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ASC 815-10-15-83 describes three criteria that all must be met for a commodity contract to qualify as a derivative instrument:
  • There is an underlying, and one or more notional amounts and/or payment provisions
  • There is little or no initial net investment
  • Net settlement is permitted or required
The following sections highlight considerations in evaluating those criteria.

3.2.1 Underlying, notional amount, payment provision

In evaluating a contract to determine whether it is a derivative, the first criterion is that it has an underlying and a notional amount (or payment provision).

ASC 815-10-15-83(a)

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
  1. One or more underlyings
  2. One or more notional amounts or payment provisions or both.

The underlying is generally clearly defined in a typical commodity contract: it is the price or rate of the specified commodity (e.g., $/MWh, $/MMBtu). ASC 815-10-55-77 through 55-83 provide additional guidance on the determination of the underlying in commodity contracts. Consistent with this guidance, the underlying may be a fixed price, the market price at the time of delivery, or a price based on a contractual formula (e.g., the prevailing market index plus or minus a basis differential).
The notional is also explicitly stated in many natural gas or power contracts, and in such cases the underlying and notional evaluation is typically straightforward. However, commodity contracts may be designed to provide flexibility in meeting operating requirements or may be tailored to meet the needs of one of the parties to the agreement. As a result, the evaluation of whether a commodity contract has a notional amount is often one of the most challenging issues in determining whether a contract is a derivative. Common contracts that may require further evaluation include:
  • Commodity contracts with volumetric optionality, including requirements contracts
  • Contracts for the sale or purchase of capacity and/or power from a specified generating facility
  • Power or capacity contracts with complex default provisions
  • Other contracts with terms that provide some flexibility to the purchaser or seller or where a notional amount is not explicitly stated

Guidance on determining the notional amount of commodity contracts is addressed in ASC 815-10-55-5 through 55-7 and is further discussed in this section.

3.2.1.1 Requirements contracts

Utilities and power companies often enter into requirements contracts for the supply or sale of power or natural gas. A requirements contract is defined in ASC 815-10-55-5 as a contract that requires one party to the contract to buy the quantity needed to satisfy its needs.

Excerpt from ASC 815-10-55-5(a)

As many units as required to satisfy its actual needs (that is, to be used or consumed) for the commodity during the period of the contract (a requirements contract). The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).

Although this type of contract is entered into to meet the needs of one of the parties to the contract, it may meet the definition of a derivative. A reporting entity will need to analyze the terms of the requirements contract to determine whether it is a derivative instrument; that determination depends in part on whether the contract contains a notional amount.
The requirements contract guidance in ASC 815-10-55-5 through 55-7 is only applicable in cases where the seller is to supply all of the purchaser’s needs and where the purchaser “cannot buy excess units for resale.” For example, this guidance would apply to the accounting for a requirements contract between a small irrigation district and its local investor-owned utility, whereby the utility procures power for the district. The utility supplies all of the power required by the irrigation district’s retail customers; however, the quantity of power sold under the contract is limited to the level required to serve the irrigation district’s retail load.
We believe that reporting entities should consider the requirements contract guidance in conjunction with the guidance on penalties for nonperformance or default in ASC 815-10-15-103. In a requirements contract, the contract has a notional amount only if the contract includes a reliable means to determine a quantity. Settlement or default provisions in the contract may provide that means. In evaluating whether this type of contract has a notional amount, reporting entities should consider:
  • Is there a specified minimum or maximum quantity?
    If the contract includes a specified minimum quantity, the notional amount will be at least equal to that amount. However, the notional may be larger than the minimum, depending on other contract provisions. If the contract specifies only a maximum quantity, the counterparties should evaluate the other contract provisions to determine whether there is a notional amount, because a maximum quantity alone would not create a notional. Any notional present would not be greater than the maximum amount specified. In all cases, the quantity requirement should be enforceable through the default provisions or another mechanism in the contract.
  • Is there an explicit mechanism to calculate a determinable amount supporting the buyer’s needs?
    Many requirements contracts include a specific methodology for determining the expected amount to meet the buyer’s needs. For example, the contract may include a formula to calculate expected deliveries under the contract based on a three-year historical average. In addition, the contract’s default provisions should be reviewed when considering whether these types of calculations are included, thus potentially creating a notional amount. If neither party has recourse against the other for failure to take or deliver the specified quantities, then the default provisions would not create a notional amount. See further discussion regarding default provisions below.
  • Does the contract have settlement or other default provisions that specify quantities?
    Consideration of the settlement and default provisions will often determine whether a commodity contract has a notional amount. In some cases, the default provisions specifically refer to anticipated quantities or specify a formula to use in the calculation of penalty amounts in the event of nonperformance. The default provisions need to be significant enough to force performance. If the penalty for default is minimal, the default provisions may not create a notional amount. The determination of whether a default provision is significant is judgmental and specific to the facts and circumstances considering the nature of the penalty, the amount in relation to the overall contract, and similar factors. See UP 3.2.1.4 for further information.
  • Does the contract include other forms of performance assurance that support calculation of a notional?
    Contracts may also include other forms of performance assurance, such as a requirement to post letters of credit or alternative forms of collateral (including parent guarantees), or to provide step-in rights if the seller fails to perform. Such contracts may include appendices or exhibits that provide quantity estimates that are used to determine the level of collateral or margining required. These types of performance requirements would generally create a notional amount under the contract if management determines (with the assistance of legal counsel if necessary) that the quantities specified are equivalent to default provisions within the contract. However, if such amounts would be considered as one factor in a default but are not determinative, in general, we do not believe that this would create a notional amount because there is no legally enforceable quantity. The key question is whether there is a quantity specified that can be enforced by either of the parties to the contract in the event of nonperformance. See Example 3-1.
In evaluating a requirements contract, there is no notional amount unless either the buyer or seller has the right or ability to enforce a quantity at a specified level, or if the seller is compelled to perform due to a material penalty provision. Provisions supporting the notional amount should be included in the contract itself or a legally binding side agreement. Informal discussions between the counterparties, information provided only for scheduling purposes, and other similar support would not be sufficient to create a notional amount. See also UP 3.2.1.3 for further information about application of this guidance to plant-specific contracts.
Question 3-1
Does the fact that a commodity agreement includes a prohibition against resale mean that it is a requirements contract?
PwC response
Not necessarily. Although a resale prohibition may be indicative that the requirements contract guidance is applicable (as illustrated in ASC 815-10-55-5(b) below), this would not, on its own, be determinative that a contract is a requirements contract. Application of the requirements contract guidance often results in a different conclusion regarding the notional amount when compared to application of the general derivative guidance. In considering whether the requirements contract guidance applies, ASC 815-10-55-5(b) addresses contracts that are designed to meet the buyer’s actual needs and that also prohibit resale.

Excerpt from ASC 815-10-55-5(b)

Only as many units as needed to satisfy its actual needs up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).

Therefore, in addition to a restriction on resale, there should also be evidence that the contract is designed to satisfy the buyer’s needs in order to qualify as a requirements contract.
Question 3-2
In a requirements contract, does the presence of contractual provisions that acknowledge potential changes in a buyer’s needs impact the determination of notional amount?
PwC response
Sometimes. Reporting entities procuring power under requirements contracts typically need some flexibility to adjust the contract quantity in response to changes in demand. Some contracts specify a minimum quantity and provide flexibility for additional amounts. Other contracts may incorporate default or other provisions based on average historical load over a specified period, with provisions for adjustments due to load shift or other factors.
ASC 815-10-55-7(a) acknowledges that the notional quantity may change over the life of a contract. In accordance with this guidance, there would be no notional if the determination of the amount is highly subjective and unreliable. However, when a contract includes default or other provisions that specify a methodology for determining a notional amount, the contract contains a notional. Subsequent changes in factors impacting the calculation (e.g., load changes) would be incorporated by updating the notional amount and the calculation of the derivative’s fair value as additional information is available.

