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L RE PORT

ABOUT THE COMPANY

IES

IE Industries was formed on July 1,

1986. Its principal subsidiary is Iowa

Electric Light and Power Company. The

other subsidiaries include the Cedar

Rapids and Iowa City Railway Company,

Industrial Energy Applications, Inc., and

IEI Container Services Corp., formed in

1987. IE Industries also has a 27 percent

equity interest in Teleconnect Company.

Iowa Electric, in its 106th year of

operation, remains the primary source of

revenue and earnings for the holding

company. Iowa Electric provides electric,

natural gas, and steam energy for

about 275,000 residential, commercial,

and industrial customers in over

400 communities in Iowa and a few

communities in Nebraska.

3

1987 ANN

1 9 8 7 HIG H LIG H TS

Operating revenues (000's) ..................... Net incom e (000's) ............................ Earnings per average common share ............. Dividends declared per common share ........... Construction expenditures (000's) ............... Funds provided internally (000's) ............... Sales of electricity to customers (Kwh) (000's) .... Total gas delivered to customers

(dekatherm s) (000's) ........................ Number of common shareholders ............ Number of full-time employees .................

1987

$ 412,778 $ 34,076 $ 2.48 $ 1.99 $ 52,887 $ 34,042 4,418,005

27,291 27,414

1,591

1986

$ 429,245 $ 28,536 $ 2.13 $ 1.95 $ 42,618 $ 48,863

4,344,324

30,513 29,869

1,551

Percent Increase Increase

(Decrease) (Decfase)1

$(16,467) $ 5,540 $ .35 $ .04 $ 10,269 $(14,821)

73,681

(3,222) (2,455)

40

(4) 19 16 2

24 (30)

2

(11) (8) 3

Abo~ut the Comipany 3

I1987 Highlights 4

At First Glance 5

Chairmian's Letter 6

Year in Reviewo 8

Iowa Electric System- Map I I Diversified Businesses . 12

Management's Discussion and Analysis 14

Selected Consolidated Quarterly Financial Data 17 Auditors' Report 20

Consolidated Financial Statements 21

Notes to Consolidated Financial Statements 26

Selected Consolidated Financial Data 35 Electric Operating Com-parison 36

Gas Operating Comnparison 37

Directors & Officers 38

Shareholder Inform-ation 39

QUARTERLY HIGH, LOW AND CLOSING PRICES OF COMMON STOCK (DOLLARS) COMMON STOCK Quarterly common stock dividends of $.495 and $.485 were paid by the Company during 1987 and 1986, respectively. The Company's common stock is traded on the New York Stock Exchange. The accompanying chart shows the range of trading prices for the last two years.

27% 27% 28

26h 26-427

26

244 25

24%

24

24% 24

241A2423-N

23%

23

22

21

20

1986 High Closing a Low

4

1987

1987 ANN

YEAR IN REVIEW

FINANCIAL RESULTS The economic climate of our service territory

continues to improve. Reflecting that recovery, kilowatt-hour sales volumes from our principal subsidiary, Iowa Electric Light and Power Company, increased about 2 percent. Many manufacturing facilities in our area are operating at high capacity levels, signaling continued growth in 1988.

Net income in 1987 rose to $34.1 million from $28.5 million the year before. Earnings per share also increased, to $2.48 from $2.13. Earnings benefited by $0.34 per share from the effects of certain accounting changes. On the other hand, earnings were reduced by a one-time $3.6 million write-off of financing costs on a canceled coal plant.

The return on average common stock equity increased to 13.6 percent in 1987. For the 12th consecutive year, the cash dividend was increased.

Construction expenditures last year totaled $52.9 million, with internal funds providing 65 percent. We project construction spending this year to be approximately $53 million, with 70 percent of the funds generated internally. These levels should decline to about $47 million in 1989, and remain relatively stable into the early 1990s. Construction expenditures, for the most part, will be funded internally during the 1989 to 1992 period.

CORPORATE COMMITMENTS Customers. The automated Customer Service

Center made significant progress during 1987. It now handles all customer calls throughout the operating territory. Our aim is to be even more responsive to customers' needs, improving the value of the service provided to them. Customers can call toll-free, 24 hours a day, for any business, including routine service hook-ups, bill inquiries, and outage reports. Consultants are trained to answer a wide variety of questions on issues ranging from energy usage to pricing policy to general information about the Company.

We can point to several examples of our commitment to customers. In July, Iowa Electric conducted a survey to identify better ways to communicate with customers. As a result, we have incorporated new, more effective communication tools, including monthly customer newsletters. The survey also provided feedback on customer attitudes

and opinions about Iowa Electric. The survey indicated that our customers generally give us high marks for service. Seminars were conducted for large commercial and industrial electric and gas customers on topics such as electrical surge protection and transportation of gas. The Marketing Department developed a program of regular contacts with industrial customers to provide a feedback mechanism and to identify profitable sales opportunities.

Employees. Throughout the Company, employees participate in the planning and goal-setting process. Task forces are formed periodically to deal with major issues facing the Company. In 1987, the employee suggestion program generated 150 suggestions for cost saving measures. Monetary awards are given to employees who provide suggestions that are implemented.

Employees should be rewarded based on the performance of the Company. In 1987, we implemented a 401(k) savings plan, which rewards employees based on the Company's attainment of predetermined goals. Seventy-five percent of our employees are participating in the plan in 1988.

Communities. Economic development activities encompass the entire service territory. Our slogan is "IE Means Business." We think we do. Last year, 65 firms successfully located or expanded operations in our market area with our assistance. For example, Eastman Kodak announced it will build a $50 million biotechnology center in Cedar Rapids. Party Pac Popcorn increased its workforce in Marshalltown by moving product lines from Greenville, North Carolina. Rockwell International moved an automotive plant from Michigan to Fairfield, Iowa, bringing 140 jobs to that community. The positive pace continues this year. In February, Swift Independent Packing Co. announced a doubling of its pork processing plant in Marshalltown, creating 600 new jobs. To enhance these efforts, Iowa Electric is linking its Sales and Business Development Department via computer with community organizations within the service area. The computer system lists available buildings and sites for new business development.

Our community efforts are not restricted to economic development. To answer another community need, Iowa Electric became the first

8

L R EP 0 R T

significantly. Prospects for grain exports are good with the weaker dollar in international markets.

For the state as a whole, real personal income increased in both 1986 and 1987, after two years of decline. Non-farm employment increased about 2.5 percent, led by manufacturing, up 4.8 percent, and construction, up 7.6 percent.

The Board of Directors raised the common stock dividend to $2.02 per share, up from $1.98 per share a year ago. This is the 12th consecutive year of dividend increases. We hope the dividends will continue to increase in future years, however, we believe future dividends will be determined not only by performance of the core utility business but also by the results of our diversification program.

Our stock continues to be attractive to many investors. In -1987, of 101 utilities on the New York Stock Exchange, IE Industries ranked ninth for stock price performance. Our stock price reached a high for the year at $278 per share, just a fraction below our 21-year high of $274, which was

.recorded in 1986. During the year, the Iowa Electric Board of

Directors named three new officers: Richard W. McGaughy as Vice President, Production; Harold W. Rehrauer as Vice President, Engineering; and Thomas R. Seldon as Vice President, Human Resources. Dr. Samuel J. Tuthill, Senior Vice President, Technical Services, retired after having served the company with distinction for the past ten years.

Effective February, 1988, Walter E. Brown, President of Kiowa Corp., retired from the Board of Directors and was named Director Emeritus. We are grateful for his years of dedicated service on the Board. Replacing Mr. Brown is Dr. George Daly, Dean of the College of Business Administration at The University of Iowa.

We are committed to the aggressive, but prudent, growth of IE Industries. Our goals are to strengthen the core business and to become significantly more diversified. We have made significant progress in both areas. With a dedicated work force and continuing support from our shareholders, we look forward to another year of progress in 1988.

Sincerely,

Lee Liu

7

1987 ANN

CHAIRMAN'S LETTER

DEAR SHAREHOLDER: It was a good year in 1987!

* Electric sales continued to increase, with 4 percent growth for major manufacturers.

* Diversified investments posted significant gains, contributing 14 percent of total earnings compared to 11.5 percent in 1986.

* Earnings rose from $2.13 to $2.48 per share. * IE Industries' stock price outperformed 92 of

the 101 utilities listed on the New York Stock Exchange.

* The economy in Iowa showed marked improvement. The theme of this year's annual report, "Serving

the Future with a New Energy," was carefully selected and conveys an important dual message:

* It reflects a concerted program of proactive management and aggressive marketing of our utility businesses. These businesses will have a strong competitive orientation, strategically seeking growth opportunities in a changing energy market.

