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Notwithstanding the definition of a derivative discussed in UP 3.2, ASC 815 provides that certain types of contracts are not within its scope if specified criteria are met. ASC 815-10-15-13 defines 14 types of contracts that may not be subject to the requirements of the standard. Two of those exceptions that may apply to commodity contracts common in the utility and power industry are:
  • Normal purchases and normal sales
  • Certain contracts that are not traded on an exchange
This section describes application of these exceptions. See DH 2.2 for further information on the other scope exceptions provided by ASC 815.

3.3.1 Normal purchases and normal sales scope exception

ASC 815 provides an elective exception to the application of fair value accounting for physically settled derivative contracts that meet the definition of normal purchases and normal sales. If a utility or power company has entered into a physically settled commodity contract that meets the definition of a derivative, it may seek to apply this exception to avoid derivative accounting and related disclosures. The term “normal purchases and normal sales” is specific to ASC 815.

ASC 815-10-15-22

Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.

To designate one or more contracts as normal purchases or normal sales, the reporting entity should evaluate the contracts within the context of its business and operational requirements. In addition, each contract should be further evaluated to ensure that it meets the technical requirements for designation under the scope exception.
ASC 815-10-15-25 and 15-26 summarize the key elements needed to qualify for the normal purchases and normal sales scope exception, and discuss the types of contracts that may have unique considerations. Figure 3-4 highlights these requirements.
Figure 3-4
Overall factors required for the normal purchases and normal sales scope exception
Area
Key considerations
Normal terms
(UP 3.3.1.1)
  • The contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business
Clearly and closely related underlying
(UP 3.3.1.2)
  • Contract pricing is clearly and closely related to the asset being purchased or sold
  • The criteria for clearly and closely related for the normal purchases and normal sales scope exception are different than the clearly and closely related criteria in an embedded derivative analysis (see UP 3.4 for further discussion of embedded derivatives)
Probable physical settlement
(UP 3.3.1.3)
  • It is probable that the contract will gross physically settle throughout the term of the contract (no net cash settlement)
  • Changes in counterparty credit should be considered in the ongoing evaluation of probable gross physical delivery
  • Net settlement of a contract will result in loss of application of the exception for that contract; it will also call into question whether other similar contracts still qualify
Documentation
(UP 3.3.1.4)
  • Failure to meet the documentation requirements precludes application
  • Documentation should include information on the basis for the reporting entity’s conclusion that the contract qualifies for the exception
  • Documentation can be maintained for individual contracts or groups of similar contracts
  • Designation is elective, but irrevocable; designation is permitted at inception or at a later date
  • A contract or group of contracts may also be conditionally designated (Question 3-21)
Type of contract
(UP 3.3.1.5)
  • The contract is a forward contract without volumetric optionality or a power purchase or sale agreement that is a capacity contract (“power contract exception”)
  • Criteria for the power contract exception are incremental to the general requirements
In accordance with ASC 815-10-15-23, the assessment of whether a contract qualifies for the exception should be performed only at the inception of the contract; however, as discussed in UP 3.3.1.4, the documentation and designation can be done at inception or a later date (application of the election commences at the time documentation is completed). In addition, because the normal purchases and normal sales scope exception is elective, its application will sometimes result in different parties to the transaction reaching different conclusions relating to whether a specific contract is required to be accounted for as a derivative instrument.
All of the relevant criteria should be met to qualify for the normal purchases and normal sales scope exception. Each of these areas is further discussed in the following sections.

3.3.1.1 Normal terms

To qualify for the normal purchases and normal sales scope exception, management should evaluate the reasonableness of the contract quantities and terms in relation to the reporting entity’s underlying business requirements. This evaluation requires judgment and a two-step conclusion that the reporting entity intends to take physical delivery and that the quantity delivered will be used in its normal business activities.
ASC 815-10-15-28 provides a series of relevant factors that should be considered when making these determinations.

ASC 815-10-15-28

In making those judgments, an entity should consider all relevant factors, including all of the following:
  1. The quantities provided under the contract and the entity’s need for the related assets
  2. The locations to which delivery of the items will be made
  3. The period of time between entering into the contract and delivery
  4. The entity’s prior practices with regard to such contracts.

In addition to the factors above, ASC 815-10-15-29 provides further examples of evidence that may assist in identifying contracts that qualify for the normal purchases and normal sales scope exception including: past trends, expected future demand, other contracts for delivery of similar items, the entity’s practice for acquiring and storing the related commodities, and operating locations.
To designate a contract under the normal purchases and normal sales scope exception, the reporting entity should be able to assert that the contract is supplying or selling goods as part of its normal business activities. For example, in performing the evaluation for a normal purchase, a reporting entity should consider all of its sources of supply of the applicable commodity in relation to its needs to ensure it is reasonable to assert it will take physical delivery. See UP 3.3.1.5 for further factors to consider based on the type of contract.

3.3.1.2 Clearly and closely related underlying

Another criterion in the evaluation of the normal purchases and normal sales scope exception is that the pricing in the contract is clearly and closely related to the asset being purchased or sold. The guidance on clearly and closely related for the normal purchases and normal sales scope exception is included in ASC 815-10-15-30 through 15-34.8

Excerpt from ASC 815-10-15-30

Contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the Standard and Poor’s index) . . . shall not be considered normal purchases and normal sales.

The clearly and closely related assessment for determining whether a contract is eligible for the normal purchases and normal sales scope exception considers both qualitative and quantitative considerations. ASC 815-10-15-32 states that the pricing adjustment would not be clearly and closely related to the asset being sold in certain specified circumstances.

Excerpt from ASC 815-10-15-32

  1. The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
  2. If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
  3. The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.