Excerpt from ASC 815-10-55-7(a)

The determination of a requirements contract’s notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. If the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable (for example, if a contract does not contain settlement and default provisions that explicitly reference quantities or provide a formula based on historical usage), such contracts are considered not to contain a notional amount as that term is used in this Subtopic.

ASC 815-10-55-7(a) provides an example of a contract with default provisions that calculate penalty amounts in the event of nonperformance based on a rolling historical average. The notional will change over time; however, because the quantity is determinable at any point, it represents a notional amount that should be used in the assessment of whether the contract is a derivative instrument. The changes in the notional amount should be incorporated as they occur on a prospective basis. This is supported by the guidance in ASC 815-10-55-7(a).
See simplified Examples 3-1 through 3-4 for illustration of application of the guidance relating to the determination of whether a contract meets the characteristics of a requirements contract.

3.2.1.2 Capacity and other option contracts

The requirements contract guidance on notional amounts applies only where the quantity sold is based on the operational needs of one of the parties to the contract and neither the buyer nor the seller can enforce the quantity specified under the contract for profit (i.e., the buyer or seller cannot make purchase or sale decisions to profit from market changes). Most commodity contracts either specify a quantity or provide volumetric control to either the seller (a put option) or the buyer (a call option); in such cases, the requirements contract guidance on notional amounts would not apply. An option contract provides at least one of the parties with the ability to compel delivery and would not meet the criteria for application of the requirements contract guidance.
The primary difference between a requirements contract and an option contract is the limitation on the ability of the parties to control the quantity taken under a requirements contract. In an option contract, the buyer and seller will put or call the commodity based on the strike price and commodity market prices or operational needs. In contrast, in a requirements contract, the quantity is defined by the specified requirements of one of the parties to the agreement, thus volumes in excess of the requirements cannot be purchased. Although the contract may be referred to as a capacity contract or a supply contract, any agreement that provides one party with the ability to profit from the flexibility to call or put a certain volume of a commodity at its option is highly likely to have a notional amount for the option’s stated volume.
Question 3-3
How is the assessment of a notional amount affected if a contract is a capacity contract rather than an option contract?
PwC response
An agreement’s classification as a capacity or an option contract has no bearing on the determination of notional amount. ASC 815-10-55-31 provides guidance for determining whether a power supply agreement is a capacity contract or an option contract. This guidance is applied to evaluate whether a contract qualifies for the power-specific normal purchases and normal sales scope exception. However, a conclusion that a contract is a capacity contract does not impact whether it has a notional amount.
In evaluating whether a contract has a notional amount, a reporting entity should assess all relevant contract terms, including settlement and default provisions to determine if a notional amount can be reliably determined. It should also assess whether the contract qualifies for the specialized guidance for requirements contracts.
Question 3-4
How should a reporting entity evaluate whether there is a notional amount when considering a hybrid instrument that includes both energy and capacity?
PwC response
In many tolling and similar agreements, the seller is required to provide a specified amount of capacity and the buyer can call an equivalent quantity of electric energy on an as-needed basis.
The evaluation of whether a tolling agreement is a derivative in its entirety or contains any embedded derivatives is discussed in UP 3.6.5. Focusing solely on the question of whether this type of contract has a notional amount, a question may arise as to the notional of the energy component. The default provisions in this type of contract often focus on plant availability and the specified amount of capacity, and may not include a separate penalty related to delivery of energy. However, because capacity represents the ability to generate energy, we believe that a sufficiently large penalty related to capacity will also create a notional amount of energy. The notional amount for the energy will be based on the required level of capacity, because the energy option can be exercised and energy can be produced if the plant is available. Therefore, the energy component would have a notional.
See UP 1 and UP 3.4 for further information on the clearly and closely related evaluation and other considerations related to embedded derivatives. See UP 3.2.1.4 for examples illustrating the determination of a notional amount for various types of contracts.

3.2.1.3 Plant-specific contracts

The determination of notional amounts also may be complex when evaluating contracts that explicitly specify a particular plant or other source of supply (plant-specific contracts). We believe the requirements contract guidance discussed in UP 3.2.1.1 may be applied by analogy to contracts where delivery is dependent upon the successful operation of a specified plant or system. This is based on the premise that the volumes under such contracts cannot be assured, absent a specific performance guarantee.
In evaluating contract terms and default provisions, reporting entities should consider the guidance provided by ASC 815-10-15-103. This paragraph addresses whether a contract has the characteristic of net settlement, not whether it has a notional amount. However, its discussion of performance penalties is helpful in assessing whether a contract has a notional amount.

Excerpt from ASC 815-10-15-103(c)

A contract that contains a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract does not contain a net settlement provision…if it also contains an incremental penalty of a fixed amount (or fixed amount per unit) that would be expected to be significant enough at all dates during the remaining term of the contract to make the possibility of nonperformance remote. If a contract includes such a provision, it effectively requires performance, that is, requires the party to deliver an asset that is associated with the underlying.

Nonperformance penalties, including certain make-whole contract provisions, sufficient to induce performance would typically result in a conclusion that a contract has a notional amount equal to the quantity used in the penalty calculation. In contrast, a contract that ties performance to the availability of a specified facility, with no penalty for nonperformance, has no notional amount and, as such, is not accounted for as a derivative.
The combination of specifying the plant and the lack of penalty for nonperformance leads to the conclusion that the contract does not have a notional amount. The lack of a nonperformance penalty alone would not lead to the conclusion that the contract has no notional amount in a contract where the quantity is specified and there is no explicit source of supply. In that case, the supplier would have no basis for nonperformance and the purchaser would have recourse under standard contract law if the supplier fails to deliver. This type of contract would have a notional calculated based on the quantity specified in the agreement.
Question 3-5
Does a unit-contingent contract for a plant under construction contain a notional amount?
PwC response
It depends. Utilities and power companies may enter into contracts for output from a specified power generating facility for which construction has not commenced or is still ongoing. In such cases, even if a quantity is specified in the contract, a question may arise as to whether the contract has a notional amount during the period between the signing of the contract and the commercial operation date.
In evaluating whether a plant-specific contract has a notional amount, the reporting entity should consider the contract terms and the enforceability of the contract. Factors to consider in making this assessment include:
  • Cancellation clauses related to permitting or other approvals—Does the contract automatically terminate if all required approvals are not received by a certain date?
  • Penalties for nonperformance—Does the contract include provisions that penalize the seller if the plant is not completed by a specified date?
  • Nature of the technology—Does the plant involve experimental technology or involve other factors that may increase construction risk and create greater uncertainty about achieving commercial operation?
  • Certification of plant—If applicable in the specified market, has the regional transmission organization or other certifying party cleared the plant to be a qualified capacity resource?
  • Other uncertainties—Are there other uncertainties associated with the construction that could impact the timing of contract commencement or quantities to be delivered?
Similar to the determination of a notional amount in other contracts, in evaluating the notional amount related to a plant under construction, the reporting entity should consider whether performance under the contract may be enforced. Therefore, cancellation clauses for various contingencies with no penalty to either party would lead to a conclusion that the contract does not have a reliable notional amount and should not be accounted for as a derivative. In contrast, contract provisions that result in significant penalties if the commercial operation date is not achieved would likely support a notional amount.
Reporting entities should consider the specific facts and circumstances in evaluating this type of contract. However, typically, we would not expect derivative accounting to commence until the plant has started commercial operation, unless the contract includes penalties for nonperformance that are sufficient to compel completion of construction of the plant by the specified date. In some cases, the determination of whether a notional exists will change over the construction period as specific milestones are met and penalties for nonperformance change. The notional amount may also need to be reassessed at the commercial operation date. In addition, in evaluating this type of contract, reporting entities should consider the general guidance for plant-specific contracts and the determination of a notional amount.