* It reflects a well-conceived diversification program designed to achieve returns greater than those in our traditional regulated business. This requires us to focus on synergistic diversification opportunities with strong management teams. We have completed the first full year of

operation in the holding company, and we are encouraged by the progress made in our diversified businesses. Teleconnect Company's earnings increased dramatically and the Cedar Rapids and Iowa City Railway Company continued to post strong earnings.

Other business development also took place in 1987 at a targeted pace. IE1 Container Services Corp., a Cedar Rapids based wholly-owned subsidiary, became operational, offering a broad range of services in rail car cleaning and repair.

A new business plan has been developed and implemented for Industrial Energy Applications, Inc. Its goal is to expand the operation from local standby generators to the national cogeneration market, through a new joint venture with Brown Engineering Company.

We are also pleased with our investment in Teleconnect Company, one of the fastest-growing telecommunications companies in the nation. Our

additional $2 million investment in 1987 enables us to retain our position as its largest shareholder with a 27 percent equity interest.

The actions taken in business expansion followed a well-defined strategic plan with a goal to generate half of our earnings from non-utility businesses in ten years. We have made substantial progress in 1987, and we are prepared to make additional financial commitments on an annual basis in future years.

As we implement this long-range corporate strategy, we recognize that our utility business must remain strong, competitive, and financially healthy. The results of the cost containment efforts over the past three years have helped us in stabilizing energy prices. We plan to continue with a disciplined cost containment program to help us maintain our competitive position at the market place.

Cost control is essential to our success, but responsiveness to customers is equally important. Our state-of-the-art Customer Service Center now centralizes all service calls 24 hours a day. Field operation has also been streamlined with wellqualified service personnel at 18 commercial offices. Electronic meter reading was implemented to speed up the billing process with higher accuracy and lower costs. Management information systems, particularly useful for budget control and communication networking, provide state-of-the-art tools for employees to make appropriate decisions.

The core utility business will not succeed through cost containment alone. Our business plan also includes an aggressive strategy to increase sales. The major ingredients for success are now in place: prices are fully cost-based; marketing programs focus on opportunities and customer responsiveness; economic development initiatives are intensifying.

Success is evident! Some 3,000 jobs in our service territory have been created or retained. Encouraging results are pouring in from many cities in our service territory. Electric sales have increased at two to three percent for the last two years, with the major industrial customers setting the pace at four percent.

The economy in Iowa is also recovering. Agricultural sector indicators show substantial

improvement. Land prices were up 11 percent in 1987 reflecting optimism in the future of farming. Commodity prices for grains have improved

6

L RE PORT

AT FIRST GLANCE

IE Industries Inc. (Industries) was formed in July, 1986, to accelerate diversification outside the utility business.

Principal subsidiary, Iowa Electric Light and Power Company (Iowa Electric), provides electric, natural gas and steam energy to about 275,000 residential, commercial and industrial customers in more than 400 communities, primarily in Iowa.

Diversified businesses include: * Teleconnect Company. IE Industries holds a

27 percent equity interest in this fast-growing telecommunications company.

* Cedar Rapids and Iowa City Railway Company (CRANDIC). This wholly-owned subsidiary is well positioned for increased rail traffic and profitable growth.

* IEI Container Services Corp. Our newest venture cleans, repairs, and paints railroad cars with stateof-the-art technology. It is a promising, natural adjunct to our transportation business.

* Industrial Energy Applications, Inc. IEA owns and operates standby generating units. Its joint venture subsidiary, EnDYNA Power Corp., is positioned for significant penetration into the national cogeneration market.

Diversification Guidelines * Investments should have the potential of earning

a return on equity in excess of that allowed by the utility business.

* Investments should feature strong management teams.

* IE Industries wants to be actively involved in the business strategy of the ventures, not merely accumulating a portfolio of passive investments.

* Synergistic investments are targets, including telecommunications, transportation-related areas and businesses complementary with the electric, gas, and steam operations.

* Investments will preferably impact positively on Iowa's economy and, therefore, on our core business.

* IE Industries will avoid capital intensive investments that will dilute its basic earnings power.

Long-term Strategy * Utility Price Increases. Increases, on a cumulative

basis, should be less than the rate of inflation to maintain and improve our competitive position. Cost containment and demand-side load management will contribute to the attainment of this goal.

* Gas and Steam Operations. The gas and steam operations will continue to be aggressively managed to take advantage of opportunities created in these rapidly changing markets. Expansion possibilities will be pursued in both markets.

* Marketing and Economic Development Program. Concerted efforts to expand existing businesses and to attract new businesses to our service area will strengthen the core business.

* Diversification Effort. IE Industries aims for a significant earnings contribution from diversified businesses, with a target of 50 percent of corporate profits coming from the diversified enterprises within 10 years.

* Dividend Policy. The level of dividend increases in the future will reflect not only the performance of the core utility business, but also the opportunities and successes of the diversified businesses.

* Higher Stock Value. Successful implementation of this strategy should, over the long term, increase shareholder value.

5

0

SL REPORT

utility in Iowa to participate in the "Gatekeeper" program. This project, sponsored by mental health and senior citizen agencies, is targeted specifically at problems of the elderly or mentally handicapped. Meter readers and linemen are trained to report anything that looks suspicious to the authorities, soassistance can be provided.

Shareholders. As always, we recognize it is our responsibility to maximize shareholder value. The primary purpose of our diversification efforts is to register higher returns than from the utility business. In 1987, Industries' stock outperformed all but 8 out of 101 utilities on the New York Stock Exchange, reflecting investor expectations of this company.

9

I

1987 ANN

IOWA ELECTRIC LIGHT AND POWER COMPANY

Iowa Electric Light and Power Company is the principal subsidiary of IE Industries. Iowa Electric provides electric, natural gas and steam energy to about 275,000 customers, located primarily in Iowa. Our generation mix remains well balanced. In 1987, fossil units represented 63 percent of generating and purchased power capacity; nuclear, 37 percent. Our pipeline suppliers for natural gas are Northern Natural Gas Company, Natural Gas Pipeline Company of America, and ANR Pipeline Company.

Iowa Electric has consistently stressed demandside load management, earning recognition as a national leader in time-of-day and interruptible service pricing. More than 90 percent of industrial sales are on time-of-day pricing. Over 10 percent of our peak load is interruptible. We also have implemented a seasonal pricing policy. These three programs have produced a total load savings in the

ELECTRIC CAPABILITY AND SYSTEM PEAK LOAD Iowa Electric's 1987 peak load of 978,322 kilowatts occurred on July 30. Its additional reserve obligation was 146,748 kilowatts. Available generating capability at that time was 1,01g,650 kilowatts, supplemented by 90,000 kilowatts of purchased capability.

In thousands of kilowatts

1,200

1,000

800

600

400

200

Capability-Purchased Capability-Generated

* Summer peak * Winter peak

150 to 200 megawatt range, equivalent to plant expansion costing in excess of $200 million.

Because of these and other efforts, we do not see the need for the construction of major generating facilities within the next decade. This will keep our capital requirements relatively modest.

ELECTRIC OPERATIONS Electric revenues rose in 1987 to $303.5 million,

from $285.4 million in 1986. These figures reflect higher sales volumes and the impact of the 1986 electric rate increase for the entire year of 1987.

In April, 1987, our first electric rate case in three years was decided. We had sought an increase of $43.9 million and were awarded $25.1 million. Significantly, we received favorable treatment on two key issues. First, the Iowa Utilities Board permitted recovery of buy out costs for two coal contracts canceled in 1984 and 1985. Second, the Board also allowed partial recovery of costs associated with canceling a major coal-fired plant in Guthrie County.

Even with price increases, cost control measures have allowed electric pricing to lag behind increases in the Consumer Price Index since 1983. This is a significant accomplishment. Our longer-term goal is even more aggressive. In order to remain competitive, we plan to keep cumulative price increases to no more than 50 percent of the inflation rate, while still maintaining our desired earnings level.

The gain in kilowatt-hour sales in almost all customer categories last year is a reflection of the growing strength of the Iowa economy. Industrial sales were up 3.1 percent; commercial, 2.2 percent; and residential, 1.4 percent. Our system capacity remains adequate to handle the increased sales.

Our largest electric customer, Archer-DanielsMidland, is constructing cogeneration facilities. While the ultimate impact is uncertain, it will marginally reduce electric profitability.

GAS OPERATIONS In 1984, we decided to encourage major

customers to purchase their own natural gas for transportation through our system. If successful, this strategy would promote gas flow through the system, improve margins, and make the gas business even more competitive with other fuels.

