EITF 98-10: Accounting for Contracts Involved in Energy Trading and Risk Management Activities
EITF 98-10 Dates Discussed
May 21, 1998; July 23, 1998; September 23-24, 1998; November 18-19, 1998
EITF 98-10 References
FASB Statement No. 80, Accounting for Futures Contracts
FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments
FASB Statement No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments
FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
FASB Statement No. 133, Accounting for Derivative Instruments and for Hedging Activities
FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts
APB Opinion No. 20, Accounting Changes
AICPA Accounting Research Bulletin No. 43, Chapter 4, Inventory Pricing
SEC Financial Reporting Release No. 48, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments
SEC Staff Accounting Bulletin No. 74, Disclosure Regarding Accounting Standards Issued but Not Yet Adopted
EITF 98-10 ISSUE
1. Entities commonly enter into contracts for the purchase and sale of energy commodities. Such activities historically have been settled by physical delivery in the entity's primary operating environment (that is, that area in which an operation typically delivers energy or could physically deliver such energy in a cost-effective manner in order to earn its revenue). These energy contracts are increasingly being entered into for the purpose of speculating on market movements or otherwise generating gains from market price differences. More recently, some entities have been entering into such energy contracts for trading purposes using both over-the-counter contracts and exchange-traded contracts and settling them on a net cash basis or by entering into offsetting positions.
2. For purposes of this Issue, energy contracts refers to contracts entered into for (or indexed to) the purchase or sale of electricity, natural gas, natural gas liquids, crude oil, refined products, coal, and other hydrocarbons (collectively, energy). Energy contracts also includes energy-related contracts (for example, capacity contracts, requirements contracts, and transportation contracts\1/). Energy trading activities or energy trading contracts refers to energy contracts entered into with the objective of generating profits on or from exposure to shifts or changes in market prices. Consistent with the way in which trading activities are defined in Statement 119, trading activities also include dealing (the activity of standing ready to trade--either buying or selling--for the dealer's own account, thereby providing liquidity to the market).
=========================================================================== \1/ Refer to Glossary in Exhibit 98-10B for definitions. ===========================================================================
3. Statement 133 was issued in June 1998 and is effective for fiscal years beginning after June 15, 1999. In accordance with that Statement, all derivatives, as defined, would be marked to market through earnings, unless designated as hedging instruments in certain types of hedging relationships. In accordance with Statement 133, energy trading contracts that can effectively be net settled will generally be considered derivatives. However, not all energy contracts that are subject to the guidance in this consensus will be derivatives under Statement 133.
4. For purposes of this Issue, contracts that are designated as and effective as hedges of nontrading activities are not considered energy trading contracts and therefore, until an entity adopts Statement 133, should continue to be accounted for in accordance with the entity's existing hedge accounting policies. In addition, ARB 43, Chapter 4, provides the applicable accounting for physical inventories held. Accordingly, the accounting for physical inventories of energy commodities is also not within the scope of this Issue.
5. The issue is how energy trading contracts should be accounted for.
EITF 98-10 DISCUSSION
6. At the November 18-19, 1998 meeting, the Task Force discussed the working group's recommended approach to accounting for contracts involved in energy trading and risk management activities. The Task Force reached a consensus that energy trading contracts should be marked to market (that is, measured at fair value\2/ determined as of the balance sheet date) with the gains and losses included in earnings and separately disclosed in the financial statements or footnotes thereto. The Task Force withdrew its prior tentative conclusion that required the gains and losses to be shown net in the income statement. With respect to balance sheet presentation, the Task Force observed that Interpretation 39 defines right of setoff and specifies what conditions must be met to offset assets and liabilities.
