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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 1-1 outlines a recommended framework for evaluating commodity contracts:
Figure 1-1
Recommended framework for accounting for commodity contracts
This general framework for the evaluation of commodity contracts provides an overall approach to performing the analysis. 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 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 a central component of accounting for commodity contracts.

1.2.1 Step one: Determine the unit of accounting

The first step in evaluating the appropriate accounting for a commodity contract is to determine the unit of accounting. The unit of accounting will depend on the nature of the agreements and may be impacted by the accounting model applied to elements of the contract, as established in Step two of the commodity contract framework.
The guidance generally applicable to commodity contracts includes lease and derivative accounting, as well as specialized industry guidance and general guidance for executory contracts. When a contract contains multiple deliverables, these accounting models require consideration of whether there are any legally separable components (i.e., freestanding elements) that should be evaluated as separate units of accounting. In addition, in some cases, multiple agreements executed at the same time and in contemplation of each other may need to be accounted for as one contract (one unit of accounting) with multiple deliverables. Considerations in evaluating the unit of accounting include:
•  Freestanding elements
Features that are written in the same contract, but that may be legally detached and separately exercised would be considered freestanding instruments that should be accounted for separately — not subject to analysis in the context of the other deliverables under the contract. In such cases, once that element is separated, the remaining elements and deliverables would be evaluated in the context of the whole contract. For information on evaluating whether an element is freestanding or embedded, see UP 3.4, DH, and FG 7.3.
•  Multiple agreements entered into at the same time—when lease model is applicable
ASC 840, Leases, provides specific guidance for multiple agreements executed at the same time. ASC 840-10-15-16 indicates that the determination of whether a contract contains a lease should be based on the totality of the arrangement with the third party.

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 agreements in contemplation of one another—when derivative model is applicable
ASC 815, Derivatives and Hedging (ASC 815), also 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 accounting, 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. The characteristics to consider in making this assessment are: (1) the transactions 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; and (4) there is no substantive business purpose for structuring the transactions separately. If it is determined these characteristics are not present, the freestanding derivative instruments would be viewed as separate units of accounting.
Once the unit of accounting is determined, the reporting entity should apply the evaluation hierarchy applicable under U.S. GAAP, as further discussed in Step two. For purposes of this discussion, we have referred to the unit of accounting as the contract; however, as noted, the unit of accounting could be part of a contract or multiple contracts combined.

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

The U.S. GAAP hierarchy establishes when and in what order reporting entities should apply the accounting guidance in evaluating a commodity contract. In particular, the order of applying the hierarchy of guidance may significantly alter the accounting conclusions reached when evaluating a contract that includes more than one deliverable. The FASB has specifically addressed the scope of the guidance and clarified the order of application for multiple deliverable contracts within ASC 605, Revenue Recognition.
ASC 605-25 addresses the interaction of the revenue recognition guidance and the application of the multiple-elements approach when a contract includes leases or elements that are in the scope of other ASC topics. In accordance with ASC 605-25-15-3A(a), deliverables in a multiple-element arrangement that are within the scope of another area of U.S. GAAP should follow the other separation and allocation guidance, as applicable.
When evaluating a multiple deliverable contract, the reporting entity should initially evaluate each element separately to determine the applicability of the lease and derivative accounting models. In applying the contract hierarchy, it would account for any lease or derivative elements as separate units of accounting if they meet the hybrid bifurcation criteria (in the case of derivatives). See UP 3.4 for further information on evaluating embedded derivatives.
New guidance
ASC 606, Revenue from Contracts with Customers, includes new guidance on revenue recognition that is effective for public companies filing U.S. GAAP financial statements in the first interim period within annual reporting periods beginning on or after December 15, 2016. Preparers and other users of this publication should consider whether the new guidance will change any conclusions reached under current U.S. GAAP.
Figure 1-2 depicts the evaluation hierarchy.
Figure 1-2
Hierarchy for application of U.S. GAAP to a sample compound commodity contract
For purposes of illustrating the hierarchy, this example assumes that the contract does not contain a lease, and is not a derivative in its entirety. It assumes that derivative accounting is applicable to the energy component, but not to the capacity, ancillary services, and renewable energy credits (RECs) within the agreement. In addition, unless the contract is a derivative in its entirety, it should be evaluated for any embedded derivatives potentially requiring separation from the host contract. The illustration is intended to depict application of the U.S. GAAP hierarchy to an example contract.
As illustrated in Figure 1-2, in accounting for a contract with multiple deliverables, a reporting entity should first determine whether the contract contains a lease. 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 requiring separation from the host contract. Both parties to the contract would then apply an executory contract accounting model to any remaining elements. The evaluation hierarchy is further discussed in the following sections. Step 2(a): Determine whether the contract is or contains a lease