3.2.1.4 Application examples—Requirements contracts

The following simplified examples are provided to illustrate the application of the guidance on requirements contracts and plant-specific contracts. The sample fact patterns have been included solely for the purpose of assessing whether the contracts have a notional amount in accordance with ASC 815.
EXAMPLE 3-1
Determination of notional amount — natural gas supply agreement with take-or-pay minimum and contract maximum
Ivy Power Producers (IPP) owns the Maple Generating Station, a 500 MW natural gas-fired power plant. IPP enters into a natural gas supply agreement with Guava Gas Company (GGC), a natural gas supply company. The parties to the agreement understand that the supply is for the operation of the Maple power plant. The contract has a maximum daily quantity (10,000 MMBtus per day). IPP is required to take or pay for a minimum amount representing at least 75% of the maximum daily quantity specified in the contract and may take additional amounts up to the maximum specified.
Does the arrangement qualify as a requirements contract?
Analysis
This contract is not a requirements contract as addressed in ASC 815-10-55-5 because it does not explicitly link the purchases to production at the plant nor does it prohibit the purchase of natural gas for resale. Rather, this is a combined forward and option contract that should be accounted for as a derivative if all of the other provisions in ASC 815 are met. Although IPP intends to use the natural gas for production at the Maple power plant, it could elect to take excess quantities for resale into the wholesale market (e.g., if the contract price is lower than the then-current market price). The conclusion would not change even if the parties to the contract had a mutual understanding that the contract was intended to supply generation at a particular plant. To qualify for the requirements contract guidance, restrictions on use of quantities provided and the prohibition on resale should be explicitly stated in the contract.
In this example, the contract represents a forward contract for 75% of the maximum daily quantity (7,500 MMBtus) and an option contract for the remaining 25% (2,500 MMBtus). See UP Example 3-18 for information on application of the normal purchases and normal sales scope exception to a contract with this fact pattern.
EXAMPLE 3-2
Determination of notional amount — natural gas supply agreement to supply all of the needs of a generating facility
Assume the same facts as in Example 3-1, except that the contract specifies that quantities provided are intended to supply all of Ivy Power Producer’s natural gas needs for the Maple Generating Station. In addition, IPP is required to take at least 7,500 MMBtus/day and may take additional amounts up to 10,000 MMBtus/day. The agreement explicitly states that all purchases under the contract must be used for generation at the Maple power plant and that resale is prohibited.
Does the arrangement qualify as a requirements contract?
Analysis
Because quantities delivered under the agreement are limited to what can be used in the Maple power plant and no amounts can be resold, the quantity supplied is not fully in the control of either party to the contract (quantity may change due to unplanned outages, performance issues, or other factors). Therefore, the contract is a requirements contract that should be evaluated in accordance with the guidance provided by ASC 815-10-55-5 through 55-7.
IPP is required to take at least 7,500 MMBtus/day, even if the Maple power plant is shut down or it cannot otherwise use it for operations. Therefore, in accordance with the requirements contract guidance, this contract represents a forward contract for the minimum amount that IPP is required to take under the contract terms (7,500 MMBtus/day). There is no derivative accounting for the additional “option” component. In this example, the notional amount is equal to the minimum quantity IPP is required to take (7,500 MMBtus). See Example 3-19 for information on application of the normal purchases and normal sales scope exception to a contract with this fact pattern.
EXAMPLE 3-3
Determination of notional amount — contract to provide power to a load-serving entity
Ivy Power Producers (IPP) participated in the 20X1 load auction in Pennsylvania and was awarded a full requirements contract with Rosemary Electric & Gas Company (REG). Under the terms of the agreement, IPP must supply all of the electric energy, capacity, and ancillary services required to meet a specified percentage of REG’s retail customer load. No notional amount is specified in the contract and the amount supplied will depend on actual customer usage. The contract includes a “check-the-box” default provision whereby settlement for default will be determined at the seller’s option either (a) in a commercially reasonable manner or (b) based on a formula tied to REG’s historical retail load. IPP elected to have default determined based on historical load.
Does the contract have a notional amount?
Analysis
To determine the notional amount of the contract, the guidance on notional amounts of requirements contracts in ASC 815-10-55-7 should be considered.

Excerpt from ASC 815-10-55-7

The conclusion that a requirements contract has a notional amount as defined in this Subtopic can be reached only if a reliable means to determine such a quantity exists. Application of this guidance to specific contracts is as follows:
(a)...One technique to quantify and validate the notional amount in a requirements contract is to base the estimated volumes on the contract’s settlement and default provisions. Often the default provisions of requirements contracts will specifically refer to anticipated quantities to utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions stipulate penalty amounts in the event of nonperformance based on average historical usage quantities of the buyer. If those amounts are determinable, they shall be considered the notional amount of the contract.