10

L RE PORT

The results of that strategy became apparent in 1987. Some customers switched to transportation services for their own gas. This, in addition to lower gas prices and mild weather, resulted in lower natural gas revenues for the year. However, the volumes either sold or transported, when adjusted for weather, actually increased for the first time in a decade.

This gas strategy of focusing on volumes transported, rather than sales, is working. Major customers have a choice between conventional gas supplies and their own gas purchases. As a result, we are able to maintain and, in many cases, improve margins while providing choices and lower prices to many customers.

The natural gas business is one that offers new challenges and opportunities. We are encouraged by the progress of our innovative gas transportation

business. We have in place an effective management organization, capable of achieving maximum profitability and results. This organization will be attentive to opportunities to expand these gas operations. Last year, we sold the Fairmont, Minnesota gas operation, which had only 4,500 customers and did not fit into our long-term growth plans.

STEAM OPERATIONS We continue to identify and exploit opportunities

with our Cedar Rapids steam business. As a result, profits continue to improve, primarily due to sales to new customers such as National Oats. Future committed customers include Eastman Kodak and its new biotechnology plant. Several major industrial firms are currently strong candidates for the profitable expansion of the steam business.

IW: SYSTEM MAPV

Electric Commercial Offices

0 Gas Commercial Offices

0 Gas and Electric

Commercial Offices

[O Electric Generating

Plants

1987 AN N

DIVERSIFIED BUSINESSES

TELECONNECT COMPANY Teleconnect is undoubtedly our most exciting

investment. We hold a 27 percent equity interest in this highly innovative telecommunications company. IE Industries has two seats on the Teleconnect Board of Directors.

Teleconnect, which is headquartered in Cedar Rapids, has been cited by Inc. magazine for three consecutive years as one of the nation's fastest growing private companies.. Its track record is impressive. The company began in 1980 with three people primarily selling telephone systems. In 1982, the company began providing long-distance services. The next year, a telemarketing operation was launched. In 1985, Teleconnect designed and marketed its own phone system. A year later, it published its first telephone directory.

Effective marketing skills have made Teleconnect a leader in several growth areas, including fiber optics. It is fast becoming a major player in this attractive field. Through its fiber optic network, Teleconnect has entered selected national markets

from Pittsburgh to Los Angeles and from Minneapolis to Dallas.

Teleconnect's digital network allows customers to communicate clearly from coast to coast. In fact, Teleconnect has a higher percentage of calls on digital facilities than any other long-distance company. The network is continually expanding to provide even better service.

Employment currently exceeds 1,700. Plans are to expand that number considerably in 1988, mainly in the Cedar Rapids area.

CEDAR RAPIDS AND IOWA CITY RAILWAY COMPANY

Our rail subsidiary, CRANDIC, has been an excellent investment. In recent years, we have achieved sizable increases in both line-haul and switching revenues. Importantly, CRANDIC is solidly in the black, with strong net margins. Over the past five years, revenues have grown from $7.5 million to $10.3 million in 1987, while earnings were up 50 percent, from $2.0 million to $3.0 million.

L R E P 0 R T

The railroad's success is due to its strategic location and to the growth of area industry. Unquestionably, the continuing expansion of food processors in our service territory bodes well for CRANDIC's long-term prospects. Last year, the railroad improved the rail line to Amana, Iowa, and began operations on that line. This opened new avenues for the transport of coal, limestone and raw materials for manufacturing.

CRANDIC's outlook for 1988 is healthy. The railroad should have another excellent year, aided by new freight contracts and a steady increase in other traffic.

IEI CONTAINER SERVICES CORP. Our newest subsidiary, IEI Container Services, is

a natural extension of the transportation business. This highly automated operation, located in Cedar Rapids, washes and repairs railroad cars, specializing in sanitizing the insides of rail cars used to haul food and food products. Container Services has little local competition. In fact, no company in the Midwest can match the state-of-the-art technology used in cleaning cars and recovering waste. The high concentration of local grain and food processors should provide a strong market for the cleaning and repair business.

Container Services should be profitable in 1988, an impressive start for a new business.

INDUSTRIAL ENERGY APPLICATIONS, INC. Now over three years old, IEA is in the process

of moving from the development stage. The subsidiary's initial focus has been installing and operating standby generating units. These standby facilities offer excellent cost reduction opportunities for large commercial and industrial customers, supplying low-cost capacity during times of interruption.

Now, however, IEA is expanding its horizons. Through its joint venture subsidiary, EnDYNA Power Corp., IEA plans to compete in the cogeneration business nationwide.

~4'

~ -J

w ~I

NET INCOME FROM MAJOR UNREGULATED INVESTMENTS The net income of Cedar Rapids and Iowa City Railway Company and Teleconnect Company increased 43o in 1987 to $4,700,000.

In thousands of dollars

5,000

4,000

3,000

2,000

1,000

13

1987 ANNI

MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION

ELECTRIC SALES Electric sales increased 2% from ig86 to 4,418,005,000 kilowatt-hours. Residential sales increased i% and rural sales decreased 9%. Commercial sales increased 2% while industrial sales increased 3%. Sales for resale and other increased 2%. The 5-year historical average growth rate is 2%.

In millions of kilowatt-hours

4,500

4,000

3,500

3,000

2,500

2,000

1,500

Sales for resale & other Industrial

* Commercial * Residential and rural

FUEL COST Coal prices decreased 9 percent in 1987 following a 24 percent decrease in both 1986 and 1985 as the result of the termination of two long-term coal contracts.

Per million Btu's burned

$3.00

2.50

2.00

The following discussion analyzes changes in the components of net income during the calendar years 1985 through 1987 for IE Industries and its wholly-owned subsidiaries (the Company).

RESULTS OF OPERATIONS The results of operations for 1987 were affected by two

changes in accounting principles. In 1987, Iowa Electric began recording revenue for service rendered but unbilled at month-end. The cumulative effect as of January 1, 1987 of recording unbilled revenues was an increase in net income of $6,894,000. This change in method of accounting for revenues decreased 1987 electric operating revenues by $602,000 and increased 1987 gas operating revenues by $304,000. (See Consolidated Statements of Income.)

In a 1987 Order issued by the Iowa Utilities Board (IUB) in connection with Iowa Electric's electric rate case, the IUB disallowed $5.2 million of allowance for funds used during construction which had been recorded for the cancelled Guthrie County generating station. The disallowed AFC, net of an amount reserved in prior years, was written-off and is reflected in "Interest expense and other - Miscellaneous, net." The Order did allow recovery of the remaining costs associated with cancelled projects, but without rate base treatment. In accordance with SFAS No. 90, Iowa Electric recorded an adjustment in 1987 of $2,347,000, net of income taxes, to discount the future revenues associated with such recoverable costs. Such amount is reflected in the Consolidated Statements of Income as a change in accounting principle. (See Consolidated Statements of Income.)

Electric revenues changed due to the following factors:

Electric Revenues Increase (Decrease)

from Prior Year 1987 1986 1985

Rate increases..........$ 11.3 Recovery of fuel costs . 3.. .4 Kwh sales and other ..... 3.3

$ 18.0

(in millions) $ 10.3 $

(17.1) 1.7 0.6 (7.6)

$ (6.2) $ (5.9)

Average 2 Nuclear

Overall electric sales (in Kwh) ........ . 1.7% 3.6% (0.3)%

As indicated in the above table, electric revenues increased significantly during 1987 but decreased during both 1986 and 1985. The increase in 1987 was primarily due to an increase in electric rates. Increased rates were placed into effect in July, 1986 on an interim basis and May, 1987 on a final basis. Partially offsetting the

14

.50

Coal

LL REPORT

increase was an electric tariff decrease, effective July 1, 1987, filed with the IUB in order to reflect the effects of the Tax Reform Act of 1986.

Iowa Electric has an electric energy adjustment clause (EAC) which is designed to currently recover the costs of fuel and the energy portion of purchased power in billings to customers. The primary reason for the decrease in 1986 revenues was the recovery of lower purchased power and fuel costs through the EAC, partially offset by the interim electric rate increase referred to above.

Further contributing to the decline in revenues during 1986 and also in 1985 was the effect of an industrial price reduction in July, 1985 and the impact of customers changing to time-of-day and interruptible rates.

The 1985 decrease in electric revenues was also attributable to changes in sales mix. While overall sales of electricity decreased only 0.3% during 1985, revenues were adversely impacted by a shift in sales from residential and rural customers (at higher unit prices) to industrial customers (at lower unit prices).

Gas revenues changed due to the following factors:

Rate increases ......... Recovery of gas costs . . . Sales and other ........

Overall gas sales (in therm s) ...........