=========================================================================== \2/ The fair value of an energy contract is, consistent with Statements 107, 125, and 133, the amount at which that contract could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. If a quoted market price is not available, the estimate of fair value shall be based on the best information available in the circumstances. The estimate of fair value shall consider prices for similar energy contracts and the results of valuation techniques to the extent available in the circumstances. Those techniques shall incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses. ===========================================================================
7. The Task Force reached a consensus that determining whether or when an entity is involved in energy trading activities is a matter of judgment that depends on the relevant facts and circumstances. The Task Force agreed that the framework in which such facts and circumstances are assessed should be based on an evaluation of the various activities of an entity rather than solely on the terms of the contracts. Inherent in that framework is an evaluation of the entity's intent in entering into an energy contract. The Task Force reached a consensus that the factors or indicators identified in Exhibit 98-10A should be considered in evaluating whether an operation's energy contracts are entered into for trading purposes. As used in Exhibit 98-10A, operation refers to any identifiable activity of an entity (for example, a subsidiary, a division, or a unit) that enters into the types of energy contracts that are within the scope of this Issue.
8. The Task Force acknowledged that it is easier to evaluate the trading activities of an entity when such activities are segregated organizationally or by legal entity. However, the Task Force observed that if an operation's trading activities are not segregated in either of those ways and an evaluation of the indicators identified in Exhibit 98-10A would conclude that a portion of the operation's activities are trading, then only that portion of the operation's activities would be considered trading and all energy trading contracts entered into by that portion of the operation's activities should be marked to market.
9. The Task Force also reached a consensus that given the nature of trading activities, reclassifications into or from the trading category should be rare. That is, if an operation is determined to be engaged in trading activities and all energy trading contracts entered into by that operation are marked to market, it would be unlikely that subsequent facts and circumstances could change the conclusion that those contracts should continue to be marked to market.
10. The SEC Observer stated that with respect to indicator F(4) of Exhibit 98-10A, the SEC staff believes that when an operation enters into complex written options or written options in which the operation does not stand ready to deliver energy, such contracts should be marked to market with gains and losses shown net in the income statement, regardless of whether the operation is considered to be involved in trading activities. The SEC Observer also stated that an operation does not stand ready to deliver energy pursuant to a written option if the written option requires net cash settlement or the writer of the option has a past practice of settling written options in cash.
11. The SEC Observer also reminded registrants of the requirements to provide disclosures identified in SAB 74 in financial statements for periods prior to the adoption of this consensus as well as Statement 133 and to provide, to the extent applicable, the disclosures required by FRR 48.
12. This consensus should be applied to financial statements issued for fiscal years beginning after December 15, 1998. For fiscal years beginning prior to December 16, 1998, an entity may initially apply this consensus as of the end of a fiscal year for which annual financial statements have not previously been issued (this consensus may not be applied retroactively to the interim financial statements for that year). The effect of initial application of this consensus should be reported as the cumulative effect of a change in accounting principle in accordance with Opinion 20. However, disclosure of the pro forma effects of application on net income is not required. Financial statements for periods prior to initial adoption of this consensus may not be restated.
EITF 98-10 STATUS
13. No further EITF discussion is planned.
Exhibit 98-10A
FACTORS TO CONSIDER FOR DETERMINING TRADING ACTIVITIES
For purposes of identifying energy trading activities, the following groups of indicators should be considered for each identifiable operation (activity) of an entity that enters into energy contracts that are within the scope of this Issue. The absence of any or all of the indicators in any category, by itself, would not preclude the operation's activities from being considered trading.\3/ Categories A and B represent the fundamentals of the operation's activities. Accordingly, the presence of indicators in both Categories A and B, in combination, may be a strong indication that such activities are trading. The presence of indicators in any one of the other categories (C-F), by itself, may indicate that the operation's activities are trading. Nevertheless, all available evidence should be considered to determine whether, based on the weight of that evidence, an operation is involved in energy trading activities.
=========================================================================== \3/ An operation that enters into energy contracts for the sole purpose of consuming energy to be used in carrying out its own business operations would not, in and of itself, be considered to be involved in trading activities even though the operation may otherwise meet the indicators in both Categories A and B. As stated above, all available evidence should be considered to determine whether, based on the weight of that evidence, an operation is involved in energy trading activities. ===========================================================================
A. Generation/production/distribution/transmission capacity
1. The primary business of the operation is not to generate/produce/ deliver energy.
2. The operation has little or no generation/production/distribution/ transmission capabilities (that is, the operation does not own any capital assets (for example, generating plants, oil and gas reserves, and so forth) that would enable the operation to deliver energy to an end user).