Consistent with this guidance, in this fact pattern, the requirements contract has a notional amount that can be determined based on the historical load-based formula included in the default provisions. The fact that the notional amount will fluctuate over time as a result of fluctuations in load does not change the conclusion that the contract has a notional amount (see the response to Question 3-2 regarding load shift). This applies to both parties to the contract. Note that the contract would not have a notional amount if IPP had instead elected to settle any default in a commercially reasonable manner (unless there is another measurable way to determine the notional based on the contract provisions).
In evaluating whether there is a notional amount, the key question is whether there is a quantity specified in the contract that can be enforced by one of the parties to the contract in the event of nonperformance. The quantity may be stable throughout the contract or may require continuous evaluation at various points in time. We believe that the parties to the contract should evaluate all contract provisions, not just default clauses, in assessing whether the contract has a notional amount. In some cases, collateral posting or other requirements, such as margining, may lead to a conclusion that there is a reliably determinable notional amount, if those terms would be used to determine penalties for default. However, if such amounts would provide an input into determining whether a default had occurred but would not be the primary basis for determining the amount of such default penalty, such provisions would typically not support a conclusion that the contract has a notional amount.
EXAMPLE 3-4
Determination of notional amount — contract for electricity sales to a retail customer
Ivy Power Producers (IPP) enters into a supply agreement with Direct Access Customer 1 (DA1), whereby IPP agrees to provide electricity sufficient to meet DA1’s needs as well as providing scheduling and related services. The contract specifies a minimum quantity of electricity that DA1 is required to take. The contract also specifies a maximum quantity. Additional amounts above the maximum may be available at the same price, subject to agreement by both parties to the contract. DA1 must source all of its electricity needs, up to the maximum specified in the contract, from IPP. The contract is silent with respect to resale.
Is the arrangement a requirements contract?
Analysis
The contract is structured to meet DA1’s actual needs, and IPP is performing scheduling and other services for the customer. Based on the factors provided, DA1 would be able to purchase additional amounts in excess of its actual needs for resale. Therefore, the requirements contract guidance would not be applicable. This is the case even though DA1 may not have knowledgeable resources to resell the energy and that it may not be practical for this type of customer to take advantage of market fluctuations. Because the requirements contract guidance is not applicable, the contract is a combined forward and option contract, similar to the contract discussed in Example 3-1. However, because this is a contract for power, it may be eligible for the normal purchases and normal sales scope exception provided by ASC 815-10-15-45 through 15-51. See UP 3.3.1 for further information on application of the normal purchases and normal sales scope exception.
Note that the evaluation would be different if the contract specified that DA1 could only take amounts necessary to meet its needs, prohibited resale, or other similar language. In such case, the requirements contract guidance would apply and the notional amount would be equal to the minimum specified in the contract.
EXAMPLE 3-5
Determination of notional amount — natural gas contract with specified source of natural gas
Assume the same facts as in Example 3-1, except that the source of natural gas supply is specified. Guava Gas Company must supply the natural gas from certain specified wells and is not permitted to source the natural gas from an alternative supply. Ivy Power Producers must take and pay for the minimum quantity specified in the contract unless GGC cannot deliver, in which case IPP is not required to take or pay for the natural gas. IPP also has an option to take additional quantities, if available. There are no specified penalties for nonperformance.
Does the minimum quantity represent a notional amount?
Analysis
Although IPP must take and pay for a minimum quantity, the contract specifies that the source of supply and natural gas cannot be provided by another source and does not include significant penalties for nonperformance. As neither party can effectively be compelled to perform, the minimum quantity does not represent a notional amount. Furthermore, since IPP’s option to take additional natural gas is only exercisable if the plant is available and IPP is required to perform only if GGC delivers, there is no notional amount. As such, the contract in this example would not qualify as a derivative in accordance with ASC 815.
Alternatively, assume the contract stated that each month GGC would notify IPP of the estimated volumes available from the wells for the next month, and IPP would notify GGC of the volumes it elected to take by the next day. If the contract required GGC to provide the elected volumes to IPP regardless of the fluctuation of the daily actual production from the wells, then the contract would have a notional amount each month for the subsequent month’s sales, as the volume has been fixed and is subject to nonperformance penalties.
EXAMPLE 3-6
Determination of notional amount — plant-specific capacity contract with a proportionate refund of capacity charge for nonperformance
Ivy Power Producers (IPP) agrees to sell all of the electric energy and capacity from Maple Generating Station, a 500 MW natural gas-fired power plant, to Rosemary Electric & Gas Company (REG). Energy and capacity supplied under the agreement must be sourced from the Maple power plant. The plant must perform at 80% (or higher) capacity during the summer peak period. The penalty for nonperformance is a refund of the capacity charge to the extent of nondelivery. For purposes of this example, assume that the contract does not contain a lease.
Does the arrangement contain a notional amount?
Analysis
There is no notional amount in a plant-specific contract where the sole penalty for nonperformance is the refund of a proportion of the capacity charge (i.e., the refund of amounts paid for capacity that was not delivered). The refund of capacity charges equal to the amount not delivered is generally not considered to be a sufficient penalty to compel performance under the contract. As such, the contract does not have a notional and does not meet the definition of a derivative under ASC 815.
EXAMPLE 3-7
Determination of notional amount — plant-specific contract with a refund of current and previously received capacity charges for nonperformance
Assume the same facts as in Example 3-6; however, failure to meet the requirements two years in a row will result in a decrease in the plant’s capacity rating under the contract. If the plant capacity rating is reduced, Ivy Power Producers will be required to refund capacity payments received related to the derated amount from the inception of the contract (i.e., if the capacity rating is reduced from 95% to 90% and the plant is 100 megawatts, it would have to refund all prior capacity payments received related to 5 megawatts of capacity).
Does the contract have a notional amount?
Analysis
IPP should perform an analysis to determine whether the refund penalty is onerous enough that it would be expected to compel performance under the contract. This analysis should compare payments under the contract to the expected market price of power. If the refund of capacity payments is significant, IPP would be expected to ensure the availability of the plant, and would thus conclude that the contract has a notional amount. In the example fact pattern, the penalty is likely sufficient to conclude that the contract has a notional amount. However, if the penalty is relatively small in relation to market prices (e.g., if only a portion of the capacity payment has to be refunded), additional evaluation, such as the existence other non-performance penalty provisions, may be necessary.
EXAMPLE 3-8
Determination of notional amount — non-firm energy contract
Ivy Power Producers (IPP) agrees to sell all of the electric energy from Wisteria Wind Power Plant, a 40 MW wind facility, to Rosemary Electric & Gas Company (REG). Electric energy supplied under the agreement must be sourced from the Wisteria Wind facility. IPP will receive energy payments based solely on amounts delivered (sometimes referred to as “as-available energy”). There is no separate capacity payment and no minimum quantity of energy or capacity specified in the contract. Furthermore, there are no forms of performance assurance or requirements.
Does the contract have a notional amount?
Analysis
A plant-specific contract with pay-for-performance contract terms and no specific performance requirements would not have a notional amount. This conclusion would not change even if IPP had reliably delivered a certain amount under the contract over multiple years. Although the buyer may assume that delivery is probable, there is no assurance of a minimum level of deliveries under the contract, thus, there is no notional amount.
It should be noted that, unlike the discussion of minimum lease payments in UP Question 2-24, where a contract for the forward purchase or sale of power generated from a renewable resource would always be deemed to be contingent rent for lease accounting, a similar arrangement may in fact be deemed to have a notional for derivative accounting if the plant-specific contract stipulates an amount and performance assurance or requirements were accompanied by a significant enough penalty for non-performance.
A penalty based only on availability and not actual production would generally not be indicative of a notional amount. For example, a renewable facility that guarantees it will be available for 90% of the contract term, but has no guarantee for actual production would not include a notional. This is because the facility can be available but not generate any electricity (if there is no sun in the case of a solar facility, or no wind in the case of a wind facility). If the contract guarantees a level of output, even for a fuel source outside the control of the parties, and would require significant compensation for not meeting that level of output, it would include a notional.
EXAMPLE 3-9
Determination of notional amount — plant under construction
Ivy Power Producers (IPP) plans to build a 575 MW combined-cycle natural gas-fired facility, Camellia Generating Station. To issue debt to raise funds to begin construction, in March 20X1 IPP signs a 25-year power sales agreement with Rosemary Gas & Electric Company (REG). REG agrees to purchase 300 megawatts of the capacity and energy generated by the Camellia plant. The power sales agreement specifically states that the capacity and energy must be supplied from the Camellia power plant and cannot be purchased from the market or generated from another facility. In addition, the agreement states that if commercial operation does not begin by January 1, 2015, then either party can terminate the agreement with no obligation by either party to make any payments to the other party. IPP has another off-taker and concludes that the REG contract is not a lease.
Does the contract have a notional amount?
Analysis
This contract does not have a notional amount until the plant is constructed and in commercial operation. Although a quantity is specified in the contract, the quantities can be provided only by the Camellia power plant, which is still under construction. Additionally, if commercial operation is not achieved by the specified date, the contract automatically terminates with no penalties paid. As a result, there is no notional amount for the agreement because there is no stated amount for which delivery can be enforced until the plant is constructed. The contract currently does not represent a binding requirement to purchase or sell any specified amount of power until construction is completed. At that time, additional evaluation of the contract will be required. Note that this conclusion would likely change if there is a significant penalty for failing to complete construction by the deadline (e.g., IPP is required to pay REG the difference between the contract price and the market price if it fails to deliver starting in January 1, 2015).