ASC 815-10-15-33 provides further guidance for evaluating contracts in which the price adjustment focuses on the changes in the fair value of the asset being purchased or sold. In accordance with this guidance, a price adjustment should be expected, at contract inception, to impact the price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice under then-existing conditions. This guidance can be applied to the fair value or the cost of the asset being sold or purchased.
In addition to these pricing factors, to qualify for the normal purchases and normal sales scope exception, the purchase or sale contract is denominated in a currency that meets the requirements of ASC 815-15-15-10(b). See DH 2.2.2.1 for further information on foreign currency considerations in evaluating whether a contract qualifies for the normal purchases and normal sales scope exception.
Application examples — normal purchases and normal sales scope exception: clearly and closely related evaluation
The following simplified examples illustrate the application of the guidance on clearly and closely related pricing. The sample fact patterns have been included solely for the purpose of assessing whether the contract pricing qualifies as clearly and closely related for purposes of the normal purchases and normal sales scope exception.
EXAMPLE 3-11
Determining whether pricing is clearly and closely related — power contract pricing linked to natural gas
Ivy Power Producers (IPP) has a power sales contract with Rosemary Electric & Gas Company (REG). IPP intends to supply REG from the Maple Generating Station, a 500 MW natural gas-fired power plant. The pricing in the contract is linked to a natural gas index.
Does the contract qualify for the normal purchases and normal sales scope exception?
Analysis
In evaluating whether this contract qualifies for the normal purchases and normal sales scope exception, IPP would consider the following factors:
  • Source (cost) of production
    In evaluating pricing mechanisms, the guidance permits reporting entities to consider the impact of the underlying on the fair value or the cost of the asset being purchased or sold. In this example, the fuel expected to be used to generate the energy under this contract is natural gas. Therefore, a pricing mechanism using a natural gas index would not be extraneous to the cost of the asset being sold.
    However, if the underlying plant did not use natural gas (e.g., if it was a coal or wind facility), changes in a natural gas index would not be reflective of the reporting entity’s cost of production. In that case, because the natural gas index is not related to the cost of production, the reporting entity would need to assess whether the natural gas index is pertinent to the fair value of the power. In practice, reporting entities have found it difficult to demonstrate that changes in natural gas prices are highly correlated to the fair value of energy produced. Therefore, it may be difficult to conclude that a natural gas index is clearly and closely related to the asset being purchased or sold if the expected source of production is not a natural gas-fired facility.
  • Natural gas index
    IPP should also specifically consider the natural gas index used in the contract. For example, assume the pricing in the contract is linked to a Henry Hub contract traded on NYMEX. However, the Maple power plant is located near the SoCal Border trading point (a market hub for natural gas located in California) and that is where IPP purchases natural gas for production. In that case, IPP would need to consider the natural gas price relationship between Henry Hub and SoCal Border. IPP would need to support that the impact of the price adjustment is of the same magnitude and direction as the underlying asset to reach a conclusion that the pricing is clearly and closely related.
  • Potential leverage
    IPP should consider whether the effect of the natural gas indexation in the pricing formula is proportionate to the impact of natural gas prices on the cost of production. If there is a disproportionate effect (i.e., the effect of natural gas is leveraged or other cost components are being indexed to natural gas prices), the contract will not qualify for the normal purchases and normal sales scope exception. However, if the pricing mechanism limits the adjustment to the proportionate impact that natural gas prices have on the cost of producing energy, it will be considered clearly and closely related.
Evaluation of whether pricing is clearly and closely related to the asset being purchased or sold requires judgment. Each of these key factors as well as other relevant facts should be considered in making this evaluation.
EXAMPLE 3-12
Determining whether pricing is clearly and closely related — heat rate contract
Assume the same facts as in Example 3-11 except that the contract includes a formula that is based on a specified heat rate multiplied by a natural gas index. Under the terms of the contract, the off-taker, Rosemary Electric & Gas Company pays for natural gas for generation, based on the heat rate specified in the contract. If the specified heat rate is higher than the plant heat rate, REG will pay more for natural gas than will be purchased by IPP for use in operations.
Is the pricing formula considered clearly and closely related to the asset being sold?
Analysis
This type of pricing formula may be considered clearly and closely related to the asset being purchased or sold, provided that the specified heat rate used is a reasonable approximation of the expected heat rate for the power to be delivered under the contract. For example, if the contract heat rate is 7.5 and the plant expected to serve the obligation has a heat rate of 7.25, we would generally conclude that the contract pricing may qualify as clearly and closely related for purposes of applying the normal purchases and normal sales scope exception. We accept some difference between the expected system or plant heat rate and the contract heat rate because of operational constraints and profit margin, but would not expect the heat rate to vary from the actual by more than a reasonable profit margin.
However, if the specified heat rate significantly exceeds the expected plant or system heat rate (e.g., in the case of a heat rate established based on market prices), the pricing formula may be viewed as having leveraged the effect of natural gas prices or, alternatively, having indexed other non-fuel cost components to natural gas prices. Consequently, the pricing under the contract would not be considered clearly and closely related to the asset being purchased or sold and would not be eligible for the normal purchases and normal sales scope exception.
EXAMPLE 3-13
Determining whether pricing is clearly and closely related — pricing escalated based on fuel, labor, and operations and maintenance costs
Ivy Power Producers (IPP) has a capacity sales contract that is serviced from the Maple Generating Station, a 500 MW natural gas-fired generation facility. The entire energy charge is escalated annually based on the Maple power plant’s actual variable cost for fuel, labor, and other operations and maintenance costs.
Is the pricing mechanism clearly and closely related to the asset being sold?
Analysis
The cost of producing energy comprises fuel, labor, and other operations and maintenance costs. Assuming the contract pricing formula is based on the respective proportion represented by each of these cost components in the production of the power under the contract, the pricing mechanism is considered clearly and closely related to the asset being sold. In that case, the contract would be eligible for the normal purchases and normal sales scope exception (assuming all other criteria are met).
A conclusion that the pricing is clearly and closely related generally should be supported by an analysis demonstrating the relative cost of production of energy from the plant or group of plants supplying the contract compared to the contract terms. Although the proportions do not have to match exactly, if the ranges are not closely aligned, it may suggest that the contract includes leverage and would not qualify for the normal purchases and normal sales scope exception.
EXAMPLE 3-14
Determining whether pricing is clearly and closely related — pricing escalated based on actual costs and inflation
Assume the same facts as in Example 3-13. However, the energy charge is based on a combination of two components: fuel costs, which are escalated based on Ivy Power Producers’ actual costs of fuel, and operations and maintenance costs, which are indexed to the Consumer Price Index.
Is the pricing mechanism clearly and closely related to the asset being sold?
Analysis
It depends. The cost of producing energy comprises fuel, labor, and other operations and maintenance costs. Because fuel costs are typically the most volatile cost component, the parties may choose to price the fuel costs based on actual costs incurred while the operations and maintenance charges are originally priced based on actual cost, with subsequent years adjusted based on the CPI. We understand that a CPI index is often used because it simplifies the pricing mechanism and is viewed as a suitable proxy for the actual movement in operations and maintenance costs given their relatively modest expected volatility.
If IPP concludes that the CPI is an appropriate (and not extraneous) factor, it should further evaluate the relative proportion of the costs tied to fuel versus CPI. Consistent with Example 3-13, the analysis should ensure that the relative linkage to the natural gas index and the CPI in the contract is consistent with the actual cost of production. It may be concluded that the pricing mechanism is clearly and closely related to the asset being sold, if (a) CPI is not extraneous, and (b) the magnitude and direction of the impact of the CPI adjustment is not significantly disproportionate to the impact of the underlying on the fair value of the asset or the actual cost of production.
EXAMPLE 3-15
Determining whether pricing is clearly and closely related — pricing escalated based on inflation
Assume the same facts as in Example 3-14. However, the entire energy charge is escalated annually based on changes in the CPI.
Is the pricing mechanism clearly and closely related to the asset being sold?
Analysis
No. The guidance in ASC 815-10-15-30 through 15-34 does not prohibit the use of a broad market index as a proxy for changes in the underlying cost. However, to conclude that the pricing is clearly and closely related, a reporting entity would need to be able to assert that the direction and magnitude of changes in the index are reflective of changes in the cost or fair value of the asset being sold.
The cost of producing energy comprises fuel, labor, and other operations and maintenance costs. Although these costs may be included in the items used to determine the CPI, and certain of these costs may actually correlate with the CPI from time to time, the direction and magnitude of changes in the CPI would not be expected to reflect changes in the cost of producing energy as a whole. Therefore, a contract that has the entire energy charge (fuel, labor, and operations and maintenance) solely indexed to the CPI would not be considered to have a pricing mechanism that is clearly and closely related to the underlying and would not qualify for the normal purchases and normal sales scope exception.
A similar conclusion would be reached in evaluating a natural gas contract with price changes based on the CPI because changes in the CPI would not be reflective of changes in the related natural gas index. As such, the pricing would not be considered to be clearly and closely related and the contract would not qualify for the normal purchases and normal sales scope exception.
EXAMPLE 3-16
Determining whether pricing is clearly and closely related — pricing adjusted for avoided cost of production
Ivy Power Producers (IPP) enters into a power sales contract with Rosemary Electric & Gas Company (REG). The power under the contract will be provided from IPP’s Wisteria Wind Power Plant, a 40 MW wind facility. The contract’s pricing includes a periodic adjustment that is based on REG’s avoided cost of production, which is primarily linked to a combination of coal and natural gas-fired generation. Because IPP is supplying from a wind facility, it has no fuel cost of production.
Is the price adjustment clearly and closely related to the asset being sold?
Analysis
No. In evaluating whether the price adjustment is clearly and closely related, IPP should assess the impact of the pricing on changes in the cost or fair value of the asset being sold. In this case, neither IPP’s cost of production nor the fair value of power delivered under the contract would be expected to be correlated to REG’s avoided cost of production. As such, the pricing would not be considered to be clearly and closely related to the asset being sold and the contract would not qualify for the normal purchases and normal sales scope exception.
8Guidance originally issued as DIG Issue C20, Scope Exceptions: Interpretation of the Meaning of Not Clearly and Closely Related in Paragraph 10(b) regarding Contracts with a Price Adjustment Feature.