Gas Revenues Increase (Decrease)

from Prior Year 1987 1986 1985

(in millions) $ 0.5 $ 1.1 $

(29.6) (27.5) (5.4) (5.9) (3.4) (3.5)

$(35.0) $(29.8) $ (8.9)

(23.4)% (12.1)% (2.0)%

Iowa Electric's gas tariffs include clauses designed to reflect changes in the cost of gas purchased for resale on a current basis. Gas revenues decreased for each of the three years primarily due to reductions in the cost of gas purchased. Decreases in gas sales also contributed to the decrease in revenues.

Gas margins (revenues less cost of gas purchased and the change in the PGA balance) were $20,224,000, $25,905,000 and $20,782,000 for the years 1987-1985, respectively. Mild weather had a significant impact on the 1987 margin.

In 1987, Iowa Electric transported gas for certain industrial customers who purchased their gas directly from pipeline suppliers. In most instances, the fees for transporting this gas maintained previous gas margins. The decrease in gas volumes was only 11% in 1987 when including these transported volumes.

GAS SALES Gas sales in ig87 totaled 22,851,000 dekatherms, a 23% decrease from ig86. However, total volumes delivered, including transported volumes, were 27,291,000 dekatherms, an Ix% decrease from 1986. Residential and commercial sales both decreased 16%. Industrial sales decreased 38% but industrial volumes delivered, including transported volumes, decreased only x%.

In millions of dekatherms

35

30

25

20

15

10

5

YEAR-END CAPITALIZATION The Company's capitalization ratios for the last five years are presented below. These ratios are consistent with the Company's long-term capital structure objectives.

In millions of dollars

550

500 43

450

400

350 11 300

250

200

150

100

5,0

15

Transported volume Industrial

* Commercial U Residential

4543 46

47

11 104

Common equity Preferred and preference stock V Long-term debt

1987 ANNI

Fuel for production decreased during 1987 and 1986. Although the cost of coal decreased approximately $3,600,000 and $11,000,000 in 1987 and 1986, respectively, the decrease in 1987 was offset by the amortization of coal contract termination costs and increased use of fossil-fueled generation. The 1986 decrease was offset by increased usage of coal and nuclear fuel for generation.

Purchased power costs increased during 1987 primarily as the result of energy purchases made during the refueling outage at the Duane Arnold Energy Center (DAEC) and decreased sales to other utilities. A reduction in the cost of capacity purchases under a long-term purchased power contract partially offset the other items.

Purchased power costs decreased in 1986 primarily due to decreases in energy purchases and increases in sales to other utilities. Cheaper fuel costs allowed Iowa Electric to generate more of its needs as well as to sell more power.

Combined other operation and maintenance expenses increased during 1987 and 1985. Such increases resulted primarily from higher costs incurred at the DAEC during the refueling outage in both years. Also contributing to the increase in 1985 were increased costs associated with leasing generating facilities.

Combined other operation and maintenance expenses decreased during 1986 because of cost control measures implemented. by the Company and reduced costs at the DAEC. Partially offsetting such decreases were increases in insurance premiums and computer equipment costs.

Depreciation expense decreased in 1987 primarily due to changing the estimated useful life of the DAEC from 28 to 36 years. This decrease was partially offset by the provision for decommissioning.

Income from stock transactions of affiliate is explained in Note 1(c) of the Notes to Consolidated Financial Statements.

Changes in income taxes for the three years are primarily related to a 1987 reduction in the Federal statutory income tax rate from 46% to 40% and changes in taxable income. See Note 3 for a detailed discussion of income tax matters, including a discussion of SFAS No. 96, Accounting for Income Taxes, released by the Financial Accounting Standards Board in December, 1987.

LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity is affected principally

by the utility's construction program, by capital requirements relating to maturing debt, reacquisition of securities and sinking fund requirements and by its diversification activities. The capital resources available to meet these requirements are funds from both internal generation and external financing. Internally generated funds depend on economic conditions and the adequacy of timely rate relief for Iowa Electric. Access to the long-term

and short-term capital and credit markets is necessary for obtaining funds externally.

CONSTRUCTION PROGRAM The percentages of construction expenditures provided

from internally generated funds were 65%, 100% and 72% for the years 1987-1985, respectively. Construction expenditures for 1988 are expected to approximate $53,000,000, with 70% of the funds expected to be internally generated. The levels of construction are expected to decline by 10% in 1989 and then remain relatively stable into the 1990's. It is estimated that substantially all construction will be funded with internally generated funds for the four year period 1989-1992.

LONG-TERM FINANCING The Company will have $96,393,000 of total debt

maturities and sinking fund requirements before 1993, including maturities of four First Mortgage Bond issues aggregating $81,790,000. Included in this amount is $35,000,000 relating to the Series V Bonds which mature April 1, 1988. In March, 1988, Iowa Electric plans to privately place a new First Mortgage Bond issue in the amount of $50,000,000. The proceeds will be used to retire the Series V Bonds and repay commercial paper. An additional issuance of First Mortgage Bonds is contemplated during the second half of 1988 depending on market conditions. Iowa Electric would use such proceeds to redeem certain high-cost securities prior to the stated maturity dates.

The Indenture pursuant to which Iowa Elctric's First Mortgage Bonds are issued contains covenants restricting the amount of additional bonds which may be issued thereunder. At December 31, 1987, the most restrictive limitations would have permitted Iowa Electric to issue $107,000,000 of First Mortgage Bonds.

The Articles of Incorporation of Iowa Electric authorize and limit the aggregate amount of additional shares of Cumulative Preferred Stock and Cumulative Preference Stock which may be issued. Under the applicable limitations, at December 31, 1987 Iowa Electric could issue shares significantly in excess of the number of shares currently authorized for both classes of stock.

SHORT-TERM FINANCING For interim financing, Iowa Electric is authorized by the

Federal Energy Regulatory Commission to issue up to $75,000,000 of short-term notes, of which a maximum of $65,000,000 can be in the form of commercial paper. This availability of short-term financing provides Iowa Electric flexibility in the issuance of long-term securities.

At December 31, 1987, Iowa Electric had lines of credit aggregating $51,100,000. Additionally, Industries had a $10,000,000 line of credit.

16

L REPORT

Under the rate making principles prescribed by the regulatory commissions to which Iowa Electric is subject, only the historical cost of plant is recoverable in revenues as depreciation. As a result, Iowa Electric has experienced a loss equivalent to the current year's impact of inflation on utility plant.

In addition, the regulatory process imposes a substantial time lag between the time when operating and capital costs are incurred and when they are recovered. During periods

of inflation, this lag, coupled with rates based on historical costs and inadequate rates of return allowed on common equity, produce revenues which do not recover the cost, in terms of purchasing power, of the productive facilities used to provide services to current customers. While the inflation gain related to debt and preferred stock financing reduces the effect of this loss, the common shareholders still experience a net erosion in their investment due to inflation. Since 1984, the inflation rate has ranged from 4% to 1%.

SELECTED CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED) The following unaudited consolidated quarterly data, in the opinion of the Company, includes all adjustments necessary

for the fair presentation of such amounts.

March 31

1987 R even u es .. .. . . .. .. . .. .. . .. .. .. .. .. .. .. .. . .. . .. . O perating incom e ................................ Income before cumulative effects of changes

in accounting principles .......................... Cumulative effects of changes in accounting

principles .... .............................. Net income ................................ Earnings per average common share before cumulative

effects of changes in accounting principles .......... Cumulative effects of changes in accounting

principles ... ............................... Earnings per average common share ................

1986 R even u es .. .. .. .. . . .. .. .. .. .. . .. .. .. .. . .. .. .. . .. O perating incom e ................................ N et incom e ..................................... Earnings per average common share .................

Because the Iowa Electric results of operation are a significant portion of the consolidated results, the above amounts are affected by seasonal weather conditions and the timing of utility rate increases.

During the four quarters of 1987, electric kilowatthour sales increased (decreased) (4.7)%, 6.8%, 6.5% and (1.4)% compared to the prior year. These sales were influenced by the mild 1986-1987 winter heating season and the hotter than normal summer cooling season.

$105,271 17,479

5,225

4,547 9,772

0.38

0.34 0.72

$130,215 19,018 6,948

0.52

Quarter Ended June 30 September 30

(in thousands)December 31

$ 89,980 $120,443 $ 97,084 8,730 36,946 9,644

3,701

3,701

0.27

0.27

$ 86,739 6,062 1,422 0.11

17,290

17,290

1.25

1.25

$109,436 31,929 13,653

1.02

3,313

3,313

0.24

0.24

$102,855 15,262 6,513 0.48

Additionally, the strengthening Iowa economy benefited sales growth for the year.