3.2.2 Initial net investment

The second criterion that needs to be met for an instrument to qualify as a derivative is that no or a minimal initial net investment in the contract is required.

ASC 815-10-15-83(b)

Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

ASC 815-10-15-94 through 15-98 define a derivative instrument as either a contract that does not require an initial net investment or a contract that requires an initial net investment that, when adjusted for the time value of money, is “less, by more than a nominal amount” than the initial net investment that would be required to acquire the asset related to the underlying or to incur an obligation related to the underlying.
For example, a natural gas contract whereby the purchaser prepays for a fixed quantity of natural gas at a stated price based on a discounted cash flow analysis as of the contract date would not be a derivative in its entirety because an initial net investment is required that is equal to the value of the natural gas. Further evaluation would be required if a reporting entity enters into an in-the-money option contract to purchase natural gas with a significant amount of cash paid at the inception of the contract. The reporting entity would need to assess whether the amount of the upfront payment is more than nominally less than what would otherwise be required to acquire the natural gas and, therefore, results in the contract not meeting the initial net investment criterion.
Although the FASB did not provide a bright line for what constitutes “less, by more than a nominal amount,” its intention appears to be that an initial net investment that is less than at least 90% of the amount that would be exchanged to acquire the asset or incur the obligation would satisfy this criterion. This has been referred to throughout the guide as the no initial net investment criterion.
Question 3-6
Does a plant-specific power contract that requires the construction of a generation facility contain a significant initial net investment represented by the construction costs of the generation facility?
PwC response
No. Capital outlays for construction of the power plant do not form part of the cash flows required to be exchanged under the terms of the power contract itself. Therefore, such cash flows should not be considered in the evaluation of whether the power contract requires an initial net investment.

3.2.3 Net settlement

The third criterion to meet the definition of a derivative is that there is a means to net settle the contract.

ASC 815-10-15-83(c)

Net settlement. The contract can be settled net by any of the following means:
  1. Its terms implicitly or explicitly require or permit net settlement.
  2. It can readily be settled net by a means outside the contract.
  3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Many utilities and power companies enter into financially settled swaps, options, and similar contracts with settlement based on changes in the underlying compared to a reference price included in the contract. Such contracts are net settled in cash and meet the ASC 815-10-15-83(c)(1) net settlement criterion. Evaluation of whether these contracts have net settlement provisions is typically straightforward and is not further discussed in this section.
In contrast, physical contracts for delivery of natural gas or power typically require delivery of the asset that is the subject of the contract (gross physical settlement). However, contracts that require physical delivery may still meet the net settlement criterion. In some cases the contract will permit explicit or implicit net settlement; other physically settled contracts will meet the net settlement criterion because of the existence of a market mechanism or because the contracts require delivery of an asset that is readily convertible to cash. The following sections describe specific considerations with respect to the net settlement evaluation of physically settled commodity contracts.

3.2.3.1 Net settlement under contract terms

When a contract has terms that implicitly or explicitly permit or require net settlement, neither party will be required to deliver an asset that is related to the underlying. Rather, settlement will be in cash or another asset based on the principal or other stated amount in the contract.

Excerpt from ASC 815-10-15-100

In this form of net settlement, neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount).

As part of the evaluation of whether a contract includes net settlement provisions, all of the contract’s default provisions and termination penalties should be evaluated. Figure 3-1 summarizes key considerations in evaluating default provisions.
Figure 3-1
Evaluating default provisions
Net settlement provisions
Not net settlement provisions
  • Symmetrical default provisions that allow either party to the contract to unilaterally settle the contract in cash without penalty
  • A variable penalty for nonperformance based on changes in the price of the underlying may be a form of net settlement
  • Asymmetrical default provisions that allow the nondefaulting party to demand payment from the defaulting party in the event of nonperformance, but do not result in the defaulting party receiving payments for the effects of favorable price changes
  • A fixed penalty for nonperformance (as the penalty does not change with changes in the underlying)
  • A variable penalty for nonperformance based on changes in the price of the underlying if it also includes an incremental penalty of a fixed amount (or fixed amount per unit) that is expected to be significant enough at all dates during the remaining term to make the possibility of nonperformance remote
ASC 815-10-15-103 states that penalties for nonperformance within a contract may constitute net settlement, and it provides examples of types of penalties and related guidance. Default provisions in a contract for delivery of a commodity such as natural gas or power may give the contract the characteristic of net settlement. Such provisions should be evaluated at contract inception to determine if they result in implicit net settlement consistent with ASC 815-10-15-100. Default provisions are further discussed in the following sections.
Symmetrical and asymmetrical default provisions
ASC 815-10-15-103 states that a penalty for nonperformance that is based on changes in the price of the items that are the subject of the contract may give the contract the characteristic of net settlement. It further states that net settlement would not occur if the default provisions are asymmetrical. Consistent with this guidance, a contract may have default provisions or termination penalties that constitute implicit net settlement. For example, a contract may include symmetrical default provisions that allow either party to the contract to unilaterally settle the contract in cash or other assets without penalty. Symmetrical default occurs if either party (including a party that defaults) can force payment under the provision. Simplified Example 3-10 provides an illustration of a symmetrical default provision.
Power and natural gas contracts typically do not include the type of default provisions illustrated in Example 3-10. Instead, it is more common to include asymmetrical default provisions such that the nondefaulting party can demand payment from the defaulting party, but cannot be forced to pay the defaulting party. A contract may include language to that effect such as:
“Under no circumstances will the nondefaulting party be required to pay the defaulting party for any gains projected to result to the nondefaulting party (i.e., if the seller is the nondefaulting party, the seller will have no duty to the buyer if the seller is able to resell the power at a higher price in the market).”
ASC 815-10-55-10 through 55-184 describe and provide guidance on asymmetrical default provisions.

ASC 815-10-55-12

Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize the changes in market price that would be favorable to the defaulting party if the contract were honored.

In addition, ASC 815-10-55-18 further describes the concept of implicit net settlement.

Excerpt from ASC 815-10-55-18

A contract that permits only one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable changes only or both favorable and unfavorable price changes in the underlying, meets the derivative characteristic . . . discussed in paragraph 815-10-15-100 for all parties to that contract. Such a default provision allows one party to elect net settlement of the contract under any pricing circumstance and consequently does not require delivery of an asset that is associated with the underlying. That default provision differs from the asymmetrical default provision in the example contract in paragraph 815-10-55-10 because it is not limited to compensating only the nondefaulting party for a loss incurred and is not solely within the control of the defaulting party.