3.3.1.3 Probable physical settlement

One of the key criteria for application of the normal purchases and normal sales scope exception is that physical delivery should be probable at inception and throughout the term of the contract. As a result, this criterion should be evaluated at the time the contract is initially designated as a normal purchase or normal sale as well as on an ongoing basis throughout the life of the contract. This section discusses considerations in assessing physical settlement as well as the impact if net settlement occurs (referred to as tainting).
Contract characteristics
In evaluating whether physical settlement is probable, a reporting entity should assess the contract for certain specific characteristics as described in the following sections.
Contract terms allow net settlement or there is a market mechanism for net settlement
Some contracts require physical delivery by their contract terms (i.e., those contracts that meet the net settlement criterion because they require delivery of an asset that is readily convertible to cash). However, other contracts may permit physical or financial settlement. Therefore, to qualify for the normal purchases and normal sales scope exception, ASC 815-10-15-35 has specific requirements for contracts that meet the characteristic of net settlement because of the terms of the contract itself or because there is a market mechanism to facilitate net settlement:

Excerpt from ASC 815-10-15-35

To qualify for the normal purchases and normal sales scope exception, it must be probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.

Note that specific consideration of physical delivery is required for these contracts because the parties to the contract have alternative options for cash settlement (whether through the contract itself or through the ability to be relieved of the contract rights and obligations through a market transaction). For all contracts designated as normal purchases and normal sales, physical delivery should be probable at inception and throughout the term of the contract. See UP 3.3.1.3 Subsequent accounting for discussion of the accounting implications if there is a change in the assessment of whether a contract will be physically settled.
Contract results in periodic cash settlement of gains and losses
ASC 815-10-15-36 indicates that application of the normal purchases and normal sales scope exception is not permitted for contracts that cash settle on a periodic basis.

Excerpt from ASC 815-10-15-36

The normal purchases and normal sales scope exception only relates to a contract that results in gross delivery of the commodity under that contract. The normal purchases and normal sales scope exception shall not be applied to a contract that requires cash settlements of gains or losses or otherwise settle[s] gains or losses periodically because those settlements are net settlements.

This concept is also addressed in ASC 815-10-15-41, which states:

Excerpt from ASC 815-10-15-41

Contracts that require cash settlements of gains or losses or are otherwise settled net on a periodic basis, including individual contracts that are part of a series of sequential contracts intended to accomplish ultimate acquisition or sale of a commodity, do not qualify for the normal purchases and normal sales scope exception.

For example, futures contracts traded on an exchange qualify for net settlement due to the existence of a market mechanism. Although this type of contract is for future delivery of a commodity (i.e., the contract will be physically settled at termination), the exchange typically requires daily cash settlements. As such, the contract would not qualify for the normal purchases and normal sales scope exception.
Transactions within an ISO
Question 3-16
Would a contract result in physical settlement if a reporting entity obtained flash title of a commodity?
PwC response
Flash title is considered to be obtained when a commodity is physically purchased and then instantaneously physically sold to another party, resulting in the reporting entity obtaining title for an instant prior to it being sold. Generally, if a reporting entity obtains flash title, it would still be able to qualify for the scope exception as long as the contract is executed as part of the entity’s normal course of business and meets the other requirements for scope exception.
Flash title is often found in electricity contracts, in which case the contract may qualify for the scope exception through the power contract exception discussed in UP 3.3.1.5 Certain power contracts.
Question 3-17
Would a contract for either the forward purchase or sale of electricity within an ISO qualify for the normal purchases and normal sales scope exception?
PwC response
It depends. If a reporting entity is purchasing or selling power within an ISO that results in the purchase of electricity at one location and the sale of that electricity at another location within the ISO, the forward transaction may still qualify for the scope exception if it ultimately results in physical delivery of the commodity, is part of the entity’s normal course of business, and meets the remaining requirements for the scope exception. For example, if an entity has an end use customer at an illiquid node, the entity may enter into a forward contract to purchase power at a more liquid location. Then, on a daily basis, the entity would sell the forward power purchased at the liquid node and then purchase spot electricity at the illiquid node. As the power is being physically purchased on the forward contract, and to the extent that the volumes purchased are not greater than their load requirements, the requirement for the commodity to be physically delivered has been met and would not by itself preclude the scope exception. The other requirements for the scope exception would also have to be met.
Counterparty creditworthiness
Gross physical delivery is required for a contract to qualify for the normal purchases and normal sales scope exception. Therefore, at inception and throughout the term of the contract, a reporting entity should assess the creditworthiness of its counterparty. Poor counterparty credit quality at the inception of the arrangement, or subsequent deterioration of the counterparty’s credit quality, which may result from issues relating to the counterparty itself and/or broad economic factors, may call into question whether it is probable that the counterparty will fulfill its performance obligations under the contract (i.e., make physical delivery throughout the contract and upon its maturity). As a result, a reporting entity should monitor and consider the impact of credit risk of the counterparty, as well as its own credit, in assessing whether physical delivery is probable.
Subsequent accounting
On an ongoing basis, a reporting entity should monitor whether it continues to expect contracts designated under the normal purchases and normal sales scope exception to result in physical delivery. ASC 815-10-15-41 discusses the impact of net settlement on the normal purchases and normal sales designation.

Excerpt from ASC 815-10-15-41

Net settlement…of contracts in a group of contracts similarly designated as normal purchases and normal sales would call into question the classification of all such contracts as normal purchases or normal sales.