Net income for the first quarter of 1987 was benefited by a change in the method of accounting for utility revenues. Partially offsetting such benefit was the recording of a change in accounting principle as required by SFAS No. 90 to discount future revenues associated with the cancelled Guthrie County generating station.

17

Plastic Recycling, Inc., turns garbage into useful products. Iowa Electric helped the company locate near Iowa Falls. 01

The Consumer Advisory Panel provides Iowa Electric with important input from community leaders and customers. Iowa Electric's Colleen Reilly visits with panel member Jim Starr at his radio station, KIFG, in Iowa Falls. y

IE means business in the communities we

serve. In 1987, Iowa Electric assisted 65

businesses in successfully locating or

expanding in our service area, resulting in

approximately 3,000 jobs.

A Party Pac Popcorn in MarshalItown increased its Iowa workforce by moving product lines from Greenville, North Carolina. Iowa Electric assisted Party Pac in qualifying for state economic development grants. Chairman Loras J. Neuroth (left) stands beside the product and Iowa Electric's Ron Rider.

A (Above, center) Contact with community leaders is a key part of the Iowa Electric program of local involvement. Here Iowa Electric's Nancy Dougherty looks over the Jefferson Bee and Herald with publisher/editor Rick Morain.

18

I r -

4 The Campanile rises above the trees on the Iowa State University campus in Ames where Iowa Electric is involved in the development of the Iowa State Research Park Corporation. One new business located at the Iowa State Research Park is Thermomass Technology, Inc. which has a patented one-step system for constructing an insulated concrete wall. y

The Sales & Business Development staff is visible throughout the IE service area. Here, Iowa Electric's Ron Rider (left) talks with a group from Jefferson Industries, Inc., the community's development group. y

A Iowa Electric's hydroelectric dam in Iowa Falls is an Iowa landmark in that community. The plant is being refurbished and will be generating power in the near future.

A The renovated Marshalltown County Courthouse is a prominent fixture on the town square in Marshalltown where Iowa Electric provides gas and electric service.

19

1987 ANN

AUDITORS' REPORT TO THE BOARD OF DIRECTORS OF IE INDUSTRIES INC.:

We have examined the consolidated balance sheets and statements of capitalization of IE Industries Inc. (an Iowa corporation) and subsidiary companies as of December 31, 1987 and 1986, and the related consolidated statements of income, retained earnings and changes in financial position for each of the three years in the period ended December 31, 1987. Our examinations were made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.

As discussed in Note 2, the Office of the Consumer Advocate (Consumer Advocate) has appealed the Iowa Utilities Board's (IUB) order in the Iowa Electric Light and Power Company (Iowa Electric) 1983 electric rate case. The ultimate outcome of the appeal and related refund obligation, if any, is uncerain at this time.

On April 2, 1987, the IUB issued a final order approving an annualized increase in retail rates of $25,100,000. Such rates were placed into effect on May 8, 1987. The order addressed, among other issues, whether certain of Iowa Electric's costs would be allowable for recovery in future rates. As discussed in Notes 2 and 11, Iowa Electric has incurred $24,307,000 related to the terminations in 1985 and 1984 of contracts with coal suppliers. The order allowed recovery of these costs over a four year period. As also discussed in Notes 2 and 11, Iowa Electric incurred

$16,466,000 of construction costs related to cancelled generation projects. The IUB order disallowed recovery of the $5,200,000 allowance for funds used during construction recorded for one of the projects and allowed the balance of such construction costs to be recovered, without rate base treatment, over a ten-year period. The Consumer Advocate has filed a notice of appeal of the IUB's order. Consequentially, the ultimate outcome of these matters is uncertain at this time.

In our opinion, subject to the effect of such adjustments, if any, as might have been required to the financial statements had the outcome of the matters referred to in the two preceding paragraphs been known, the financial statements referred to above present fairly the financial position of IE Industries Inc. and subsidiary companies as of December 31, 1987 and 1986, and the results of their operations and the changes in their financial position for each of the three years in the period ended December 31, 1987, in conformity with generally accepted accounting principles which, except for the changes, with which we concur, in the method of accounting for costs of cancelled generating projects as discussed in Note 2 and in the method of accounting for revenues as discussed in Note 1, were applied on a consistent basis.

Chicago, Illinois January 29, 1988

20

44o,44-A,-, t_ L/.O- .

L REPORT

CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31

1987 1986 1985 (in thousands)

Revenues: Electric ....................................................... $303,491 $285,448 $291,624 G as .......................................................... 90,17 1 125,158 154,970 O ther ....................................................... 19,116 18,639 15,204

412,778 429,245 461,798

Expenses: Gas purchased for resale ......................................... 71,995 99,867 133,394 Fuel for production ............................................. 56,011 57,234 57,660 Purchased power, net ........................................... 49,667 46,565 61,996 O ther operation ................................................ 86,050 78,912 78,113 M aintenance .................................................. 24,046 21,188 23,041 Depreciation and amortization .................................... 31,784 34,226 32,638 Taxes other than income taxes .................................... 20,426 18,982 18,670

339,979 356,974 405,512

Operating income . 72,799 72,271 56,286

Interest expense and other. Interest expense ................................................ 26,193 25,305 25,581 Allowance for funds used during construction ........................ (1,198) (2,375) (2,085) Preferred and preference dividend requirements of subsidiary ........... 1,812 3,410 4,145 Income from stock transactions of affiliate ........................... . (2,344) -Miscellaneous, net .............................................. 4,237 (1,187) (995)

28,700 25,153 26,646

Income before income taxes and cumulative effects of changes in accounting principles .......................................... 44,099 47,118 29640

Federal and state income taxes . . 14,570 18,582 10,584

Income before cumulative effects of changes in accounting principles ......................................... 29,529 28536 19056

Cumulative effect of discounting recoverable cancelled plant costs, net of $1,177,000 income tax benefit ............................ (2,347)

Cumulative effect as of January 1, 1987 of change in method of accounting for revenues, less income taxes of $4,599,000 .......... 6,894 -

Net income - As reported ....................................... $ 34,076 $ 28,536 $ 19,056 - Pro forma (Notes 1(e) and 2) ....................... $ 29,529 $ 23,641 $ 21,102

Average number of common shares outstanding ........ . 13,748 13,408 12,973

Earnings per average common share before cumulative effects of changes in accounting principles $ 2.14 $ 2.13 $ 1.47

Cumulative effect of discounting recoverable cancelled plant costs .( .17) -Cumulative effect of change in method of accounting for revenues .51 -

Earnings per average common share - As reported ........ . $ 2.48 $ 2.1 $ 1.47 - Pro forma (Notes 1(e) and 2).. $ 2.14 $ 1.76 $ 1.63

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

21

1987 ANN

CONSOLIDATED BALANCE SHEETS

December 31 1987 1986ASSETS

(in thousands)

Property, plant and equipment, at original cost: Utility

Plant in serviceElectric...................................................... Gas......................................................... Other ......................................................

Less-Accumulated depreciation ......................................

Leased nuclear fuel, net of amortization .................................. Construction work in progress ........................................

Other property, net of accumulated depreciation of $3,066,000 and $2,689,000, respectively............................

$ 905,252 70,842 27,639

1,003,733 378,635 625,098

33,866 15,373

674,337

23,000 697,337

$ 870,818 70,785 22,761

964,364 354,641 609,723

41,296 16,547

667,566

18,200

685,766

Current assets: C ash .................................................................... 1,4 0 7 1,58 1 Accounts receivable

Customer, less reserve .................................................... 35,587 37,957 O ther ................................................................. 4,8 16 7,137

U nbilled revenues ......................................................... 11,224 Incom e tax refunds receivable. ................................................ 582 1,711 Production fuel, at average cost............................................... 15,220 14,769 Materials and supplies, at average cost .......................................... 11,625 9,289 Adjustm ent clause balances......................... ......................... 2,903 855 Prepayments and other ..................................................... 12,816 13,532

96,180 86,831 Deferred charges and other (Note 11) .. __41,360 56,184

Investments: Teleconnect Com pany ............................. .. Nuclear decommissioning trust fund ................. . O th e r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24,490 1,223 4,472

30,185 $ 865,062

18,414

4,015 22,429

$ 851,210

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

22

L REPORT

CAPITALIZATION AND LIABILITIESDecember 31

1987 1986 (in thousands)

Capitalization (See Consolidated Statements of Capitalization): C o m m o n sto ck . . .. .. .. . .. .. .. . .. .. .. .. . .. . .. .. .. . .. .. . .. .. . .. .. . .. .. . .. .. . R etain ed earn in gs . .. . .. .. .. . .. .. .. .. .. . ... . .. . .. .. . .. .. . .. .. .. . .. . .. .. .. .. ..

