The accounting for commodity contracts brings together a breadth of accounting standards—leases, derivatives, revenue recognition, and consolidation—which are individually among the most complicated areas of accounting. Add their interaction, and it is understandable that commodity contract accounting is one of the most difficult areas of accounting for utilities and power companies.
Figure UP 1-1 outlines a recommended framework for evaluating commodity contracts.
Figure UP 1-1
Framework for accounting for commodity contracts
This general framework provides an overall approach to performing the analysis of commodity contracts. Reporting entities should apply the framework and consider all applicable guidance, even though the accounting for a particular contract may appear to be straightforward. For example, even a short-term power purchase agreement may include components that require the application of different accounting models if (1) more than one product is being delivered under the contract, (2) the contract includes unique pricing elements, and/or (3) the contract meets the definition of a lease. Further, because of the complex interaction of the relevant guidance, the order of the analysis is important and a central component of accounting for commodity contracts.

1.2.1 Step one: Determine the unit(s) of account

The first step in evaluating the appropriate accounting for a commodity contract is to determine the unit(s) of account. The unit of account will depend on the nature of the agreement and may be impacted by the accounting model applied to components of the contract, as established in Step two of the commodity contract framework.
Generally, the guidance applicable to commodity contracts includes lease and derivative accounting as well as the specialized industry revenue guidance in ASC 980-605-25, and general guidance for executory contracts. When a contract contains multiple components, these accounting models require consideration of whether there are any legally separable components that should be evaluated as separate units of account. In addition, in some cases, multiple contracts executed at the same time and in contemplation of each other may need to be accounted for as one contract (one unit of account) with multiple components. Considerations in evaluating the unit of account include the following:
  • Freestanding components

Features that are written into the same contract, but that may be legally detached and separately exercised would be considered freestanding instruments that should be accounted for separately. These features would not be subject to analysis in the context of the other components under the contract. Once a freestanding component is separated, the remaining components are evaluated in the context of the remaining contract components taken as a whole. For information on evaluating whether a component is freestanding or embedded, see UP 3.4, DH, and FG 5.3.
  • Multiple contracts entered into at the same time—when lease model is applicable (after the adoption of ASC 842)

If two or more contracts are executed at the same time, the reporting entity should assess whether the contracts should be evaluated as a single transaction. ASC 842-10-25-19 specifies criteria to consider in making this determination.

ASC 842-10-25-19

An entity shall combine two or more contracts, at least one of which is or contains a lease, entered into at or near the same time with the same counterparty (or related parties) and consider the contracts as a single transaction if any of the following criteria are met:
  1. The contracts are negotiated as a package with the same commercial objective(s)
  2. The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
  3. The rights to use underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component in accordance with paragraph 842-10-15-28

  • Multiple contracts entered into at the same time—when lease model is applicable (prior to the adoption of ASC 842)

ASC 840, Leases, provides specific guidance for evaluating the unit of account for multiple contracts executed at the same time.

Excerpt from ASC 840-10-15-16

… separate contracts with the same entity or [its] related parties that are entered into at or near the same time . . . [should] be evaluated as a single arrangement in considering whether there are one or more units of accounting, including a lease.

  • Multiple contracts entered into in contemplation of one another—when derivative model is applicable

ASC 815, Derivatives and Hedging, discusses the accounting for multiple contracts executed at the same time. In general, ASC 815 does not require the combination of two freestanding derivatives to be viewed as one unit of account, unless the derivative instruments are jointly designated in a hedging relationship. However, ASC 815-10-25-6 requires reporting entities to apply judgment to determine if separate derivatives have been executed in lieu of a structured transaction.

Excerpt from ASC 815-10-25-6

If separate derivative instruments have all of the following characteristics, judgment shall be applied to determine whether the separate derivative instruments have been entered into in lieu of a structured transaction in an effort to circumvent GAAP:
  1. They are entered into contemporaneously and in contemplation of one another.
  2. They are entered into with the same counterparty.
  3. They relate to the same risk.
  4. There is no substantive business purpose for structuring the transactions separately.
If such a determination is made, the derivative instruments shall be viewed as a unit.