Consistent with this guidance, a reporting entity should monitor any contracts designated as normal purchases or normal sales to ensure that physical delivery is still probable. This section discusses factors to consider in monitoring the probability of physical delivery, the timing of recognition if net settlement is expected to occur, as well as the subsequent accounting if there is a tainting event.
Monitoring the physical delivery assertion
One way to support the continued expectation that the forecasted transaction will result in physical delivery is to perform backtesting of contracts that settled during the period that were designated under the normal purchases and normal sales scope exception. Another approach is to review the forecast of production, or physical purchases and sales, and compare the forecast to the current portfolio of contracts that are designated under the normal purchases and normal sales scope exception.
If a reporting entity has multiple contracts for which the normal purchases and normal sales scope exception has been elected, it should ensure that physical delivery of the volumes for all of those contracts is probable. Factors that may change the assessment that a contract will result in physical delivery include:
  • Changes in the reporting entity’s expected production levels
  • Changes in markets and demand or supply in the region
  • Changes in the reporting entity’s or the counterparty’s creditworthiness
  • Macro changes in the overall economy
The ongoing evaluation of whether physical delivery is probable should incorporate information about any changes to the business approach used by the reporting entity, net settlement of any contracts, changes in market conditions, and other relevant factors.
Timing of recognition when physical delivery is no longer probable
Once a reporting entity elects the normal purchases and normal sales scope exception, it is irrevocable (see UP 3.3.1.4 Timing of election). However, if a reporting entity determines that it is no longer probable that a contract will result in physical delivery, it may need to discontinue application. Whether and when a reporting entity should discontinue application of the normal purchases and normal sales scope exception partially depends on the form of net settlement applicable to the contract.
Figure 3-5
Impact of form of net settlement on the requirement or ability to discontinue the application of the normal purchases and normal sales scope exception
Method of net settlement
Timing of change in designation
Net settlement under contract terms (ASC 815-10-15-99a)
Net settlement through a market mechanism (ASC 815-10-15-99b)
The normal purchases and normal sales scope exception will cease to apply when physical delivery is no longer probable; this could occur prior to the actual net settlement.
Net settlement by delivery of asset that is readily convertible to cash (ASC 815-10-15-99c)
The normal purchases and normal sales scope exception will continue to apply until net settlement actually occurs, even if management intends or otherwise knows the contract will net settle in the future.
If a reporting entity determines it is no longer probable that a contract will result in physical delivery and the contract allows for net settlement via the contract or because of a market mechanism, the reporting entity should immediately cease to apply the normal purchases and normal sales scope exception to the contract. To qualify for the normal purchases and normal sales scope exception, the reporting entity should be able to assert that physical delivery is probable (see UP 3.3.1.3). Once it is no longer able to make this assertion, the contract no longer meets the criteria for the exception. Accordingly, the contract would be recorded at fair value in the financial statements in the period in which the reporting entity determines that it no longer meets the probability requirement, with an immediate impact to earnings. In addition, subsequent changes in fair value of the derivative are also recognized in earnings.
If, however, the contract meets the net settlement criterion of the definition of a derivative because it requires delivery of an asset that is readily convertible to cash, then the contract’s designation cannot be changed until the net settlement occurs. Thus, the contract would not be initially or subsequently recorded at fair value until the net settlement occurs. This type of contract requires gross physical delivery under the contract terms; therefore, physical delivery is assumed in assessing whether the normal purchases and normal sales scope exception applies. Because the normal purchases and normal sales scope exception is irrevocable, a reporting entity cannot change the designation of a contract before it is net settled, even if it determines that net settlement is probable, unless it amends the contract to permit net settlement under the contract terms. Furthermore, once such a contract is net settled, it is immediately tainted.
If a reporting entity determines that one contract no longer qualifies for the normal purchases and normal sales scope exception, this may call into question its ability to assert probable physical delivery for other similar contracts or contracts within a group. It may also call into question the entity’s initial election of the normal purchases and normal sales scope exception. See further discussion of tainting in the following section.
Subsequent impact of net settlement (Tainting)
The normal purchases and normal sales scope exception applies solely to contracts that result in gross physical delivery of nonfinancial items. Therefore, a reporting entity that designates a contract as a normal purchases or normal sales contract should be able to assert that the contract will not net settle. Net settlement of a particular contract would preclude application of the normal purchases and normal sales scope exception to that contract (i.e., the contract should be recorded at fair value in earnings at the time the exception is no longer applicable as discussed in UP 3.3.1.3 Timing and recognition when physical delivery is no longer probable). In addition, it may “taint” the ability to apply the normal purchases and normal sales scope exception to other similar contracts and to the business in its entirety.
Question 3-18
How many times does a reporting entity have to net settle a normal purchases or normal sales contracts to be precluded from applying the exception to future contracts?
PwC response
ASC 815 does not contain guidance on how many contracts designated under the normal purchases and normal sales scope exception can be net settled before similar contracts are tainted. Although a reporting entity should consider its facts and circumstances, we would expect that it would be unusual for management to continue to apply the normal purchases and normal sales scope exception to a group of contracts after more than one or two net settlements, except in very rare circumstances. For example, a reporting entity may net settle a contract for the delivery of natural gas due to economic considerations whereby it decided to monetize an unrealized gain. We would consider this a tainting event that may require de-designation of the entire group of contracts. However, a net settlement due to a supplier bankruptcy may be viewed as a one-time, unpredictable event that taints the particular contract but not the reporting entity’s entire group of contracts.
Net settlement as described in ASC 815-10-15-83(c)(3) (readily convertible to cash) is not referenced in the normal purchases and normal sales scope exception. This is because contracts that are readily convertible to cash have terms that do not provide for a net settlement between the parties either directly or through a market mechanism. However, there may be situations in which counterparties agree to a net cash settlement of a contract even if the terms of the contract do not provide for a net settlement. We would consider a negotiated settlement of this type to be a net settlement that results in a tainting event that would need to be evaluated as described above. Accordingly, the circumstances resulting in net cash settlement of contracts that are readily convertible to cash and designated as normal purchases and normal sales will have to be monitored carefully.
Question 3-19
Does a force majeure event taint a contract designated under the normal purchases and normal sales scope exception?
PwC response
No. Certain commodity purchase and sale contracts, which meet the definition of a derivative, may contain a force majeure clause that provides for the cancellation of all or part of the contract when force majeure events occur. Typically, such events are defined in the contract as situations where one of the parties cannot perform in accordance with the terms of the contract as a result of circumstances that are outside its control. Examples of force majeure events include the shutdown of a facility as a result of a fire, flood, or major weather event such as a hurricane. Contracts may also expand the definition of force majeure to include events that are less extraordinary in nature, such as those due to an unplanned maintenance shutdown resulting from the breakdown of critical operating equipment. Oftentimes when force majeure events occur, the contract calls for cancellation of the delivery of the applicable quantities without penalty or net settlement.
In such cases, although no delivery occurs, there is usually no net settlement of the contract. Instead, the contract is partially or fully cancelled and the parties under the contract are no longer obligated to deliver or pay for the applicable quantities. Therefore, when the delivery of contract quantities is cancelled as a result of a force majeure event, we believe there is no tainting of the contract itself if the force majeure event meets all of the following criteria:
  • It is not within the control of either party to the contract.
  • It does not result in net settlement of the cancelled quantities.
  • It relieves or eliminates the rights and obligations of the parties under the contract for the applicable quantities.
In addition, if all of these criteria are met, there would be no tainting of similarly designated contracts.
Application example — normal purchases and normal sales scope exception: Change in forecast
The following simplified example is provided to illustrate the application of the guidance on the normal purchases and normal sales scope exception when a reporting entity’s forecast changes.
EXAMPLE 3-17
Application of the normal purchases and normal sales scope exception — natural gas contract
Ivy Power Producers (IPP) enters into a forward contract to purchase 10,000 MMBtus of natural gas per day from January 1, 2015 to December 31, 2015. It plans to use the natural gas at the Maple Generating Station. In April 2015, IPP takes delivery of the entire contractual volume of natural gas. However, not all of the purchased natural gas was used as the facility did not operate at full capacity due to a decrease in power prices. IPP resells 100,000 MMBtus of natural gas into the market.
Is the resale of the 100,000 MMBtus a tainting event?
Analysis
Even though IPP did not net settle the 100,000 MMBtus of natural gas (i.e., the total amount of natural gas was physically delivered), it is likely that the circumstance described above would be considered a tainting event. However, the specific facts and circumstances would need to be considered. For example, if the change was due to a specific event and did not result in a change in the business activities of IPP (e.g., the natural gas was not used because of an unusual or unforeseen plant outage), we would not expect this to cause a tainting issue. However, if IPP’s forecast showed that the full quantity of natural gas would not be used in April 2015, the contract should not have been designated as a normal purchase because IPP did not need the full volume under the contract for its operations.

3.3.1.4 Documentation

ASC 815 does not specify the timing of documentation requirements for the normal purchases and normal sales designation. However, reporting entities making the election should maintain appropriate documentation to distinguish those contracts designated as normal purchases and normal sales. In accordance with ASC 815-10-15-38, failure to comply with the documentation requirements precludes application of the exception, even if the contract would otherwise qualify. ASC 815-10-15-37 specifies the minimum documentation requirements for a contract designated as a normal purchase or normal sale.

Excerpt from ASC 815-10-15-37

For contracts that qualify for the normal purchases and normal sales exception…the entity shall document the designation of the contract as a normal purchase or normal sale, including either of the following:
  1. For contracts that qualify for the normal purchases and normal sales exception under paragraph 815-10-15-41 or 815-10-15-42 through 15-44, the entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
  2. For contracts that qualify for the normal purchases and normal sales exception under paragraphs 815-10-15-45 through 15-51, the entity shall document the basis for concluding that the agreement meets the criteria in that paragraph, including the basis for concluding that the agreement is a capacity contract.