As noted above, to meet the net settlement characteristic described in ASC 815-10-15-100, one or both of the parties to the contract must have the ability to net settle under any pricing circumstances. Net settlement must be solely within the control of one of the parties (i.e., if both of the parties have to agree to net settlement the criterion would not be met) and that party must be able to realize its gains on the contract without delivering the asset associated with the underlying.
Therefore, until default occurs, asymmetrical default provisions do not create the characteristic of net settlement because they do not allow either party to participate in both favorable and unfavorable price changes. However, upon default, the nondefaulting party would have the unilateral right to elect net settlement. In such a case, delivery of the asset would not be required and the net settlement characteristic could be met. In addition, it should be noted that ASC 815-10-55-17 states that a pattern of applying the asymmetrical default provision between certain counterparties would indicate an understanding that there will always be net settlement and consideration would need to be made as to whether the criterion in ASC 815-10-15-100 is met.
Question 3-7
Does a contract that does not contain liquidated damages or allow for recourse in the event of default have the characteristic of net settlement?
PwC response
No, unless the contract includes other provisions that explicitly permit net settlement. Many contracts that predate ASC 815 are silent with respect to the calculation of liquidated damages or the method of settlement if one of the parties defaults under the contract. Furthermore, such contracts typically do not include explicit net settlement provisions. As a result, these types of contracts do not have the characteristic of net settlement through contract terms. Although default may lead to a cash payment from one of the parties to the other, this is not typically unilateral (i.e., the defaulting party would not automatically be eligible to receive a payment) and the amount of the payment would require some type of agreement or negotiation. See related Question 3-8.
Question 3-8
Does a contract with damages in the event of default based on commercially reasonable terms have the characteristic of net settlement?
PwC response
No, unless the contract includes other provisions that explicitly permit net settlement. As discussed in this section, to meet the net settlement characteristic described in ASC 815-10-15-100, net settlement must be solely within the control of one of the parties to the contract and that party must be able to realize its gains on the contract without delivering the asset associated with the underlying. A default provision that requires negotiation for settlement based on commercially reasonable terms does not create the characteristic of net settlement because it does not allow either party to participate in both favorable and unfavorable price changes, until a default occurs. Additionally, once default occurs, the parties must then agree to the amount of the damages because no specific formula or method of calculation is specified.
Application example — default provisions
The following simplified example is provided to illustrate the application of the guidance on symmetrical and asymmetrical default provisions. The sample fact pattern has been included solely for the purpose of assessing whether the contract has the characteristic of net settlement in accordance with ASC 815-10-15-83(c)(1).
EXAMPLE 3-10
Evaluation of net settlement — power purchase contract with symmetrical default provision
Ivy Power Producers (IPP) enters into an agreement with Rosemary Electric & Gas Company (REG) to sell an hourly quantity of 100 MWs of firm power during on-peak hours for the month of March 2015 at a price of $50/MWh. Under the terms of the agreement, if either party fails to perform, a payment will be made for the differential between the contract price and the market price. If the market price is above contract price, IPP will pay REG; if the market price is below contract price, REG will pay IPP. The payment will be made regardless of which party defaults.
During March 2015, the market price of power decreases to $40/MWh. IPP fails to deliver any power under the contract.
Is the contract able to be net settled?
Analysis
In this fact pattern, REG would be required to pay IPP the market differential, even though IPP did not perform under the contract. Because the contract requires payment regardless of the defaulting party, the contract has the characteristic of net settlement in ASC 815-10-15-83(c)(1).
Note that if the terms of the contract instead stated that under no circumstances would the nondefaulting party be required to pay the defaulting party for any gains projected to result, then the contract would not have the characteristic of net settlement in ASC 815-10-15-83(c)(1).
Fixed and variable penalties
Commodity contracts often include penalties that may be fixed, variable, or a combination of both. The guidance in ASC 815-10-15-103 indicates that a fixed penalty for nonperformance is not considered a net settlement provision because it does not vary with changes in the underlying. A penalty that is variable solely based on changes in the price of the item that is the subject of the contract would be a net settlement provision. In addition, ASC 815-10-15-103(c) provides guidance relating to contracts that have variable and fixed penalties for nonperformance.

ASC 815-10-15-103(c)

A contract that contains a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract does not contain a net settlement provision as discussed beginning in paragraph 815-10-15-100 if it also contains an incremental penalty of a fixed amount (or fixed amount per unit) that would be expected to be significant enough at all dates during the remaining term of the contract to make the possibility of nonperformance remote. If a contract includes such a provision, it effectively requires performance, that is, requires the party to deliver an asset that is associated with the underlying. The assessment of the fixed incremental penalty shall be performed only at the contract’s inception. The magnitude of the fixed incremental penalty shall be assessed on a standalone basis as a disincentive for nonperformance, not in relation to the overall penalty.

Consistent with this guidance, reporting entities should assess performance penalties at the inception of the contract. Factors to consider include:
  • Fixed penalties do not constitute contractual net settlement (because the amount is fixed and does not vary with the underlying).
  • Variable penalties should be evaluated further to determine if they are asymmetrical and would therefore not constitute net settlement.
  • Variable penalties with an additional fixed penalty that would be sufficient to compel performance would not constitute contractual net settlement.
In addition, any fixed penalties that are sufficient to compel performance would typically create a notional amount. See UP 3.2.1 for further information on the determination of a notional amount.
Question 3-9
Would a power contract that has a penalty based on predetermined rates meet the contractual net settlement criterion?
PwC response
Maybe. Certain bilateral power contracts include contractually scheduled termination penalties that could result in a cash payment from the seller to the buyer if the seller fails to perform under the contract. Qualifying facilities contracts and other contracts with large and/or variable capacity payments frequently include these types of penalties.
Consider a contract in which the termination amount is equal to the difference between the purchase price that would have been paid for electric energy delivered from the project during the operating period based on contractual pricing, and the amount actually paid. In this case, the penalties are based on rates included in the contracts, with no reference to external market prices or expected future deliveries (i.e., a fixed penalty for nonperformance). In contrast, as indicated in ASC 815-10-15-103, a net settlement provision would be based on the market value of expected future deliveries under the contracts. As such, in this example, the termination penalties do not result in net settlement under the contract.
However, note that such penalties may be significant enough to force continued performance under the contract, and in some cases, this may create a notional amount under the contract. See UP 3.2.1 for further information on the determination of a notional amount. In addition, if management concludes that the contract does not have net settlement provisions as described in ASC 815-10-15-83(c)(1), the contract may still have net settlement provisions under ASC 815-10-15-83(c)(2) or 15-83(c)(3).
Question 3-10
Do contracts with displacement provisions meet the contractual net settlement criterion?
PwC response
Generally, no. Some take-or-pay power contracts include a “displacement” provision that explicitly permits net settlement of a portion of the contract at the concurrence of both parties. Displacement provisions may be exercised if the replacement cost of energy (i.e., the cost to purchase energy in the market) is less than the incremental generation rate (i.e., the cost to produce the energy). Displacement provisions generally require that the parties agree on the period of displacement, the incremental generation rate, the replacement cost, and the amount of power to be displaced. If the parties agree to displacement, the seller will shut down or curtail generation to the extent agreed and the seller will pay a defined percentage of the difference between the incremental generation rate and the replacement cost.
If the displacement provisions are exercised, the parties will cash settle a portion of the contract and physical delivery is not required. Because this contract provision may result in cash payment instead of physical delivery, a question arises as to whether this provision constitutes net settlement. This provision does not eliminate the seller’s obligation to deliver power under the contract. Furthermore, it does not provide a contractual right allowing nonperformance. Neither of the parties has the unilateral right to force net settlement under the contract because the contract requires both parties to agree. As such, the contract does not contain an explicit net settlement provision.
However, the contract may have an implicit net settlement provision if the parties have a pattern of net settling the contract. If the parties ever exercise this provision and displace power under the contract, or expect to exercise this provision at contract inception, the contract would not be eligible for the normal purchases and normal sales scope exception. See UP 3.3.1 for information on the normal purchases and normal sales scope exception.
4Guidance originally issued as DIG Issue A8, Definition of a Derivative: Asymmetrical Default Provisions.

3.2.3.2 Net settlement through a market mechanism

In this form of net settlement, one of the parties is required to deliver an asset equal to the notional amount, but there is an established market mechanism that facilitates net settlement outside the contract.