Once the unit of account is determined, the reporting entity should apply the evaluation hierarchy applicable under US GAAP to determine the accounting model(s) to apply, as further discussed in Step two. For purposes of this discussion, we have referred to the unit of account as the contract; however, as noted, the unit of account could be part of a contract or multiple contracts combined.

1.2.2 Step two: Determine the accounting model(s) for the contract components

The US GAAP hierarchy establishes when and in what order reporting entities should apply the accounting guidance in evaluating a commodity contract. The order of applying the hierarchy of guidance may significantly alter the accounting conclusions reached when evaluating a contract that includes more than one component. The FASB has specifically addressed the scope of the guidance and clarified the order of application for multiple component contracts within ASC 606, Revenue Recognition. In addition, the leases and derivative guidance clarify that a contract should first be assessed to determine if it contains a lease, as discussed in UP
ASC 606-10-15-4 addresses the interaction of the revenue recognition guidance and the application of the multiple components approach when a contract includes a lease or components that are in the scope of certain other topics. In accordance with this guidance, if a contract has components that are within the scope of another area of US GAAP, a reporting entity should follow the separation and allocation guidance within that topic
When evaluating a contract with multiple components, the reporting entity should first determine whether there are any lease components. If the contract does not contain a lease, the reporting entity should next assess whether it is a derivative in its entirety. Unless the contract is a derivative in its entirety, a reporting entity should then consider whether the contract contains any embedded derivatives that require separation from the host contract. Any remaining components should then be accounted for following an executory contract accounting model. See UP 3.4 for information on evaluating embedded derivatives.
Figure UP 1-2 illustrates the application of steps one and two of the contract hierarchy. This example assumes the contract (1) does not contain any features that may be legally detached and separately exercisable (i.e., no freestanding components), (2) does not contain a lease and (3) is not a derivative in its entirety.
Figure UP 1-2
Hierarchy for application of US GAAP to a sample commodity contract Step 2(a): Determine whether the contract is or contains a lease

In determining the unit of account, a commodity contract should be evaluated to determine whether the contract is or contains a lease. A reporting entity should perform the lease assessment prior to the application of any other potentially applicable US GAAP. Lease accounting may apply if the contract explicitly or implicitly identifies property, plant, or equipment to be used.
The lease assessment is performed before evaluating application of the derivative guidance in accordance with ASC 815-10-15-79, which provides a scope exception for leases that are within the scope of the leases guidance.
There are some contracts that contain a lease that also include a derivative or embedded derivative and would be subjected to derivative accounting if it was considered first. Therefore, the order of application of the guidance may have a significant impact on accounting and disclosure.
See UP 2 and UP 2A for further information on determining whether a contract is or contains a lease in accordance with ASC 842 and ASC 840, respectively. Step 2(b): Determine whether the contract is or contains a derivative

If the contract does not contain a lease, the reporting entity should next assess whether it is a derivative in its entirety or whether it contains any embedded derivatives requiring separation from the host contract.
A compound contract may potentially include more than one component that would be a derivative on a stand-alone basis (e.g., both energy and natural gas) along with nonderivatives (e.g., ancillary services). ASC 815 provides guidance on the evaluation of compound contracts. Specifically, ASC 815-15-25-7 and ASC 815-15-25-8 address hybrid contracts with multiple embedded derivatives and require that they be bundled together and accounted for separately from the host contract as a single, compound embedded derivative, instead of accounted for as separate components representing separate risks. The evaluation of hybrid instruments and the determination of whether embedded derivatives should be separated from the host contract will be an ongoing area of focus as contracts and markets continue to evolve. See UP 3 for information on evaluating derivatives and embedded derivatives in commodity contracts. Step 2(c): Apply executory contract accounting

Once a reporting entity has identified any lease or derivative components that require separate accounting, it should apply executory contract accounting for any remaining contract components. ASC 980, Regulated Operations (ASC 980), provides guidance for accounting for regulated entities and specialized literature for all entities to consider in accounting for power purchase agreements that are not leases or derivatives (ASC 980-605-25-5 through ASC 980-605-25-15, ASC 980-605-25-17, and ASC 980-605-25-18). In addition, reporting entities may need to consider revenue recognition guidance for contractual components such as renewable energy credits (see UP 7). Accrual accounting should be applied to any remaining components of the contract.