Specific factors to consider as required by ASC 815-10-15-37(a) and 15-37(b) are further discussed in UP 3.3.1.5. This section addresses the method and timing of designation as well as other matters to consider in developing a documentation policy.
Designation method
ASC 815-10-15-38 specifies that the documentation required to designate a contract as a normal purchase or normal sale can be applied to individual contracts or to groups of contracts. Designation of individual contracts may provide more flexibility; however, it also increases the documentation requirements.
Potential bases for global designation include chronology, time of year, and trading point. However, the global designation policy should be based on objectively determinable criteria with sufficient specificity such that there is no ambiguity in the classification of a particular contract. For example, a reporting entity may decide to group all of its on-peak purchase contracts for delivery in a certain quarter or the first set of sales (such as the first 250 megawatts purchased) in a certain month. A reporting entity that applies a global methodology of electing contracts for the normal purchases and normal sales scope exception should do so consistently for similar contracts.
The rationale a reporting entity uses in its grouping of contracts for purposes of designating the normal purchases and normal sales scope exception is important. The guidance stipulates that net settlement of a contract that was designated as a normal purchase or normal sale would call into question the reporting entity’s designation of other contracts in the same group. In addition, net settlement of such contracts would also call into question the reporting entity’s ability to designate similar contracts as normal purchases and normal sales in the future. See UP 3.3.1.3Subsequent impact of net settlement (Tainting) for more information on the impact of contracts that are net settled on application of the normal purchases and normal sales scope exception.
Timing of election
Although application of the normal purchases and normal sales scope exception is elective, once made, the election is irrevocable.

Excerpt from ASC 815-10-15-39

The normal purchases and normal sales scope exception could effectively be interpreted as an election in all cases. However, once an entity documents compliance with the requirements of paragraphs 815-10-15-22 through 15-51, which could be done at the inception of the contract or at a later date, the entity is not permitted at a later date to change its election and treat the contract as a derivative instrument.

There is no specific requirement to perform the normal purchases and normal sales assessment prior to entering into a contract or to document the conclusions contemporaneously with execution of the contract. However, to support the reporting entity’s accounting position, at a minimum the election of the normal purchases and normal sales scope exception should be documented prior to the end of the accounting period in which it is first applied (e.g., by March 31 for a contract designated in March).
If a reporting entity designates a contract subsequent to inception, the normal purchases and normal sales scope exception will apply as of the period of designation.
Question 3-20
What is the accounting for the carrying value of a contract that is designated under the normal purchases and normal sales scope exception on a date subsequent to the trade date of the contract?
PwC response
If a contract qualifies as a derivative and is designated as a normal purchase or normal sale subsequent to the contract execution date, the reporting entity will have an asset or liability on its balance sheet equal to the fair value of the contract on the date the election is made. After designation as a normal purchase or normal sale, the contract will no longer be recorded at fair value. The pre-existing fair value, however, will remain as an asset or liability and should be amortized into income over the remaining life of the contract. The carrying value of the contract is subject to impairment analysis to the extent it is recorded as an asset upon execution.
The accounting for the carrying value of the contract subsequent to election of the scope exception is similar to the subsequent accounting for the fair value of nonderivative contract assets recorded as part of a business combination. See UP 8.4.1 for further information.
Other documentation considerations
The guidance requires that the documentation of the designation as a normal purchase or normal sale include certain information, including management’s basis for concluding that physical delivery is probable when electing the commodity forward exception, and that the contract meets all of the requirements for the power contract exception, if elected (see UP 3.3.1.5 for further information on these exceptions).
In addition, as part of the process of reassessing whether specific contracts continue to qualify for the normal purchases and normal sales scope exception each period, reporting entities should ensure that the documentation supporting the designation of the contract as a normal purchase or normal sale has been updated as applicable.
Question 3-21
Can the normal purchases and normal sales scope exception be elected for a contract that is not a derivative at inception but could potentially become one in the future (conditional designation)?
PwC response
Yes. Provided the normal purchases and normal sales criteria are met, a contract could be designated under the exception prior to the time it becomes a derivative. We believe the ability to conditionally designate a contract is reasonable in consideration of the guidance in ASC 815-10-55-84 through 55-89, which allows for conditional hedging designations. If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. Absent such a designation, the reporting entity would be required to initially fair value the contract at the time the contract is determined to be a derivative.

ASC 815-10-15-3

If events occur after the inception or acquisition of a contract that cause the contract to meet the definition of a derivative instrument, then that contract shall be accounted for at that later date as a derivative instrument under this Subtopic unless one of the scope exceptions in this Subsection applies. (emphasis added)

ASC 815-10-25-2 provides additional guidance on the accounting at the time the contract becomes a derivative. However, if the normal purchases and normal sales scope exception has already been applied, then no recognition in earnings at the time the contract meets the definition of a derivative is required.

ASC 815-10-25-2

If a contract that did not meet the definition of a derivative instrument at acquisition by the entity meets the definition of a derivative instrument after acquisition by the entity, the contract shall be recognized immediately as either an asset or liability with the offsetting entry recorded in earnings.

From a practical perspective, often the reporting entity will not know the exact date a contract meets the definition of a derivative. As a result, the contract could meet the definition of a derivative prior to a contemporaneous election of the normal purchases and normal sales scope exception. A conditional designation avoids this issue and allows for continued accounting for the contract as an executory contract.
Reporting entities should be careful that the contracts that are conditionally designated under this scope exception do not result in net settlement. Net settlement of a conditionally designated contract would result in the specific contract no longer qualifying for the normal purchases and normal sales scope exception and could result in tainting of other designated contracts.
Question 3-22
Can an embedded derivative qualify for the normal purchases and normal sales scope exception?
PwC response
Yes. If a reporting entity would otherwise be required to separate an embedded derivative from a host contract, it may elect the normal purchases and normal sales scope exception for that embedded derivative if all the criteria for election are met. Once the embedded derivative is identified as an element that requires separate accounting, it is accounted for under ASC 815 as a separate unit of account. This includes the accounting, disclosures, and evaluation of scope exceptions. The embedded derivative would not require separation if the normal purchases and normal sales scope exception is elected.

3.3.1.5 Types of contracts that may qualify for the normal purchases and normal sales scope exception

ASC 815-10-15-40 through 15-51 describe the types of contracts that may qualify for the normal purchases and normal scope exception, as summarized in Figure 3-6.
Figure 3-6
Types of contracts that may be designated normal purchases or normal sales
Type of contract
Key considerations
Freestanding option contracts
  • Not eligible, except for the limited exception for power contracts as defined in ASC 815-10-15-45
Forward contracts (non-option-based)
  • Applies to forward contracts with no volumetric optionality
  • Must be probable at inception and throughout the contractual period that physical delivery will occur
  • Contracts subject to unplanned netting (i.e., book-out) are not eligible for this exception. See specific exception for power purchase or sale agreements subject to book-out below.
Forward contracts with optionality features
  • Generally, contracts with volumetric optionality are not eligible for the normal purchases and normal sales scope exception
  • Limited exception for power contracts as defined in ASC 815-10-15-45
  • Contracts with other types of optionality (e.g., market price) may be eligible for the exception if the criteria in ASC 815-10-15-42 through 15-43 are met
Power purchase or sale agreements
  • A power purchase or sale agreement (forward, option, or a combination) is eligible for the scope exception if the contract meets the definition of a capacity contract
  • Specific to power contracts—other commodities are not eligible for this exception
  • Buyer and seller should meet certain requirements
  • The power contract exception may be applied even if the contract is subject to book-out, if all other requirements are met
The considerations for applying the normal purchases and normal sales scope exception to each of these types of contracts are discussed in the following sections.
Freestanding option contracts9

ASC 815-10-15-40

Option contracts that would require delivery of the related asset at an established price under the contract only if exercised are not eligible to qualify for the normal purchases and normal sales scope exception, except as indicated in paragraphs 815-10-15-45 through 15-51.

