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Energy Earnings and FASB: A Volatile Mix

Understanding how the "normal purchase and sale exclusion" under FASB 133 affects earnings volatility.
Fortnightly Magazine - June 1 2002

current value of all the open obligations to purchase or sell the energy commodity at today's prices. In other words, it is the amount one would receive from a willing buyer or seller if sold into the market.

In the day-to-day world of energy trading transactions, the valuation of mark-to-market can be simple or complex. The simple step is to contact a broker and receive the current bids and offers for the energy at the location and for the time period specified in the agreement. This step presumes the broker has at least one or more buyers and sellers who are now, or have recently, entered into an agreement to buy or sell for energy at the location in the specific time period, e.g. the month of March 2003 in our example.

The complex step occurs when the location of the transaction is such that no willing buyers or sellers can be ascertained. In that event, the market price may have to be calculated from a formula that includes such items as transportation costs and/or storage fees to estimate the current market value at the delivery locations. Generally accepted accounting principles will require that the mark-to-market valuation be the firm's best estimate of value to be received.

The Hedge Exemption

A derivative transaction can be treated as a cash flow hedge if it can be reliably determined that any change in the value of a primary transaction will be offset by the change in value of another related transaction. The offset must be at least 80 percent, and not more than 125 percent of the change in value; the primary transaction creates the obligation and the offsetting transaction creates the hedge. An example of hedge treatment can be applied to our preceding example. ()

Because the futures contract $2,000 gain offsets the $2,000 loss on the forward contract shown in Figure 1, we have a 100 percent effective hedge. Consequently, the value of the forward and the hedge are posted to comprehensive income, but are not posted to the earnings accounts.

If, however, the futures contract value had closed at $3.715 on Dec. 31, 2002, the effectiveness would have been only 50 percent. In this event, the hedge treatment is disallowed. Further, if the hedge is only effective between 80 percent and 120 percent, the gain or loss on the ineffective portion of the hedge must be taken to earnings.

One requirement of using the hedge exemption is that the company must have a system to first identify the primary transaction and then identify the corresponding hedge transactions. Moreover, accounting rules require that the method of determining hedge effectiveness must be consistently applied. If a change in hedge effectiveness is determined to be necessary, the change in valuation results may have to be reported in footnotes to the financial reports.

Normal Purchase and Sale Exclusion

The most notable of exceptions to FASB 133 is the purchase and/or sale of energy in the ordinary course of business within a reasonable period of time. The critical element here is that the company believes at