in
excess of the 85% is subordinated to the Series 2014 bonds. Thereby, the ratio of
Debt to Capital must be equal to or less than 1.0. As of December 31, 2015 and 2014,
Pennichuck Water Works has a Debt to Capital Coverage ratio of 0.4 and 0.4,
respectively.

All Bonds Test - Additionally, Pennichuck Water cannot create, issue, incur, assume
or guarantee any new funded debt, if the total outstanding funded debt (“Total Funded
Debt”) will exceed the sum of MARA (as defined in Note 12 of these consolidated
financial statements) and 85% of its Net Capital Properties (‘MARA and Capital
Properties”), and unless net revenues or EBITDA (earnings before interest, taxes,
depreciation and amortization) shall equal or exceed for at least 12 consecutive
months out of the 15 months preceding the issuance of the new funded debt by
1.1 times the maximum amount for which Pennichuck Water will be obligated to pay
in any future year (“Max Amount Due”), as a result of the new funded debt being
incurred. Thereby, the ratio of Total Funded Debt to MARA and Capital Properties
must be equal to or less than 1.0; as of December 31, 2015 and 2014, this coverage
ratio was 0.4 and 0.5, respectively. Also, the ratio of EBITDA to the Max Amount
Due must be equal to or greater than 1.1; as of December 31, 2015 and 2014, this
ratio was 1.6 and 4.0, respectively.

Rate Covenant Test - If during any fiscal year, the EBITDA of Pennichuck Water
shall not equal at least 1.1 times all amounts paid or required to be paid during that
year (“Amounts Paid”), then the Company shall undertake reasonable efforts to
initiate a rate-making proceeding with the NH Public Utilities Commission, to rectify
this coverage requirement in the succeeding fiscal years. Thereby, the ratio of
EBITDA to Amounts Paid must be equal to or greater than 1.1; as of December 31,
2015 and 2014, the Rate Covenant coverage ratio was 2.10 and 3.52, respectively.

Pennichuck East’s loan agreement for its unsecured notes payable to a bank of $6.5 million
and $6.2 million at December 31, 2015 and 2014, respectively, contains a minimum debt
service coverage ratio requirement of [.25. At December 31, 2015 and 2014, this ratio was
1.64 and 1.83, respectively. Also, Pennichuck East is required to maintain a maximum ratio
of total debt to total capitalization of 65%; at December 31, 2015 and 2014, this ratio was

50% and 44%, respectively.

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The Company’s revolving credit loan facility with TD Bank contains a covenant that requires
the Company to maintain a minimum fixed charge coverage ratio of at least 1.0; at December
31, 2015 and 2014, the fixed charge coverage ratio was 1.07 and 1.12, respectively. The
Company is also required to maintain an equity capitalization ratio of not less than 35%; at
December 31, 2015 and 2014, the equity capitalization ratio was 37% and 41%, respectively.

Under this agreement, the Company is also precluded from declaring or paying dividends, or
making any other payment or distribution of its equity without the bank’s prior written
consent, except for: (1) its obligations under Rate Order No. 25,292 as it pertains to the
Company’s specific obligations under the City Bond Fixed Revenue Requirement
(“CBFRR”) which provides for payments of approximately $707,000 per month of the note
payable to the City of Nashua (the “City”), and quarterly dividends to the City for the
remainder of this annual obligation, as defined by the order; and (2) a specific allowance,
under Rate Order No. 25,292, whereby the Company is allowed to make distributions to the
City from current earnings and profits in excess of the CBFRR, to provide funds to allow the
City to reimburse itself for the costs incurred by the City relating to its efforts in pursuing the
eminent domain proceedings from January 2002 through August 2009; provided, however,
that such amount shall not exceed $500,000 in any fiscal year, or $5,000,000 in the
aggregate, of all such distributions. No special dividend was declared or paid in 2015 or

2014.

Our short-term borrowing activity under this revolving credit loan facility for the years ended
December 31, 2015 and 2014 was:

(in thousands) 2015 2014

Established line as of December 31, $ 10,000 $ 10,000
Maximum amount outstanding during period 229 5,446
Average amount outstanding during period 1 2,833
Amount outstanding as of December 31, - -

Weighted average interest rate during period 2.01% 0.10%
Interest rate as of December 31, 1.981% 1.981%

As of December 31, 2015 and 2014, we had a $3.5 million and $3.7 million, respectively,
interest rate swap which qualifies as a derivative. This financial derivative is designated as a
cash flow hedge. This financial instrument is used to mitigate interest rate risk associated
with our outstanding $3.5 million loan which has a floating interest rate based on the three-
month London Interbank Offered Rate (“LIBOR”) plus 1.75% as of December 31, 2015. The
combined effect of the LIBOR-based borrowing formula and the swap produces an “all-in
fixed borrowing cost” equal to 5.95%. The fair value of the financial derivative, as of
December 31, 2015 and 2014, included in our Consolidated Balance Sheets under “Other
Liabilities and Deferred Credits” as “Derivative instrument” was $548,000 and $583,000,
respectively. Changes in the fair value of this derivative were deferred in accumulated other
comprehensive income (loss).