Excerpt from ASC 815-10-15-110

In this form of net settlement, one of the parties is required to deliver an asset of the type described in paragraph 815-10-15-100, but there is an established market mechanism that facilitates net settlement outside the contract. (For example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract.) Market mechanisms may have different forms.

The term “market mechanism” should be interpreted broadly and includes any institutional arrangement or other agreement having the requisite characteristics. For example, any institutional arrangement or over-the-counter agreement that permits either party to (1) be relieved of all rights and obligations under the contract and (2) liquidate its net position in the contract without incurring a significant transaction cost is considered to achieve a net settlement. ASC 815-10-15-110 through 15-118 includes detailed information about what constitutes a market mechanism with the primary characteristics summarized in ASC 815-10-15-111.

Excerpt from ASC 815-10-15-111

Regardless of its form, an established market mechanism must have all of the following primary characteristics:
  1. It is a means to settle a contract that enables one party to readily liquidate its net position under the contract…
  2. It results in one party to the contract becoming fully relieved of its rights and obligations under the contract…
  3. Liquidation of the net position does not require significant transaction costs…
  4. Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract.

See DH 2.1.3.2 for further information on the characteristics that should be considered when determining if a market mechanism exists.
Given the continued evolution of commodities markets, all contracts, whether exchange-traded, over-the-counter, or bilateral in nature, should be evaluated to determine whether this criterion is met. Figure 3-2 highlights key considerations in assessing whether a market mechanism exists.
Figure 3-2
Key areas of consideration — market mechanism
  • The evaluation of whether a market mechanism exists should be performed at inception of the contract and on an ongoing basis (ASC 815-10-15-118).
  • The assessment should be performed at an individual contract level and for the full term of the contract (e.g., the full five-year term of a five-year natural gas supply agreement).
  • An assessment of any prohibitions of one party to assign the contract to a third party should be performed to determine if there is an impact to the contract’s ability to be net settled through a market mechanism.
The New York Mercantile Exchange (NYMEX) is one common example of a market mechanism for certain commodities, which offers physically settled peak and off-peak power futures and physically settled natural gas futures with various locations. In contrast, most local markets for physically settled power and natural gas contracts do not have a market mechanism for net settlement. There may not be sufficient liquidity in the market or sufficient market participants that are willing and able to transact for such contracts. However, some markets provide for more liquidity than others, which may create a market mechanism for net settlement. See UP 4 for further information on power markets in the United States.
As stated above, the assessment of whether a market mechanism exists should be performed on an individual contract basis and not on an aggregate holdings basis. Because the criteria are applied at the individual contract level, the lack of a liquid market for a group of contracts does not affect the determination of the existence of a market mechanism that facilitates net settlement for an individual contract within that group.
Additionally, ASC 815-10-55-111 emphasizes that the evaluation of whether a contract contains a market mechanism must be made over the entire term of the contract (e.g., a five-year contract must be considered for the full five-year term, not in individual hour, day, or month increments). Multiple independent brokers standing ready to assume the rights and obligations related to one year of a five-year contract would not constitute a market mechanism for the contract at inception. However, if there was only one year left of the contract term, and there were multiple brokers standing ready to step into the rights and obligations for the remaining term, then the contract would meet the net settlement criterion at that time.
As discussed in ASC 815-10-15-111, a threshold of 10% should be used when considering “significant transaction costs” in liquidation of the net position. This is consistent with the guidance in ASC 815-10-15-126, which specifically relates to the determination of whether an asset is readily convertible to cash and states that an entity would consider conversion costs to be significant if they are 10% or more of the gross sales proceeds of the asset based on the spot price at the inception of the contract. If significant transaction costs are required to be incurred in order to liquidate the position, a market mechanism would not exist as it would not meet the required characteristic as discussed in ASC 815-10-15-111(c). This analysis should be conducted at the inception of the contract and be based on the most economically available spot price that can be accessed by the entity.
Question 3-11
Does the ability to enter into offsetting contracts constitute a market mechanism?
PwC response
No. In accordance with ASC 815-10-15-111, a market mechanism provides one party to the contract the ability to become fully relieved of its rights and obligations under the contract. It further states that the ability to enter into an offsetting contract, in and of itself, does not constitute a market mechanism because the rights and obligations from the original contract survive. Generally, an offsetting contract does not replace an original contract’s legal rights and obligations and therefore this criterion would no
t be met.

3.2.3.3 Net settlement by delivery of an asset that Is readily convertible to cash

ASC 815-10-15-119

In this form of net settlement, one of the parties is required to deliver an asset of the type described in paragraph 815-10-15-100, but that asset is readily convertible to cash or is itself a derivative instrument.

As discussed in ASC 815-10-15-122, in this form of net settlement, “Parties generally should be indifferent as to whether they exchange cash or the assets associated with the underlying.” As a result of the growth of independent system operators and regional transmission organizations, as well as the development of bilateral markets for power and natural gas across most of the United States, we generally believe that there is a rebuttable presumption that contracts for delivery of energy or natural gas meet this criterion. However, this presumption may be overcome based on the location of the specific asset, access to active markets, and the volume and liquidity of the markets. See UP 3.6 for further information on accounting for certain common commodity products.
Key considerations for the evaluation of the readily convertible to cash criterion are summarized in Figure 3-3 and are further discussed in the following sections.
Figure 3-3
Key areas of consideration — readily convertible to cash
  • The evaluation of whether an asset is readily convertible to cash should be performed at the inception of the contract and on an ongoing basis (ASC 815-10-15-139).
  • A key question in evaluating whether an asset is readily convertible to cash is whether there is an active spot market for the particular product being sold under the contract.
  • The assessment of whether a reporting entity has access to an active market generally should be performed at inception of the contract and should be based on the spot price of the asset on that date (see Access to an active market below).
  • Assuming the active spot market can rapidly absorb the quantity specified in the contract for each individual delivery month, and the spot market is expected to be in existence in the future for each delivery date, then the contract is readily convertible to cash.

Determining if the market is active
The term readily convertible to cash is defined in ASC 815-10-20.

Definition from ASC 815-10-20

Readily Convertible to Cash: Assets that are readily convertible to cash have both of the following:
  1. Interchangeable (fungible) units
  2. Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.
(Based on paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.)

The FASB further discussed this criterion in the Basis for Conclusions of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133).

Excerpt from FAS 133, paragraph 265

Net settlement is an important characteristic that distinguishes a derivative from a nonderivative because it permits a contract to be settled without either party's accepting the risks and costs customarily associated with owning and delivering the asset associated with the underlying (for example, storage, maintenance, and resale). However, if the assets to be exchanged or delivered are themselves readily convertible to cash, those risks are minimal or nonexistent. Thus, the parties generally should be indifferent as to whether they exchange cash or the assets associated with the underlying.

Paragraph 266 further discusses the FASB’s conclusion that readily convertible to cash was the appropriate criterion “because it addresses whether the asset can be converted to cash with little effort.” Therefore, to meet this criterion, there should be an active spot market for the particular product being sold under the contract to facilitate the conversion of the asset into cash with minimal effort. Although it may be obvious in some cases that a market is active or inactive, in other situations the determination may be difficult. Reporting entities should consider the definition of an active market in making this assessment. The term “active market” is used throughout the Codification and is defined in ASC 820, Fair Value Measurement (ASC 820).