A contract with volumetric optionality is not eligible for the normal purchases and normal sales scope exception because it cannot be determined if it is “probable at inception and throughout the term of the individual contract that the contract will result in physical delivery.” Option contracts only contingently provide for such physical delivery (i.e., delivery is made only when the price of the item is above the strike price and the holder exercises the option).
In evaluating option contracts, the key factor that should be considered is whether the optionality impacts the quantity to be delivered under the contract. A volumetric option is not eligible for the normal purchases and normal sales scope exception, except in the case of certain qualifying power contracts. Contracts that contain optionality related only to price or other non-volumetric features would be eligible for the normal purchases and normal sales scope exception if the other required criteria are met.
Forward contracts (Non-option based)
ASC 815-10-15-41 states that the normal purchases and normal sales scope exception can be applied to forward contracts, which would include contracts for natural gas, coal, oil, and other commodities (hereinafter referred to as the commodity forward exception). One of the underlying principles of the commodity forward exception is that it applies to contracts for physical delivery. However, some commodity contracts may include implicit or explicit net settlement provisions (UP 3.2.3.1) or have a market mechanism that permits net settlement (UP 3.2.3.2). Because a contract with one of those features may not require physical delivery, it must be probable at inception and throughout the term of the contract that physical delivery of the commodity will occur in order for this type of contract to qualify.

Excerpt from ASC 815-10-15-41

Forward contracts are eligible to qualify for the normal purchases and normal sales scope exception. However, forward contracts that contain net settlement provisions as described in either paragraphs 815-10-15-100 through 15-109 or 815-10-15-110 through 15-118 are not eligible for the normal purchases and normal sales scope exception unless it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.

As noted, contracts with net settlement provisions will not quality for the normal purchases and normal sales scope exception unless it is probable that physical delivery will occur throughout the entire term of the contract. Net settlement of a particular contract would preclude application of the normal purchases and normal sales scope exception to that contract in the future and would call into question whether similar contracts qualify. See UP 3.3.1.3 Subsequent impact of net settlement (Tainting).
Question 3-23
Can a power contract subject to book-out qualify for the normal purchases and normal sales scope exception in ASC 815-10-15-26(b)?
PwC response
Generally, no. Due to the structure of the power markets, there is an institutional convention that allows certain power contracts to be “booked out.” A book-out is an unplanned netting of a purchase and sale agreement by the contracting counterparties. Book-outs are an accepted practice in the industry and arise as multiple transactions routinely occur at the same point of delivery as utilities and power companies balance their loads. Counterparties will offset their schedules (i.e., book out) when they have a buy and a sell of the same quantities at the same point. Booking out results in no physical delivery under the contract and avoids transmission losses and administrative fees.
A book-out is a form of net settlement and the ability to book out precludes qualification for this exception, even if the reporting entity does not intend to and does not have a practice of booking out. As a result, most power contracts do not qualify for this exception. However, ASC 815 provides an exception for certain power contracts. See UP 3.3.1.5 Certain power contracts for further information on this exception.
Forward contracts that contain optionality10
Consistent with the guidance for freestanding options discussed in UP 3.3.1.5, ASC 815 precludes application of the normal purchases and normal sales scope exception to any forward contract that contains volumetric optionality (except certain power contracts).

Excerpt from ASC 815-10-15-42

Except for power purchase or sales agreements addressed in paragraphs 815-10-15-45 through 15-51, if an option component permits modification of the quantity of the assets to be delivered, the contract is not eligible for the normal purchases and normal sales scope exception, unless the option component permits the holder only to purchase or sell additional quantities at the market price at the date of delivery.

Therefore, a contract cannot qualify for the normal purchases and normal sales scope exception if its terms include volumetric optionality, unless the volumetric option is priced based on the market price at the time of delivery. Furthermore, ASC 815-10-55-26 specifically prohibits a reporting entity from bifurcating the forward component and the option component in a combined contract and then electing the normal purchases and normal sales scope exception for the forward component. However, a reporting entity may be able to avoid some of the accounting implications of this guidance as follows:
  • Separate forward and option contracts
    As discussed in ASC 815-10-55-27, instead of executing a single supply contract, a reporting entity could enter into two separate contracts: a forward contract for a specified quantity and an option contract for additional quantities whose purchase is conditional on the exercise of the option. The separate forward contract may then be eligible for the normal purchases and normal sales scope exception, provided all the criteria are met.
  • Requirements contracts
    A requirements contract specifies that the supplier will provide amounts equal to the purchaser’s needs, with prohibition against resale. In some cases, the contract requires a certain level of minimum purchases (resulting in a derivative for the specified minimum amount). Any remaining fluctuation in quantity would not be included in the notional amount. In a requirements contract, the portion of the contract that is accounted for as a derivative would be eligible for designation under the normal purchases and normal sales scope exception, provided all the criteria are met. See UP 3.2.1.1 for further information on requirements contracts.
  • Power contracts
    Power contracts may be eligible for the normal purchases and normal sales scope exception in accordance with ASC 815-10-15-45 through 15-51. See UP 3.3.1.5 Certain power contracts for further information.
Furthermore, once a volumetric option feature expires or has been exercised, it would no longer affect the evaluation.

Excerpt from ASC 815-10-15-43

If the optionality feature in the forward contract can modify the quantity of the asset to be delivered under the contract and that option feature has expired or has been completely exercised (even if delivery has not yet occurred), there is no longer any uncertainty as to the quantity to be delivered under the forward contract. Accordingly, following such expiration or exercise, the forward contract would be eligible for designation as a normal purchase or normal sale, provided that the other applicable conditions in this Subsection are met.

Therefore, if a contract includes a volumetric option, the reporting entity may reassess whether the contract qualifies for the normal purchases and normal sales scope exception upon exercise or expiration of the option. Once the option has expired, the contract no longer has any volumetric optionality and the reporting entity can determine whether the contract will result in physical delivery. See UP 3.3.1.4 Timing of election for the accounting when a contract is designated as normal subsequent to its inception.
Question 3-24
Can a contract that requires the sale of a fixed volume of natural gas with an embedded option for additional volumes at a price based on an index plus a fixed-price adjuster qualify for the normal purchases and normal sales scope exception?
PwC response
It depends. A contract that includes both a forward component and an option component can only qualify for the normal purchases and normal sales scope exception if the optional volumes are purchased or sold at market prices at the time of the delivery. Price adjustments to market should be carefully considered prior to concluding that the contract can qualify for the normal purchases and normal sales scope exception. For example, if the market price is adjusted to compensate for a customary fee or administrative costs that are typically incurred, then the contract may still be eligible for designation under the normal purchases and normal sales scope exception. However, if the differential is intended to reflect basis differences due to the delivery location (e.g., the contract is priced on NYMEX Henry Hub but the delivery location is SoCal Border, a market hub for natural gas located in California), then the price differential may not be reflective of market at all delivery dates. In such cases, the contract would not qualify for this exception.
Application examples — normal purchases and normal sales scope exception: Contracts with volumetric optionality
EXAMPLE 3-18
Application of the normal purchases and normal sales scope exception — contract with volumetric optionality
Assume the same facts as in Example 3-1: Ivy Power Producers agrees to purchase natural gas from Guava Gas Company for delivery to the Maple Generating Station. The contract has a maximum daily quantity (10,000 MMBtus per day). IPP is required to take or pay for at least 75% of the maximum daily quantity specified in the contract (i.e., 7,500 MMBtus per day) and may take additional amounts up to the maximum specified.
Does the contract qualify for the normal purchases and normal sales scope exception?
Analysis
As discussed in Example 3-1, this arrangement represents a forward contract for 7,500 MMBtus per day combined with an option contract for up to an additional 2,500 MMBtus per day. As a result of the volumetric optionality, the contract does not qualify for the normal purchases and normal sales scope exception in this fact pattern.
However, the contract may potentially qualify for accounting as a normal purchase in the following circumstances:
  • The option component permits the holder only to purchase or sell additional quantities at the market price at the date of delivery (see ASC 815-10-15-42).
  • The option feature is expired or has been completely exercised (even if delivery has not yet occurred) (see ASC 815-10-15-43).
  • The contract is determined to be a requirements contract (because the volumetric optionality would not be included in the notional amount of the contract). See UP 3.2.1.1 for further information. See Example 3-19.
In such cases, the contract could qualify for the normal purchases and normal sales scope exception if all other requirements are met.
EXAMPLE 3-19
Application of the normal purchases and normal sales scope exception — requirements contract with volumetric optionality
Assume the same facts as in Example 3-18, except that the contract specifies that the Guava Gas Company is to supply all of Ivy Power Producers’ 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 its maximum needs (total needs are expected to be around 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. This is the same fact pattern described in Example 3-2.
Does the contract qualify for the normal purchases and normal sales scope exception?
Analysis
As discussed in Example 3-2, this contract is a requirements contract with a notional amount of 7,500 MMBtus/day. The additional quantity above the required amount is not included in the notional because this is a requirements contract. Because the notional relates only to the forward component, the contract could qualify for the normal purchases and normal sales scope exception if all other requirements are met.
EXAMPLE 3-20
Application of the normal purchases and normal sales scope exception — natural gas contract
Ivy Power Producers (IPP) enters into a forward contract with Guava Gas Company to purchase 10,000 MMBtus of natural gas per day for 3 years for use in the Maple Generating Station. In addition, the contract states that at the end of each year, the parties will cash settle for any difference between the contracted amount of natural gas and the amount of natural gas that was delivered. If the total natural gas delivered is greater than the contractual amount, IPP will pay the then-current market rate for the excess natural gas. However, if the natural gas delivered is less than the contractual amount, IPP will receive the difference between the then-current market rate and the fixed price.
Does the contract qualify for the normal purchases and normal sales scope exception?
Analysis
Although the contract has certain provisions that may result in financial settlement, the contract is eligible for the normal purchases and normal sales scope exception if IPP can assert that all contractual volumes will result in physical delivery. The contract is still eligible for the exception because the additional volumes are purchased at the then-current market price. If, however, at the end of any particular year, the contract is net settled because IPP did not take physical delivery of the full contractual amount of natural gas, then the contract will need to be recorded at fair value. The net settlement would also call into question the designation of other similar contracts.