3. The primary assets/liabilities of the operation are contracts.
4. The operation does not use its own capital assets to satisfy its delivery requirements to customers.
5. The operation offers products as a dealer, not as a "user" or "producer" of the commodity.
B. Customers, counterparties, and competitors
1. The majority of the counterparties to the energy contracts are not retail customers or industrial customers that take delivery of and consume the commodity in their businesses (for example, the customers or counterparties are brokers/traders).
2. The major competitors of the operation are traders.
C. Volume of purchases and sales
1. The volume of purchases and sales significantly differs from the operation's historical generation/production and delivery in its primary operating environment (that is, that area in which an operation typically delivers energy or could physically deliver such energy in a cost-effective manner in order to earn its revenue).
2. There has been a change in the volume of purchases and sales that is significant relative to the change in demand in the primary operating environment.
3. Quantities contracted for far exceed normal needs.
4. The operation does not consume the energy to meet its normal needs.
5. The operation's volume of purchases and sales is not dictated by physical capacities (for example, transportation (pipelines, wires), production, or distribution).
6. There is a high turnover rate of the portfolio of energy contracts.
D. Ability to gather/transmit/transport energy efficiently and effectively
1. The operation typically enters into forward delivery or purchase contracts for delivery/receipt outside the operation's primary operating environment (that is, the counterparties to the energy contracts are outside the primary operating environment).
2. The operation does not have the capabilities to gather and transmit energy efficiently and effectively in the primary operating environment in which the operation's energy contracts are located.
3. The operation has no available sources by which it can obtain the energy without resorting to market purchases.
E. Management and controls\4/
=========================================================================== \4/ As stated earlier, for purposes of this Issue, contracts that are designated as and effective as hedges of nontrading activities are not considered energy trading contracts and are therefore not subject to an evaluation under these indicators. ===========================================================================
1. Compensation and/or performance measures are tied to the short-term results generated from energy contracts (that is, the operation is measured based on trading profits or changes in the market values of its positions as opposed to profitable management of income-producing assets, such as power plants, pipelines, and manufacturing facilities).
2. The operation communicates internally in terms of "trading strategy" (that is, management reports identify contractual positions, fair values, hedging activities, risk exposure, and so forth).
3. The operation sets limits on market positions and related strategies, sets policies as to what types of contracts it will deal in, and sets the controls it will follow; in addition, the management is involved in reviewing compliance with those limits, strategies, policies, and controls on a daily basis.
4. The word "trading" is in the name of the operation for internal or external purposes.
5. Employees of the operation are referred to as "traders" or have prior experience in derivative trading or risk-management activities.
6. Assessment of net market positions of the operation is done on an hourly or overnight basis.
7. Infrastructure of the operation is similar to that of a trading operation of a bank or investment bank-front office, middle office, and back office (that is, there is a segregation of back office processing and front office trading functions).
8. An infrastructure exists that enables the operation to capture price and other risks on a real-time basis.
9. The activities are managed on a portfolio or "book" basis.
10. Management searches for opportunities to take advantage of favorable price spreads, arbitrage opportunities, or outright positions in the marketplace.
F. The contracts
1. The operation has a history of pairing off contracts or otherwise settling the contracts without physically receiving or delivering energy. That is, past practices of the operation have resulted in net cash settlement, offsetting, booking out, netting out, as well as flash title, and the type of settlement has changed quickly from one type to another to maximize profits/mitigate losses.\5/
=========================================================================== \5/ Refer to Glossary in Exhibit 98-10B for definitions. ===========================================================================
2. The energy contracts do not permit physical delivery and must be settled net in the market, in cash.
3. Settlement of the contract is not likely to be by delivery of the energy (that is, the operation has a pattern of net settlement).