Definition from ASC 820-10-20

Active Market: A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

See the PwC Fair value measurements guide (FV), FV 4.4.1 for further information on whether data is observable and market-based and FV Question 4-6, which provides guidance on evaluating whether a market is active. This is an area of judgment and a reporting entity’s conclusions with respect to a specific market may change over time. As discussed in ASC 815-10-15-139, evaluation of the readily-convertible-to-cash criterion should be performed at inception and on an ongoing basis throughout the contract life (except as specifically discussed in Access to an active market below with respect to conversion costs).
Access to an active market
ASC 815-10-15-125 through 15-1276 further clarify the definition of readily convertible to cash and provide that an entity should consider conversion (delivery) costs in determining whether an asset is readily convertible to cash. If the estimated conversion costs are 10% or more of the gross sale proceeds that would be received from the sale of those assets in the closest or most economical active market, then the costs are considered significant and the asset would not be readily convertible to cash. The guidance states that the assessment of the significance of conversion costs should be based on the spot price at the inception of the contract and should be performed only at the inception of the contract.
Question 3-12
Should the reporting entity reassess access to a liquid market if a new market emerges?
PwC response
Yes. ASC 815-10-15-126 states that the assessment of conversion costs should be performed only at the inception of the contract. However, in some cases, new markets may emerge subsequent to contract inception.
ASC 815-10-15-139 requires the evaluation of whether items to be delivered under a contract are readily convertible to cash to be performed at inception and on an ongoing basis throughout a contract’s life, except for the evaluation of conversion costs. Consistent with this guidance, no reevaluation of conversion costs should be performed if there are no fundamental changes in the market. Reassessment of the classification of a contract would not occur as a result of a change to estimates in the original evaluation (e.g., estimates of line loss, spot price at the active market location, or changes in transportation costs), or a new method to access an existing market.
However, in evaluating whether an asset is readily convertible to cash, reporting entities should monitor market changes, such as the emergence of a liquid hub or a new transportation resource, or a substantial decline in the liquidity of a trading point. Market changes may result in the need to reconsider the readily-convertible-to-cash criterion and may change the determination of whether a contract is a derivative.
We believe reporting entities should update their evaluation of conversion costs in response to significant market changes. If a reassessment is performed as a result of a change in the markets, the inputs (e.g., commodity price, transportation cost, line loss) should be updated to reflect current data as of the date of the reevaluation of the contract and the commodity price should be based on the spot price on the date of reevaluation.
Restrictions on resale
The derivatives guidance was amended after its issuance to provide specific guidance stating that restrictions on resale do not impact the evaluation of whether an asset is readily convertible to cash.

ASC 815-10-15-132

Restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant shall not be analogized to any other type of contract.

There is a limited exception to this guidance that relates to the sale of stock by its issuer, in which case the restriction would impact the assessment. Other restrictions on resale would not impact the determination of whether an asset is readily convertible to cash.
Question 3-13
Is the asset delivered under a contract considered readily convertible to cash if one of the counterparties is limited as to resale?
PwC response
Yes. In certain cases, one of the parties to a contract may have tax-exempt financing or other restrictions that limit or preclude resale of the product outside a specified area (e.g., “two-county bonds”). Restrictions outside the contract itself should not be considered in evaluating whether a contract is a derivative. Therefore, in general, these types of restrictions would not impact the evaluation of whether the contracts require delivery of an asset that is readily convertible to cash. Similarly, a natural gas supply contract that has a contractual restriction on resale by the buyer, but requires delivery at a location where the delivery of the asset would be readily convertible to cash exclusive of the terms of the contract, would still be considered readily convertible to cash and qualify to be a derivative if the other elements of the definition are met (e.g., notional, underlying).
Question 3-14
Are the assets delivered under a plant-specific contract readily convertible to cash?
PwC response
Generally, yes. Many contracts, such as power supply contracts from qualifying facilities and other plant-specific power purchase agreements, require that the supplier provide power from a specific facility. The assessment of whether an asset is readily convertible to cash should consider the rights and abilities of both parties under the contract. The fact that a contract is linked to a specific facility does not affect this evaluation. If either of the parties to the contract has the ability to access active markets without significant incremental costs (i.e., transportation/transmission), both parties should account for the contract as a derivative (assuming other derivative criteria are met). This would be the case even if one of the parties to the contract cannot access a liquid market.
Impact of transaction volume
Assets that are readily convertible to cash have active markets that can rapidly absorb the quantity held by the reporting entity without significantly affecting the price. Determining whether an active market can rapidly absorb the contract quantity requires judgment. ASC 815-10-55-99 through 55-1107 provide guidance on how transaction volume impacts the assessment of whether an asset is readily convertible to cash. The spot market should be evaluated by comparing the daily commodity contract quantity to the daily transaction volume to determine if and how the market price could be impacted by the contract. If the price would not be significantly impacted, then the market can rapidly absorb the contract. For example, delivery of the power from a supply contract with large daily contract volumes to a market with historically low daily volumes may significantly impact the power price. If that is the case, the asset delivered under the contract would not be readily convertible to cash.
In addition, ASC 815-10-15-128 clarifies the evaluation of contracts involving multiple deliveries.

ASC 815-10-15-128

For contracts that involve multiple deliveries of the asset, the phrase in an active market that can rapidly absorb the quantity held by the entity in the definition of readily convertible to cash shall be applied separately to the expected quantity in each delivery.

For example, in evaluating a five-year supply contract that requires delivery of a specified quantity at a predetermined price each month, the reporting entity would need to assess whether the market could rapidly absorb the specified quantity each month rather than considering whether the market could absorb the total contract quantity to be delivered over the five years.
Question 3-15
Are the assets delivered under a long-term supply contract readily convertible to cash if there is no forward market?
PwC response
Generally, yes. The evaluation of whether an asset is readily convertible to cash is based on the spot market, not the forward market.

Excerpt from ASC 815-10-55-116

The five-year commodity supply contract meets the net settlement characteristic as discussed beginning in paragraph 815-10-15-119. The criterion discussed beginning in that paragraph [readily convertible to cash] is met because an active spot market for the commodity exists today and is expected to be in existence in the future for each delivery date…under the multiple delivery supply contract. The spot market can rapidly absorb the quantities specified for each monthly delivery without significantly affecting the price.

Assuming the active spot market can rapidly absorb the quantity specified in the contract for each individual delivery month, and the spot market is expected to be in existence in the future for each delivery date, then the contract is readily convertible to cash.
However, a reporting entity should assess whether it can reliably expect to have access to active spot markets for future deliveries under a contract. For example, due to congestion and other factors, in certain areas, there may be significant volatility in market prices associated with demand, plant maintenance, available supply, and weather. If a reporting entity has difficulty accessing active markets during certain periods, this may lead to an overall conclusion that the contract is not readily convertible to cash. This is a matter of judgment and careful evaluation is required.
6Guidance originally issued as DIG Issue A10, Definition of a Derivative: Assets That Are Readily Convertible to Cash.
7Guidance originally issued as DIG Issue A12, Definition of a Derivative: Impact of Daily Transaction Volume on Assessment of Whether an Asset Is Readily Convertible to Cash.
1 1 Guidance originally issued as DIG Issue A11, Definition of a Derivative: Determination of an Underlying When a Commodity Contract Includes a Fixed Element and a Variable Element.
2 2 Guidance originally issued as DIG Issue A6, Definition of a Derivative: Notional Amounts of Commodity Contracts.
3 Guidance originally issued as DIG Issue A5, Definition of a Derivative: Penalties for Nonperformance That Constitute Net Settlement.
5 Guidance originally issued as DIG Issue A19, Definition of a Derivative: Impact of a Multiple-Delivery Long-Term Supply Contract on Assessment of Whether an Asset Is Readily Convertible to Cash.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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