Total com m on equity ..................................................... Preferred stock of subsidiary .................................................. Redeemable preference stock of subsidiary ..................................... L o n g-term d eb t . . .. . .. . .. . .. . .. .. .. .. .. . .. .. . .. .. . ... . . .. .. .. . .. .. . .. .. .. . .

Current liabilities: C o m m ercial p ap er .......................................................... N o tes p ayab le . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C apital lease obligations ..................................................... Long-term debt m aturities .................................................... D ebt sinking fund requirem ents ............................................... Preference stock sinking fund requirements ..................................... A cco u n ts p ayab le . .. . .. . .. .. .. .. .. . .. .. . .. .. .. . .. .. .. . .. .. .. .. . .. .. . .. .. . .. . A ccru ed in terest . .. . .. .. . .. .. .. .. .. .. . .. . .. .. . ... . .. .. . .. .. .. .. . .. .. . .. .. . . A ccru ed taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accum ulated refueling outage provision ......................................... O th e r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$187,383 71,273

258,656 18,320 8,000

230,471 515,447

30,430

12,937 36,073

1,033 1,000

33,865 4,670

16,586 2,437

12,183 151,214

$179,578 64,192

243,770 18,320 10,000

264,932 537,022

2,500 16,200 11,975

850 1,033 1,000

37,681 4,722

19,380 6,385 9,993

111,719

Other long-term liabilities: Capital lease obligations ..................................................... 26,454 35,367 O th er .. . .. . .. .. . .. . .. . .. .. .. .. .. . .. .. .. . .. .. . .. .. .. .. . .. .. . .. .. .. . .. . .. .. 12 ,0 0 6 10 ,20 6

38,460 45,573

Deferred credits: Accumulated deferred income taxes ............................................ 115,042 111,969 Accumulated deferred investment tax credits .................................... . 44,899 44,927

159,941 156,896

Commitments and contingencies (Note 10)

$865,062 $851,210

23

1987 AN N

CONSOLIDATED STATEMENTS OF CAPITALIZATION December 31

1987 1986 (in thousands)

Common equity: Common stock - no par value - authorized 24,000,000 shares; outstanding

13,883,161 and 13,548,441 shares, respectively ................................ $187,383 $179,578 Retained earnings ($20,414,000 restricted as to payment of cash dividends) ............ . 71,273 64,192

258,656 243,770

Cumulative preferred stock: Iowa Electric Light and Power Company - par value $50 per share - authorized

466,406 shares; outstanding 366,406 shares 6.10% - Outstanding 100,000 shares...................................... 5,000 5,000 4.80% - Outstanding 146,406 shares...................................... 7,320 7,320 4.30% - Outstanding 120,000 shares...................................... 6,000 6,000

18,320 18320

Redeemable cumulative preference stock: Iowa Electric Light and Power Company - par value $100 per share - authorized

700,000 shares 8.55% - Outstanding 90,000 and 110,000 shares 9,000 11,000 Less - Amount to be redeemed within one year 1,000 1,000

8,000 10,000

Long-term debt: Series 1986 debentures, 8Vs%, due 1993 ........................................ Iowa Electric Light and Power Company

First mortgage bonds Series 1, 5V % , due 199 1 ................................................. SeriesJ, 614% , due 1996 ................................................. Series K , 8Ys% , due 1999 ................................................ Series L, 7s% , due 2000 ................................................ Series M , 7Y8% , due 2002 ................................................ Series 0 , 9.80% , due 1991 ............................................... Series P & Q, 6.70% , due 2006 ........................................... Series R , 814% , due 2007 ................................................ Series T , 14 % , due 1991 ............................................... Series U , 9Y % , due 2000 ................................................ Series V , 11% , due 1988 ................................................

Guarantee of pollution control bonds, 5.73%, $4,400,000 due serially 1988-1994; $ 10,200,000 due 2003 ..................................................

Other subsidiaries' debt maturing through 1992 .................................

Unamortized debt premium and (discount), net ..................................

Less - Amount due within one year.......................................

45,000

16,000 15,000 20,000 15,000 30,000

3,888 9,200

25,000 30,000

5,300 35,000

204,388

14,600 218,988

4,599 268,587

(1,010) 267,577

37,106 230,471

$515,447

45,000

16,000 15,000 20,000 15,000 30,000

4,921 9,200

25,000 30,000

5,300 35,000

205,421

15,400 220,821

2,100 267,921

(1,106) 266,815

1,883

264,932 $537,022

24

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

L REPORT

CONSOLIDATED STATEMENTS OF CHANGES IN FINANCIAL POSITION

Cash and equivalents at beginning of period ...................... Funds provided internally:

N et in co m e . .. .. . .. .. . ... . .. .. .. . ... . .. . .. .. . ... . .. .. . .. .. . .. . Non-cash items included in net income

U nbilled revenues ............................................ Disallowed costs associated with Guthrie County generating station ..... Discount of recoverable cancelled plant costs ....................... Depreciation and amortization .................................. Deferred taxes and investment tax credits .......................... Amortization of deferred charges ................................ Refueling outage provision ..................................... (Income) loss from Teleconnect Company investment ............... Allowance for equity funds used during construction ................

Total funds provided internally .............................. Less - Dividends on common stock ...............................

NTf d iddi llA _ _

Year Ended December 31 1987 1986

(in thousands)

$ 1,581 $ 8,243 $

34,076

(11,224) 3,615 3,524

30,385 3,045 6,210

(3,948) (4,076)

(195) 61,412 27,370 -2A i

28,536

34,226 3,462 5,658 4,494

(86) (1,271) 75,019 26,156 48863

1985

5,334

19,056

32,638 8,815 5,441

(6,261) 72

(1,133) 58,628 24,794

I un s r e ntern . . . ..y . ... .. . . . ... . .. ,

Funds provided from external sources: Issuance of common stock ....................................... 7,805 8,106 9,036 Issuance of long-term debt ....................................... 2,550 46,633 35,278 Net change in commercial paper and short-term notes payable ........... 11,730 (2,580) (4,588) Sinking fund requirements and reduction in long-term debt and

preference stock ............................................. (3,884) (61,133) (16,079) Other ........................................................ 375 (349) 316

Net funds from external sources .............................. 18,576 (9323) 23,963 Funds used for construction (52,887) (42,618) (47,866) Other changes:

Cash on deposit with trustee...................................... - 493 9,849 Accounts receivable ............................................. 5,820 3,239 4,326 M aterials, supplies and fuel ....................................... (2,787) 1,020 7,609 Adjustment clause balances....................................... (2,048) (107) 1,460 Accounts payable............................................... (3,816) (4,300) 4,090 A ccrued taxes ................................................. (2,794) 740 2,416 Investm ents ................................................... (2,457) (396) (18,902) Deferred charges ............................................... 749 (5,054) (20,149) O ther ........................................................ 7,4 28 78 1 2,279

Net funds from other changes............................... 95 (3,584) (7,022) Increase (decrease) in funds ..................................... (174) (6,662) 2,909 Cash and equivalents at end of period ............................ $ 1,407 $ 1,581 $ 8,243

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

25

1987 ANN

CONSOLIDATED STATEMENTS OF RETAINED EARNINGS Year Ended December 31

1987 1986 1985

(in thousands)

Balance at beginning of year..................................... $ 64,192 $ 62,161 $ 67,743 Add:

N et incom e ................................................... 34,076 28,536 19,056 Tax benefit resulting from the deduction of ESOP dividends ............ 375 585 156

98,643 91,282 86,955

Deduct: Cash dividends declared on common stock, at per share rates of $1.99,

$1.95, and $1.91, respectively .................................. 27,370 26,156 24,794 Preference stock redemption premiums of subsidiary .................. - 934

27,370 27,090 24,794

Balance at end of year ($20,414,000 restricted as to payment of cash dividends) .............. $ 71,273 $ 64,192 $ 62,161

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (a) Basis of Consolidation

The consolidated financial statements include the accounts of IE Industries Inc. (Industries) and its whollyowned subsidiaries (the Company). The principal operating companies are Iowa Electric Light and Power Company (Iowa Electric) and the Cedar Rapids and Iowa City Railway Company (CRANDIC). All significant intercompany balances and transactions have been eliminated from the consolidated financial statements. (b) Regulation

Industries is currently exempt from regulation under the Public Utility Holding Company Act of 1935. Iowa Electric is subject to regulation by the Iowa Utilities Board (IUB) and the Federal Energy Regulatory Commission (FERC). (c) Accounting for the Investment in Teleconnect Company

Teleconnect Company (Teleconnect) is engaged principally in supplying long distance and telemarketing services. Industries uses the equity method to account for its investment in Teleconnect and the Consolidated Statements of Income include Industries' portion of Teleconnect's net income.