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Swap settlements are recorded in the statement of income with the hedged item as interest
expense. During the years ended December 31, 2015 and 2014, $144,000 and $152,000,
respectively, was reclassified pre-tax from accumulated other comprehensive income (loss)
to interest expense as a result of swap settlements. We expect to reclassify approximately
$134,000, pre-tax, from accumulated other comprehensive income (loss) to interest expense
as a result of swap settlements, over the next twelve months.

Note 11 —- Accumulated Other Comprehensive Income

The following table presents changes in accumulated other comprehensive income by
component for the years ended December 31, 2015 and 2014:

Interest Rate Contract
(in thousands) 2015 2014
Beginning balance $ 180 = § 298
Other comprehensive income
before reclassifications (65) (209)
Amounts reclassified from
accumulated other
comprehensive income 86 91
Net current period other
comprehensive income 21 (118)
Ending balance $ 201s $ 180

The following table presents reclassifications out of accumulated other comprehensive
income for the years ended December 31, 2015 and 2014:

Amounts Reclassified Affected Line Item In
Details about Accumulated Other from Accumulated Other the Statement Where
Comprehensive Income Components Comprehensive Income Net Income is Presented
(in thousands) 2015 2014

Gain (loss) on cash flow hedges
Interest rate contracts $ 144 $ 152 Interest expense

(58) (61) Tax expense

Amounts reclassified from accumulated
other comprehensive income $ 86 | $ 9I Net of tax

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Note 12 — Transaction with the City of Nashua

On January 25, 2012, in full settlement of an ongoing Eminent Domain lawsuit filed by the
City of Nashua (“City”) and with the approval of the New Hampshire Public Utilities
Commission (“NHPUC”), the City acquired all of the outstanding shares of Pennichuck
Corporation (“Pennichuck”) and, thereby, indirect acquisition of its regulated subsidiaries.
The total amount of the acquisition was $150.6 million (“Acquisition Price”) of which
$138.4 million was for the purchase of the outstanding shares, $5.0 million for the
establishment of a Rate Stabilization Fund, $2.6 million for legal and due diligence costs,
$2.3 million for severance costs, $1.3 million for underwriting fees, and $1.0 million for
bond discount and issue costs. The entire purchase of $150.6 million was funded by General
Obligation Bonds (“Bonds”) issued by the City of Nashua. Pennichuck is not a party to the
Bonds and has not guaranteed nor is obligated in any manner for the repayment of the Bonds.
Pennichuck remains an independent corporation with an independent Board of Directors with
the City of Nashua as its sole shareholder.

Pennichuck Water Works, Inc. (““PWW”), Pennichuck East Utility, Inc. (“PEU”), Pittsfield
Aqueduct Company, Inc. (“PAC”), Pennichuck Water Service Corporation, and The
Southwood Corporation will continue as subsidiaries of Pennichuck Corporation and PWW,
PEU and PAC will continue as regulated companies under the jurisdiction of the New
Hampshire Public Utilities Commission. The terms of the merger and the requisite
accounting and rate-setting mechanisms were agreed to in the NHPUC Order 25,292 (“PUC
Order”) dated November 23, 2011.

Transactions with Related Party — City of Nashua

Pennichuck issued a promissory note to the City of Nashua in the amount of approximately
$120 million to be repaid over a thirty (30) year period with monthly payments of
approximately $707,000, including interest at 5.75%. Pennichuck recorded an additional
amount of approximately $30.6 million as contributed capital. The remaining outstanding
balance of the note payable to the City at December 31, 2015 and 2014 was approximately
$112.9 million and $114.7 million, respectively, as disclosed in Note 10 to these consolidated
financial statements. During 2015 and 2014, dividends of approximately $278,000 and
$277,000, respectively, were declared and paid to the City. The dividends paid to the City
during 2015 comprised approximately $278,000 of regular quarterly dividends declared and
paid; and no special dividend was declared or paid in 2015. The dividends paid to the City
during 2014 comprised approximately $277,000 of regular quarterly dividends declared and
paid, and no special dividend was declared or paid in 2014.

Additional ongoing transactions occur in the normal course of business, between the
Company and the City, related to municipal water usage, fire protection and sewer billing
Support services, and property taxes related to real property owned by the Company within
the City of Nashua. For the years ended December 31, 2015 and 2014, respectively,
approximately $3.1 million and $3.3 million were paid to the Company by the City for
municipal water consumption, fire protection charges, and sewer billing support services.
Conversely, the Company paid property taxes to the City of Nashua of approximately

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