Certain power contracts11
Due to unique characteristics in the electric power industry, particularly the fact that power cannot be readily stored in significant quantities, ASC 815 provides a specific normal purchases and normal sales scope exception for certain qualifying power contracts (herein referred to as the power contract exception). Guidance on application of the power contract exception is provided in ASC 815-10-15-45 through 15-51 as well as ASC 815-10-55-31.
This scope exception solely applies to power purchase and sales agreements and cannot be analogized to other commodities such as natural gas, crude oil, or fuel oil. This exception allows for power contracts that meet the specified criteria to qualify for application of the normal purchases and normal sales scope exception, even if the contract contains volumetric optionality or is subject to book-out (see Question 3-23). Contracts that are subject to book-out, whether through local operating protocols or as a result of the requirements of an independent system operator or regional transmission organization, should be evaluated under the power contract exception.
In determining whether a contract qualifies for this exception, there are certain criteria that should be met by all parties to the contract. There are also additional criteria applicable to contracts with volumetric optionality. Note that forward contracts that are not subject to unplanned netting also may be evaluated under ASC 815-10-15-41 (forward contracts exception) and are not required to meet the additional requirements of the power contracts exception.
Criteria for all qualifying contracts
Overall guidance on application of the power contracts exception is provided in ASC 815-10-15-45.

Excerpt from ASC 815-10-15-45

Notwithstanding the criteria in paragraphs 815-10-15-41 through 15-44, a power purchase or sales agreement (whether a forward contract, option contract, or a combination of both) that is a capacity contract for the purchase or sale of electricity also qualifies for the normal purchases and normal sales scope exception if all of the following applicable criteria are met.

Definition from ASC 815-10-20

Capacity Contract: An agreement by an owner of capacity to sell the right to that capacity to another party so that it can satisfy its obligations. For example, in the electric industry, capacity (sometimes referred to as installed capacity) is the capability to deliver electric power to the electric transmission system of an operating control area.

While the standard specifies that the contract must be a capacity contract, we believe that the application of the power contracts exception is applicable for capacity contracts that include the physical delivery of power in the arrangement. To qualify for this exception, power contracts should be assessed to determine if the criteria set forth in ASC 815-10-15-45 are met. Figure 3-7 highlights the criteria applicable to each party to the contract.
Figure 3-7
Power contracts exception criteria
Criteria
Applicable to buyer
Applicable to seller
The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in ASC 815-10-15-100 through 15-109. (ASC 815-10-15-45(a)(1))
Yes
Yes
The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business. (ASC 815-10-15-45(b) and 15-45(c)(1))
Yes
Yes
The buyer of the electricity under the power purchase or sales agreement is an entity that meets both of the following criteria: (i) The entity is engaged in selling electricity to retail or wholesale customers; (ii) The entity is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base. (ASC 815-10-15-45(c)(2))
Yes
Not applicable
The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations. (ASC 815-10-15-45(c)(3))
Yes
Not applicable