In 1987, Teleconnect privately placed 1,554,000 shares of original issue common stock. Such shares were sold at a price significantly in excess of book value and Teleconnect thereby experienced an increase in net assets. Accordingly, Industries' share of Teleconnect's net assets increased and resulted in the pre-tax credit to "Income from stock transactions of affiliate" as shown in the Consolidated Statements of Income.

Industries' 27% investment in Teleconnect at December 31, 1987 included $12,600,000 of unamortized purchase price in excess of book value at the date of acquisition (May, 1985) which is being amortized over a forty year period. (d) Depreciation

Iowa Electric's provision for depreciation, except for the Duane Arnold Energy Center (DAEC), is based on straight-line composite rates. The average rate was 3.3% of the cost of depreciable electric property for 1987, 3.7% for 1986 and 3.6% for 1985. The average rate for gas property was 3.0% for 1987-1985.

The DAEC is currently being depreciated using a remaining life method. In its Order dated April 2, 1987 relating to Iowa Electric's 1986 electric rate case, the IUB permitted Iowa Electric to change the original estimated life of the DAEC from 28 to 36 years. Pursuant to the Order, Iowa Electric identified $21,709,000 of the accumulated depreciation as an internal decommissioning reserve. In addition, the IUB required Iowa Electric to commence external funding of revenues collected for future decommissioning costs. Based on a study completed in December, 1985, Iowa Electric's 70% share of the cost to decommission the DAEC approximated $107 million in 1985 dollars. (e) Revenues

In 1987, Iowa Electric began accruing revenue for service rendered but unbilled at month-end in order to more properly match monthly revenue with the cost of service provided to customers. This change in method of recording revenue decreased 1987 income by $162,000, before the cumulative effect for prior periods. The cumulative effect of this change and pro forma effects on income are shown in the Consolidated Statements of Income. The pro forma information presents the financial

26

L REPORT

results which would have been experienced had Iowa Electric been accounting for revenues under its current method throughout the periods. (f) Allowance for Funds Used During Construction

The allowance for funds used during construction (AFC), which represents the cost during the construction period of funds used for construction purposes, is capitalized by Iowa Electric as a component of the cost of utility plant. The amount of AFC applicable to debt funds and to other (equity) funds, a non-cash item, is computed in accordance with the formula prescribed by FERC. The aggregate gross rates for 1987-1985 were 8.2%, 10.8% and 11.1%, respectively. (g) Adjustment Clauses

Iowa Electric's tariffs include an electric energy adjustment clause (EAC) designed to reflect the current costs of fuel, including nuclear fuel and an estimated cost associated with nuclear waste disposal, and the energy portion of purchased power in billings to customers. The clause is based on the estimated cost of fuel consumed and the estimated energy cost of purchased power for the current month and the immediately preceding month. A correction factor is included to reflect previous over-orunder collections of revenue resulting from variances between the actual cost of fuel consumed and the amount included in billings to customers. Iowa Electric records the change in over-or-under collections by charging or crediting other operation expense. The cumulative effect is reflected in the Consolidated Balance Sheets as a current asset or current liability, pending automatic reflection in future billings to customers.

Iowa Electric's gas tariffs also include clauses designed to reflect changes in the cost of gas purchased for resale on a current basis. These clauses are accounted for in a manner similar to the EAC. (h) Accumulated Refueling Outage Provision

The IUB allows Iowa Electric to collect, as part of its base revenues, funds to offset higher operation and maintenance expenditures during refueling outages at the DAEC. As these revenues are collected, an equivalent amount is charged to other operation and maintenance expenses with a corresponding credit to a reserve. During a refueling outage, such reserve is reversed to offset the higher expenditures. (i) Income Taxes

Federal income tax expense includes provisions for deferred taxes to reflect the tax effects of timing differences between when certain costs are recorded in the accounts and are deducted for tax return purposes.

- As these timing differences reverse, the related accumulated deferred income taxes are reversed to income.

Iowa Electric provides deferred taxes, in accordance with rate making practices, only for timing differences resulting from accelerated tax depreciation for which deferred taxes are required to be provided by the Internal Revenue Code. State deferred income taxes have not been recognized for rate making purposes since June 1, 1981, pursuant to an order of the IUB. An August 1, 1984 court decision requires that certain accumulated Federal and state deferred income taxes previously

provided by Iowa Electric be amortized to income over a seven year period ending in 1990.

Iowa Electric also provides Federal and state deferred taxes on certain other timing differences as indicated in Note 3.

Investment tax credits are utilized to offset Federal income taxes which otherwise would be currently payable. Such credits are deferred and are subsequently credited to income over the lives of the property which gave rise to the credits.

(2) RATE MATTERS:

Tax Reform Act of 1986 In order to reflect the effects of the Tax Reform Act

of 1986, Iowa Electric filed tariffs with the IUB to reduce electric and gas rates on an annual basis by $5.6 million and $157,000, respectively. Such rate reductions went into effect on July 1, 1987. Although the IUB allowed the $5.6 million reduction in electric rates to be placed into effect, it rejected Iowa Electric's electric filing asserting that such rate reduction was deficient and should be approximately $3.0 million greater. Iowa Electric filed suit with the Iowa District Court for Linn County for judicial review of the alleged deficiency. Iowa Electric has reserved for the amount in dispute.

1986 Electric Rate Case On April 25, 1986, Iowa Electric applied to the IUB

for an electric rate increase to be charged to Iowa retail customers. Of the amount requested, $43.9 million on an annual basis, an interim increase of $19.2 million was allowed by the IUB effective July 24, 1986. On April 2, 1987, the IUB issued its final Order establishing rates based on an increase of $25.1 million. Such rates were placed into effect on May 8, 1987.

In its Order, the IUB disallowed $5.2 million of AFC recorded for the cancelled Guthrie County generating station. The disallowed AFC, net of an amount reserved in prior years, was written-off in 1987 and is reflected in "Interest expense and other - Miscellaneous, net." The disallowance was based on an interpretation of state law regarding when construction began. Iowa Electric believes that the IUB is in error on this matter and has appealed to the State District Court for relief from this finding.

The Order did allow recovery of the remaining costs associated with cancelled generating projects, but without rate base treatment. In accordance with SFAS No. 90, Iowa Electric recorded an adjustment in 1987 to discount the future revenues associated with such costs. The cumulative effect of such discounting and pro forma effect on income are shown in the Consolidated Statements of Income. The pro forma information presents the financial results which would have been experienced had Iowa Electric discounted the recoverable cancelled plant costs at the date of cancellation in February, 1986.

Other adjustments were also recorded in 1987 to reflect the remaining provisions of the rate case settlement.

The Consumer Advocate filed a notice of appeal on issues in this case that were also appealed in the 1983 rate case (see discussion following) as well as other issues

27

1987 ANN

initially raised in this case, including recovery of a portion of the coal contract termination costs (see Note 11), recovery of certain future nuclear decommissioning expenses, and recovery of a portion of the cancelled Guthrie County generating station costs (see Note 11). Iowa Electric believes the probability that the Consumer Advocate will be successful in its appeal is remote. Accordingly, no refund liabilities have been recorded.

1983 Electric Rate Case On June 8, 1987, the Linn County District Court

issued its Order relating to Iowa Electric's $44.2 million 1983 electric rate increase, of which $40.0 million on an annual basis was approved by the IUB on August 1, 1984. The issue appealed by Iowa Electric relating to a single deferred income tax item was decided in Iowa Electric's favor. The Court upheld the IUB on all issues

appealed by the Consumer Advocate. No rate adjustments were required as a result of the Order.

Certain issues appealed to the Linn County District Court by the Consumer Advocate have now been appealed to the Iowa Supreme Court. A significant reduction of the $40.0 million rate increase would be required if all issues were decided against Iowa Electric. A final court decision adverse to Iowa Electric relating to one of the issues would result in an immediate refund obligation. An adverse decision on the remaining appealed issues would result in refund obligations through prospective rate reductions. Iowa Electric is of the opinion that the likelihood of a decision overturning the IUB and Linn County District Court's Orders for any of the issues remaining on appeal by the Consumer Advocate is remote. Accordingly, no refund liabilities have been recorded.