1.2.3 Step three: Determine if consolidation accounting applies

If one of the parties to a commodity contract is a variable interest entity (VIE), ASC 810, Consolidation, may apply, regardless of the accounting model(s) applied to the contract or its components. In addition, the accounting model(s) applied to the commodity contract may impact the evaluation and conclusions reached under VIE consolidation model. For example, there are different considerations in assessing the design of a VIE depending on whether the power purchase agreement contains a lease, a derivative, or is accounted for as an executory contract. As a result, the determination of the appropriate accounting model(s) for the contract is performed prior to applying the consolidation guidance. If neither of the parties to a commodity contract is a VIE, consolidation accounting under the voting interest model may apply. See UP 10 for information on evaluating whether arrangements or structures involving a single power plant entity should be consolidated.

1.2.4 Step four: Allocate consideration

The way that contract consideration is allocated over the term of the contract may be complex due to the interaction of the lease, derivative, and revenue recognition guidance. Similar to other aspects of the commodity contract framework, the determination may be straightforward for a simple contract with only one component, but may be more complex if the contract contains multiple components.
A reporting entity should allocate contract consideration after determining the accounting for each component in the contract. The hierarchy for allocating consideration differs from that used to determine the appropriate accounting model.
Figure UP 1-3 summarizes key guidance to consider in determining the appropriate allocation of revenue and costs among contract components once the unit of account has been established.
Figure UP 1-3
Allocation of contract consideration
Allocation considerations
4(a) Allocate fair value to derivative components
  • Contract is a derivative in its entirety—A contract that is a derivative in its entirety should be recorded at fair value (unless the normal purchases and normal sales scope exception is applied, in which case the contract follows an executory contract model).
  • Contract includes an embedded derivative—ASC 815-15-30-2 requires reporting entities to record an embedded derivative separate from its host contract at fair value at inception (i.e., generally at zero on day one for non-option based derivatives and at fair value for options, resulting in no “day one” gain or loss); the remaining value is assigned to the host contract.
  • Contract contains multiple embedded derivatives—If the contract contains multiple embedded derivatives, they should be accounted for as one component (i.e., a compound derivative). See UP 3.4 for further information.
4(b) Allocate consideration between lease and nonlease components (excluding derivatives)
After the adoption of ASC 842:
  • Contract consideration should be allocated between lease components (lease of property) and nonlease components (other products and services, excluding any derivatives) generally based on the relative standalone price of the separate components.
  • A lessee may elect an accounting policy, by asset class, to include both the lease and nonlease components as a single component and account for it as a lease. If elected, allocation between lease and nonlease components would not be required. See LG 2.4.
  • A lessor may elect to aggregate nonlease components that otherwise would have been accounted for under ASC 606 with the associated lease component, if certain conditions are met. If elected, allocation between lease and nonlease components would not be required. See LG 2.4.

Prior to the adoption of ASC 842:
  • Figure UP 2A-6 within UP 2A summarizes key guidance to consider in determining the appropriate allocation related to the lease components under ASC 840.
4(c) Allocate to remaining components
  • Guidance for arrangements that contain multiple components (ASC 606-10) should be applied by both buyers and sellers to allocate contract consideration to any nonderivative, nonlease components.

1.2.5 Step five: Apply applicable accounting and disclosure

Individual topics associated with application of the commodity contract framework are further addressed in specific chapters within this guide. Refer to the relevant chapters highlighted below for further information.
  • Leases accounted for under ASC 840 – see UP 2A
  • Leases accounted for under ASC 842 – see UP 2
  • Derivatives and hedging – see UP 3
  • Consolidation – see UP 10
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