In determining the unit of accounting, a commodity contract should be evaluated to determine whether the contract contains a lease. It should perform the lease assessment prior to the application of any other potentially applicable U.S. GAAP. Lease accounting under ASC 840 would apply if the contract explicitly or implicitly identifies specified property, plant, or equipment.
See UP 2 for further information on determining whether a contract contains a lease.
Question 1-1

Why is lease accounting considered first when determining the accounting model(s) to apply to a commodity contract?
PwC response
The lease assessment is performed before evaluating application of the derivative guidance in accordance withASC 815-10-15-79, which provides a scope exception for leases.

ASC 815-10-15-79

 Leases that are within the scope of Topic 840 are not derivative instruments subject to this Subtopic, although a derivative instrument embedded in a lease may be subject to the requirements of paragraph 815-15-25-1.

There are some contracts that contain a lease under ASC 840 that 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. 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 element that would be a derivative on a stand-alone basis (e.g., both energy and natural gas) along with nonderivatives (e.g., renewable energy credits). ASC 815 provides guidance on the evaluation of compound contracts. Specifically, ASC 815-15-25-7 and 25-8 address compound embedded derivatives in a hybrid contract and require that they be bundled together as a single, compound embedded derivative to be accounted for separately from the host contract, instead of being separated as 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): Determine whether executory contract accounting applies

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 elements. 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). In addition, reporting entities may need to consider revenue recognition guidance for contractual elements such as renewable energy credits (see UP 7). Accrual accounting should be applied to any remaining elements of the contract.

1.2.3 Step three: Determine whether 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 accounting. 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.
New guidance
In February 2015, the FASB issued ASU 2015-02, Consolidation–Amendments to the Consolidation Analysis. The standard is effective for public reporting entities in fiscal periods beginning after December 15, 2015, and fiscal periods beginning after December 15, 2016 for nonpublic business entities. Early adoption is permitted. See UP 10 for information on evaluating whether a single power plant entity should be consolidated under both the current and amended guidance.

1.2.4 Step four: Determine allocation of 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 deliverable, but may be more complex if the contract contains more than one element.
A reporting entity should allocate contract consideration after it determines the accounting model applied to each component or element of the contract. The hierarchy for allocating consideration differs from that used to determine the appropriate accounting model. Consideration should be allocated first to any derivative elements (in contrast, lease accounting is assessed first in the determination of the appropriate accounting model).
Figure 1-3 summarizes key guidance to consider in determining the appropriate allocation of revenue and costs among contract components once the unit of accounting has been established.
Figure 1-3
Allocation of contract consideration
Allocation considerations
4(a) Allocate fair value to derivative elements
• 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 separated 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 element (i.e., a compound derivative). See UP 3.4 for further information.
4(b) Allocate relative fair value between lease and nonlease elements (excluding derivatives)
• Overall allocation—In accordance with ASC 840-10-15-19, total consideration should be allocated between lease elements (lease of property and related executory costs) and nonlease elements (other products and services, excluding any derivatives), based on relative fair value in accordance with ASC 605-25-15-13A(b).
• Methods of allocation—There are three acceptable methods of allocating between lease and nonlease elements: (1) variable expected volume method; (2) fixed expected volume method; and (3) minimum volume method. See ARM 4650.161 for information.
• Nonlease elements—The allocation of consideration among the nonlease elements should follow the guidance for derivatives or multiple-element arrangements as applicable.
4(c) Allocate among lease elements
• Lease payments should first be allocated to executory costs, including profit thereon.
• The amount remaining is assigned to lease payments, assuming there are no contingent rentals.
4(d) Allocate to remaining elements
• Guidance for multiple-element arrangements (ASC 605-25) should be applied by both buyers and sellers to allocate contract consideration to any nonderivative, nonlease elements.

1.2.5 Step five: 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 for further information.
1Guidance originally issued as Emerging Issues Task Force (EITF) Issue No. 91-6, Revenue Recognition of Long-Term Power Sales Contracts, and EITF Issue No. 96-17, Revenue Recognition under Long-Term Power Sales Contracts That Contain both Fixed and Variable Pricing Terms, has been primarily codified as ASC 980-605-25-5 through 25-15 and ASC 980-605-25-17 and 25-18, respectively.

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