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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.
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