4. The energy contracts are not customarily used for general commercial business purposes or by the industry in general (for example, complex written options or written options in which the operation does not stand ready to deliver energy).
5. The energy contracts contain provisions for liquidated damages in an amount that is based on changes in the price of the energy commodity that is the subject of the contract.
Exhibit 98-10B
Glossary
For purposes of this Issue, certain terms are defined as follows:
Booking Out (or Netting Out)--Booking out is a procedure for financially settling a contract for the physical delivery of energy. Booking out occurs when one party appears more than once in a contract path for the sale and purchase of energy. In that instance, the intervening counterparties may agree that they will not schedule or deliver physical energy that originates and ends with the same counterparty, but rather will settle in cash the amounts due to or from each intervening counterparty, thus booking out the transaction.
Example:
In March, Utility X sells electricity for delivery in June to Marketer A. Marketer A sells June electricity to B, B sells to C, C sells to D, D sells back to A and A sells to Utility Z. Marketer A appears twice in the contract path. Prior to June, Marketers A, B, C, and D agree to settle the amounts due to/from each other in cash and agree not to schedule the flow of physical electricity between them. Rather, Utility X schedules the flow of electricity to Marketer A, who in turn schedules delivery of the electricity to Utility Z.
Flash Title--Flash title is an instantaneous flow-through of title caused by purchases and sales of energy for delivery at the same time and location, resulting in no physical movement by the purchaser or seller of the energy (also known as physical bookout).
Capacity Contract--A capacity contract is an agreement by an owner of capacity to sell theright to that capacity to another party to satisfy its obligations. For example, in the electric industry, capacity (sometimes referred to as installed capacity) is the capability to deliver electric power to the electric transmission system of an operating control area. A control area is a portion of the electric grid that schedules, dispatches, and controls generating resources to serve area load (ultimate users of electricity) and coordinates scheduling of the flow of electric power over the transmission system to neighboring control areas. A control area requires entities that serve load within the control area to demonstrate ownership or contractual rights to capacity sufficient to serve that load at time of peak demand (usually annual) and to provide a reserve margin to protect the integrity of the system against potential generating unit outages in the control area.
Requirements Contract--A requirements contract is a contract to serve the full needs of an end user of energy. For example, in the electric industry, an end user's electricity requirements consist of several components including:
o Installed capacity--the need to have generation owned or under contract which, if available, is sufficient to serve the expected peak demand of the customer plus reserves
o Load-following energy--energy provided when and as demanded by the end user, including adjusting the level of energy provided to reflect instantaneous changes in demand
o Transmission and ancillary services--those services necessary to deliver power from the generation source to the end user as well as the other services necessary to maintain the operational security and the integrity of the electric grid.
Transportation Contract--A transportation contract obligates one or more of the contracting parties to transport energy from one place to another.
EITF 98-10 Footnote 1
Refer to Glossary in Exhibit 98-10B for definitions.
EITF 98-10 Footnote 2
The fair value of an energy contract is, consistent with Statements 107, 125, and 133, the amount at which that contract could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. If a quoted market price is not available, the estimate of fair value shall be based on the best information available in the circumstances. The estimate of fair value shall consider prices for similar energy contracts and the results of valuation techniques to the extent available in the circumstances. Those techniques shall incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses.
EITF 98-10A Footnote 3
An operation that enters into energy contracts for the sole purpose of consuming energy to be used in carrying out its own business operations would not, in and of itself, be considered to be involved in trading activities even though the operation may otherwise meet the indicators in both Categories A and B. As stated above, all available evidence should be considered to determine whether, based on the weight of that evidence, an operation is involved in energy trading activities.
EITF 98-10A Footnote 4
As stated earlier, for purposes of this Issue, contracts that are designated as and effective as hedges of nontrading activities are not considered energy trading contracts and are therefore not subject to an evaluation under these indicators.
EITF 98-10A Footnote 5
Refer to Glossary in Exhibit 98-10B for definitions.