(3) INCOME TAXES: Federal and state income taxes as set forth in the Consolidated Statements of Income are comprised of the following:

Year Ended December 311987 1986 1985

(in thousands)Federal income taxes:

C u rre n t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred

Unbilled revenues ........................................... Coal contract termination costs ................................. Plant abandonm ents ........................................... Refueling outage provision ...................................... Internal decom m issioning ....................................... D ep reciatio n . .. . .. . .. .. .. . .. .. .. .. .. .. .. . .. .. .. . .. .. .. .. .. . .. O th e r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P rio r years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Investment tax credits D eferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A m ortization and other.........................................

Total Federal incom e taxes .................................. State income taxes:

C u rren t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred

U nbilled revenues ............................................. Coal contract termination costs ......... ........................ Plant abandonm ents ........................................... Refueling outage provision ...................................... Internal decom m issioning ....................................... D ep reciatio n ................................................. O th e r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P rio r years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total state incom e taxes .................................... Total incom e taxes ........................................

Included in Consolidated Statements of Income as: Federal and state incom e taxes .................................... Cumulative effects of changes in accounting principles .................

$ 11,060 $ 11,786 $ 242

3,590 (3,615)

(676) 2,058

(6,176) 6,700 1,489

(1,777)

1,911 (1,941) 12,623

3,905

817 1,771

681 (223)

(1,685) (484)' 846

(259) 5,369

$ 17,992

$ 14,570 3,422

$ 17,992

(963) 3,998

(2,067)

3,561 6,984

(7,153)

1,645 (1,847) 15,944

3,289

(484) 666

(833) 2,638

$ 18,582

$ 18,582

$ 18,582

3,283

2,880

5,976 1,237

(7,164)

4,884 (1,670) 9,668

1,474

(459) 673

(772) 916

$ 10,584

$ 10,584

$ 10,584

28

L REPORT

The overall effective income tax rates shown below were computed by dividing total income tax expense by the income before income taxes.

1987;Statutory Federal income tax rate .................. Add (deduct):

Allowance for funds used during construction ........ Amortization of investment tax credits ............... Amortization of certain accumulated deferred

income taxes over five and seven years ............. Preferred and preference dividend requirements

of subsidiary ................................. State income taxes, net of Federal benefits ............ O ther item s, net ................................

Overall effective income tax rate ...................

At December 31, 1987, primarily as a result of rate making practices, Federal and state deferred income taxes have not been provided on cumulative net tax timing differences of $73,000,000 and $175,000,000, respectively. Iowa Electric believes that the income taxes payable in the future, due to the reversal of such timing differences, will be recovered through the rate making process.

In December, 1987, the Financial Accounting Standards Board issued SFAS No. 96 which establishes accounting and reporting standards for the effects of income taxes. The Company is required to adopt the new

40.0

Year Ended December 3 1986

% 46.0%

(0.9) (3.7)

(6.3)

1.4 5.1

(1.0) 34.6%

(2.3) (4.0)

(7.5)

3.3 4.0

(0.1) 39.4%

1 1985 46.0%

(3.2) (5.8)

(12.8)

6.4 2.6 2.5

35.7%

accounting and disclosure requirements of SFAS No. 96 prior to 1990. When adopted, the Company will record the cumulative effect of SFAS No. 96. Adjustments to accumulated deferred income taxes will be recorded for additional deferred income tax liabilities not provided as a result of rate making practices and the effects of income tax rate changes. It is expected that such adjustments will be offset primarily by regulatory assets and liabilities. Although the Company has not yet determined the amount of such adjustments, it does not anticipate an adverse impact on the Consolidated Statements of Income.

(4) LEASES: Iowa Electric has a nuclear fuel lease covering its 70%

undivided interest in the nuclear fuel purchased for the DAEC. Future purchases of fuel may also be added to the fuel lease. This capital lease provides for annual one year extensions which Iowa Electric presently intends to exercise to a date not later than December 31, 2023. The credit agreement between the lessor and the bank has a termination date of December 31, 1990, but will continue on a year to year basis unless either party provides at least a three year notice of termination. The maximum amount of financing available under the agreement is currently $80 million. Iowa Electric is responsible for the payment of taxes, maintenance, operating cost, risk of loss and insurance relating to the leased fuel.

Annual nuclear fuel lease expenses include the cost of fuel, based on the quantity of heat produced for the generation of electric energy, plus the lessor's interest costs related to fuel in the reactor and administrative expenses. These expenses (included in fuel for production) for 1987-1985 were $11,541,000, $13,708,000 and $9,560,000, respectively.

Iowa Electric is operating the Prairie Creek Generating Station, Units 1, 2 and 3, under a ten year capital lease agreement. Iowa Electric expects to purchase the units in

1988 for approximately $5,500,000. The lease payments (included in other operation expenses) for 1987-1985 were $1,101,000 annually.

Operating lease rental expenses were $7,852,000, $7,444,000 and $7,242,000 for 1987-1985, respectively.

Future minimum lease payments, which include the estimated annual expenses for fuel currently under Iowa Electric's nuclear fuel lease, are as follows:

Year

19 8 8 ................. 19 89 ................. 1990 ................. 19 9 1 . . .. . .. .. . .. . .. .. 199 2 ................. Through 2003 ..........

Less: Amount representing interest . ..

Present value of net minimum lease obligations ......

Capital Operating Leases Leases

(in thousands)

$ 13,958 $ 3,679 15,055 3,423 7,712 3,315 5,244 3,304 1,998 3,268 2,450 34,814

46,417 $ 51,803

7,026

$ 39,391

29

1987 ANN

(5) RETIREMENT PLAN: The Company has a non-contributory retirement plan

which covers substantially all of its employees. Plan benefits are based on years of service and compensation during the employees' latter years of employment. Payments made from the pension fund to retired employees and beneficiaries during 1987 totaled $5,852,000.

The Company's policy is to expense and fund the pension cost determined using the frozen entry age actuarial cost method, provided that this amount is at least equal to the minimum funding requirements mandated by the Employee Retirement Income Security

Act (ERISA) and does not exceed the maximum tax deductible amount for the year. Total pension cost requirements paid to the Trustee were $2,786,000 and $2,535,000 for 1986 and 1985, respectively.

As of January 1, 1987, the Company accounts for its retirement plan pursuant to the provisions of SFAS No. 87. However, since Industries' major subsidiary is Iowa Electric, a public utility subject to the provisions of SFAS No. 71, certain adjustments are necessary in order to reflect the amount of annual pension cost allowed in Iowa Electric's most recent rate case.

The components of 1987 pension cost are as follows:

Service cost .. ................................................................... Interest cost on projected benefit obligation ............................................. Assumed return on plan assets (actual return on plan assets was $4,723,000)...................... Amortization of unrecognized plan assets as of January 1, 1987 ................................. SFAS No. 87 pension cost ........................................................... Adjustment to funding level .......................................................... Pension cost recognized in the Consolidated Statements of Income ..............................

(in thousands) $2,226

5,558 (6,449)

(261) 1,074 1,442

$2,516

A reconciliation of the funded status of the Plan under SFAS No. 87 to the amounts recognized in the Consolidated Balance Sheets is presented below:

December 31 1987 1986

Fair market value of plan assets ........................................... Actuarial present value of benefits rendered to date

Accumulated benefits based on compensation to date, including vested benefits of $52,893,000 and $57,263,000, respectively ...............................

Additional benefits based on estimated future salary levels ...................... Projected benefit obligation ...............................................

Plan assets in excess of projected benefit obligation ............................ Remaining unrecognized net asset existing at January 1, 1987, being amortized

o v er 2 0 y ears . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U nrecognized net gain ........................................................ Prepaid pension cost recognized in the Consolidated Balance Sheets .................

Assumed rate of return ................................................

Weighted average discount rate of projected benefit obligation .....................

Assumed rate of increase in future compensation levels ..........................

In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. The cost of such benefits is expensed

(in thousands) $ 83,650 $ 82,263

58,436 13,420 71,856 11,794

(4,956) (5,396)

$ 1,442 8.00%

8.25%

5.75%

62,543 14,503 77,046

5,217

(5,217)

8.00%

7.50%

5.75%

as claims are paid. Such costs totaled $914,000, $754,000 and $769,000 for 1987-1985, respectively.

30

L REPORT

(6) CHANGES IN OUTSTANDING SHARES OF COMMON STOCK: The following table presents information relating to the issuance of common stock:

Common Stock Number of

Shares Amount

Balance, D ecem ber31, 1984 ................................................... 12,672,902 Stock plan issuances* ....................................................... 499,991

Balance, D ecem ber 31, 1985 ................................................... 13,172,893 Stock plan issuances* ....................................................... 375,548

Balance, D ecem ber 31, 1986 ................................................... 13,548,441 Stock plan issuances* ....................................................... 334,720

Balance, December 31, 1987 ..........