Understanding how the "normal purchase and sale exclusion" under FASB 133 affects earnings volatility.

You are a utility service provider. You don't normally have to hedge your energy purchases. You simply obtain a mix of long-term, medium-term, and spot physical purchases, and pass the costs on to your customer through your rate recovery mechanism-such as a fuel adjustment clause or a rate filing. Now, however, you are going to start serving customers who can purchase energy outside of the traditional rate recovery mechanism. These so-called "deregulated customers" are not going to accept pass-through of annual energy cost increases-although they may accept pass-through of energy cost decreases.

Funny how fickle a customer can be. But the problem of customer retention and satisfaction can be compounded for management when shareholders object to increased volatility of corporate earnings. Greater earnings volatility usually translates into lower price/earnings (P/E) ratios and lower P/Es equal lower share prices.

The P/E ratio is the price of a stock divided by its earnings per share. The P/E ratio, also known as a multiple, gives investors an idea of how much they are paying for a company's earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

The earnings volatility arises from the Financial Accounting Standards Board (FASB) Rule 133. Rule 133 mandates that energy contracts (purchases and sales) that are derivative contracts must be reported on the balance sheet as an asset or liability at fair value. Changes in fair value are recognized in earnings unless specific conditions are met.

If one enters into a supply contract that can be classified as a derivative, the change in value from one period to the next will be reflected in earnings. Consequently, a forward contract to purchase energy at an index price would be classified a derivative because the value of the contract will be uncertain until physical energy actually flows.

Fair value is determined by marking to market the value of the contract, e.g., the amount one would receive in cash if one sold the contract to a third party. The value is usually determined by reference to existing market data, also called a forward curve, published by a service provider (Platts, Bloomberg, Reuters, etc), the closing price of futures contracts traded on a commodity exchange (NYMEX, CBOT, etc.) or from broker quotations (APB Energy, PreBon, Amerex, etc.). In the case of an obligation to purchase, fair value would be reported as a liability, while the obligation to sell would be treated as an asset. If the fair value of the purchase changes from one accounting period to another, the change in fair value is reflected as an increase (fair value goes up) or a decrease (fair value does down) in earnings. For an example of this, see Figure 1.

The earnings volatility can be avoided by three different techniques.

Mark-to-Market Accounting Explained

Used by most large buyers and sellers of energy who are in the business of energy intermediation, mark-to-market accounting implicitly calculates fair value. Simply stated, it is the 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 contract inception, and throughout its term, that physical delivery will occur.

In our earlier figures, if the natural gas in question would be placed in storage during the delivery month, and it was purchased for the purpose of supply to the company's customers, it could have been placed in inventory at cost on the day it was received. As with traditional accrual accounting, the purchase into inventory is booked as an asset.

Be aware, however, that behavior subsequent to contract execution can be interpreted as preventing the normal purchase or sale exemption treatment under FASB 133. These activities tend to indicate that the energy procurement agreement was entered into to generate profits from the price movement of the commodity, i.e., physical arbitrage. Such activities include: net settlement of the agreement with the same counterparty; flash title transactions (short term holding of title with no corresponding physical movement); and uniqueness of the transaction itself (not having similar agreements in the past or in the future).

Given the nature of earnings volatility in energy, however, the decision as to the accounting treatment of any purchase or sale should be made within the scope of a comprehensive risk management policy. That policy should require the use of techniques not discussed here to quantify the probability of market price movements and its impact on cash flow to the company. It is only when the board of directors, executive management, and the corporate auditor has a thorough understanding of the risks undertaken by the firm in its day-to-day activities that the choices available for accounting treatment will be made for the benefit of all corporate stakeholders.

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