ASC 815-10-15-45 also includes criteria that are only applicable to contracts with volumetric optionality (see UP 3.3.1.5 Certain power contracts).
To qualify for the power contracts scope exception, a reporting entity should assess not only its own compliance with the requirements but also whether the contract counterparty meets the requirements. For example, the seller under the contract should consider whether the purchaser is buying to meet its obligation. To meet the requirement, it is not sufficient to only consider that the seller has capacity to support the contract. Therefore, to assist reporting entities in applying the guidance, PwC has developed interpretive guidance and specific criteria to consider in assessing whether the counterparty meets the relevant criteria. Key factors to consider are summarized in Figure 3-8.
Figure 3-8
Assessment of a counterparty in power purchase or sale agreements
Counterparty
Considerations
Buyer’s assessment of seller
  • Seller’s source of power does not necessarily have to be specified
  • Buyer should have evidence (beyond the regulatory requirements to qualify as a “firm power forward”) that seller has access to capacity at or near the delivery point (e.g., known generating capacity at or near the delivery point)
Seller’s assessment of buyer
  • Seller has knowledge (including publicly available information) about buyer’s existing load commitments at or near the delivery point
  • Buyer’s load commitments can include retail, wholesale, and certain contractual commitments
  • Seller does not have to verify that the quantity being purchased, when added to existing generation capacity and other purchases, would exceed buyer’s projected power needs
  • There is a presumption (which can be overcome with appropriate evidence) that a sale to a non-load serving entity (e.g., power brokers and load serving entities with no load in the applicable area) would not qualify under this criterion.
The considerations in Figure 3-8 are further discussed below.
Buyer’s evaluation
For the buyer to meet its requirement to evaluate the seller, it would not be necessary for the contract to specify the source of the energy. However, the buyer should have evidence (beyond the regulatory requirements to qualify as a “firm power forward”) that the seller has access to capacity at or near the delivery point at the time the contract is designated as qualifying under the normal purchases and normal sales scope exception. In addition to the broad regulatory requirement, the buyer would have to consider evidence of the seller’s existing capacity. This requirement could be met if any of the following conditions are present:
  • The seller is known to have generating capacity at or near the delivery point
  • The seller is selling to the buyer at a location where the seller has access to a power pool (e.g., PJM Interconnection, L.L.C., California Independent System Operator) that makes generating capacity available to all participants, in which case the buyer can assume such capacity because the power pool would, if necessary, provide it to the seller
  • Other evidence is obtained that demonstrates that the seller has the available capacity through direct ownership of a generating plant or by contract
For example, if the seller is a power broker that does not have access to a pool, the buyer would have to obtain evidence supporting a conclusion that the seller has access to capacity at or near the delivery point (e.g., a long-term power purchase contract or tolling agreement) to back the contract. Similarly, such evidence would have to be obtained if the seller (or a sister company) is a known owner of generation but the delivery point in the contract is a location that cannot be served from its owned capacity.
Seller’s evaluation
In assessing whether it has sufficient capacity to meet its commitment, the seller should consider its own existing generating assets plus firm capacity purchase contracts, and deduct existing native load requirements and any other existing power sales contracts. In other words, the seller cannot double count the same capacity (i.e., it cannot count existing capacity as both meeting its native load capacity requirements and at the same time backing a sales contract it wishes to designate as a normal sales contract).
In making this assessment, the seller may also consider power resources that it has available because it has access to a power pool that makes generating capacity available to all participants. Furthermore, the seller should meet this requirement on the date the contract is designated (i.e., a sales contract would not qualify if the seller intends to obtain the quantity through a future purchase, unless the future purchase will be from a power pool that makes generating capacity available to all participants, or if access to the power pool provides a back-up source to fulfill the delivery obligation).
In assessing whether the buyer needs the energy for use or sale, the seller could assess the buyer’s ability based on knowledge (including publicly available information) of the buyer’s existing load commitments (i.e., the seller could presume the buyer is purchasing under the contract to meet its load requirements if the buyer is known to have such a requirement at or near the delivery point under the contract). Load requirements would include retail and wholesale requirements and certain contractual requirements. In assessing whether this criterion is met, the seller would not have to verify whether the specific quantity being purchased, when added to the buyer’s existing generating capacity and other purchases by the buyer, would exceed the buyer’s projected needs.
There is a presumption that a sale to a non-load serving entity (including a power broker or a load serving utility with no load at or near the delivery point) would not qualify under this criterion. However, that presumption could be overcome if evidence is obtained that demonstrates that the ultimate use of the power will be to fulfill a load serving requirement (e.g., of a customer of the non-load serving purchaser). Such evidence can be assumed to exist if the purchaser is a sister company of a load serving entity that has a load requirement at or near the delivery point (see further discussion below).
Consolidated groups
Reporting entities that are members of a consolidated group should apply the criteria above based on facts existing at the consolidated level. For example, if a power broker subsidiary buys power to sell to a load serving sister company, the broker subsidiary’s purchase transaction would (1) meet the purchaser criterion that the purchaser has an obligation to maintain sufficient capacity and (2) qualify as a capacity contract (assuming the other criteria are met) at both the subsidiary and consolidated levels.
Similarly, in applying the criteria, reporting entities may assume certain facts about intercompany relationships with respect to a counterparty’s consolidated group, if the circumstances support such an assumption. For example, a sale to the power broker subsidiary of a consolidated group that includes a load serving entity would meet the seller criterion if the purchase is at a location where the load serving sister company is known to have a load requirement. On the other hand, absent further evidence of the intended use of the power, that seller criterion would not be met in a sale to a power broker subsidiary of a consolidated group that includes a load serving entity if the delivery point is not at or near the load requirement of the sister company.
Option contracts
In general, contracts with volumetric optionality cannot qualify for the normal purchases and normal sales scope exception. However, ASC 815 contains a special exemption for certain qualifying power contracts with volumetric optionality because of the unique considerations related to power as described above. In accordance with ASC 815-10-15-45, in addition to the criteria applicable to all contracts discussed in UP 3.3.1.5 Certain power contracts, for option contracts, physical delivery is required if the option is exercised. Furthermore, option contracts should be assessed using the additional criteria provided by ASC 815-10-55-31. This guidance differentiates between qualifying option contracts (i.e., capacity contracts) and financial options on electricity. Factors to consider in assessing whether a contract is a capacity contract as outlined in ASC 815-10-55-31 are summarized in Figure 3-9.
Figure 3-9
Distinguishing between capacity contracts and financial option contracts
Characteristic
Capacity contract
Financial option contract
Source of power
Usually specifies the plant or group of plants
No reference is made to the source of power
Price
Includes pricing terms to compensate plant operator for variable operations and maintenance costs during production period
Structured based on the forward price of power
Quantity
Based on individual needs of parties to the agreement
Standard market amounts
Delivery
Usually one or a group of physical delivery locations; seller or buyer specific location
Major market hub (liquid hub)
Operations
Certain operational criteria are usually specified (e.g., heat rate of facility)
No criteria specified
Transmission
May include interconnection or physical transmission requirements
No requirements specified
Outages
May specify jointly agreed-to plant outages and may include penalties for unexpected outages
Not plant specific; no penalties pertaining to a specific plant
Default
Usually based on a refund of the capacity payment; default provision usually tied to the expected facility
Damages based on market liquidating damages
Duration
Term is usually long (one year or more)
Term reflects liquid market period (18 to 24 months in the guidance)
In determining whether a contract with volumetric optionality qualifies for the power contract exception, a reporting entity should consider all relevant contract characteristics. Not all of the characteristics in ASC 815-10-55-31 need to be met to conclude that the contract qualifies as a capacity contract; however, the conclusion should be based on the predominant characteristics of the contract. Consideration of the purpose for executing the agreement may also be helpful in performing this assessment.
Application examples — normal purchases and normal sales scope exception: option contracts
The following simplified examples are provided to illustrate the application of the power contracts exception to option contracts, specifically considering the evaluation under ASC 815-10-55-31. For purposes of these examples, assume all of the other relevant criteria for application of the normal purchases and normal sales scope exception are met.
EXAMPLE 3-21
Application of the normal purchases and normal sales scope exception — option contract
Ivy Power Producers (IPP) enters into an agreement to sell electric energy to Rosemary Electric & Gas Company (REG). The contract states that REG has an option to take an hourly quantity of 100 MWs during on-peak hours for the month of August 2015. Energy will be delivered from the Maple Generating Station for an initial option premium plus start-up fees, variable operating and maintenance fees, and a natural gas charge based on a heat rate of 7.0. The delivery location is at the power plant. REG has retail customer load commitments near the Maple Generating Station.
Is the contract eligible for the power contract exception?
Analysis
This contract exhibits a significant number of the characteristics of a capacity contract including specified plant location and delivery point, as well as pricing based on plant operations. Although the contract is short-term (one month), it would be eligible for the power contract exception because the predominant characteristics of the contract meet the capacity contract criteria.
If, however, no plant is specified, the pricing is based on the forward price curve for power, and delivery is to a liquid trading point, the contract would predominantly have characteristics of an option contract and it would not be eligible for the normal purchases and normal sales scope exception.
EXAMPLE 3-22
Application of the normal purchases and normal sales scope exception — option contract
Ivy Power Producers (IPP) enters into a contract with Rosemary Electric & Gas Company (REG) to sell electric energy from the Maple Generating Station. The contract term is five years. REG has an option to take up to an hourly amount of 100 MWs during on-peak hours. The contract price includes a start-up fee, variable operating and maintenance fee, and a natural gas charge based on a 7.0 heat rate. The delivery location is a liquid trading location for power. The contract specifies the timing of plant outages. REG has retail load commitments located near the Maple power plant.
Does the contract qualify for the normal purchases and normal sales scope exception?
Analysis
Although this contract includes some characteristics of a financial option (e.g., delivery at a liquid trading point), the predominant characteristics are that of a capacity contract. Therefore, the contract is eligible for the normal purchases and normal sales scope exception. This would likely still be the case even if the pricing was market-based. However, assessing whether a contract is a capacity contract requires judgment and all relevant criteria should be considered in the assessment.
9Guidance originally issued as DIG Issue C10, Scope Exceptions: Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception?
10Guidance originally issued as DIG Issue C16, Scope Exceptions: Applying the Normal Purchases and Normal Sales Exception to Contracts That Combine a Forward Contract and a Purchased Option Contract.
11Guidance originally issued as DIG Issue C15, Scope Exceptions: Normal Purchases and Normal Sales Exception for Certain Option-Type Contracts and Forward Contracts in Electricity (DIG Issue C15) and in FAS 133, paragraph 58(b).

3.3.2 Certain contracts not traded on an exchange

In addition to the normal purchases and normal sales scope exception, ASC 815 includes certain scope exceptions for contracts that are not exchange-traded. Unlike the normal purchases and normal sales scope exception, these exceptions are not elective. Therefore, if a contract meets the criteria for one of the exceptions, derivative accounting is not applied.
The scope exceptions described in ASC 815-10-15-59 through 15-62 apply in part if the underlying on which the settlement is based is any one of:
  • A climatic or geological variable or other physical variable
  • The price or value of a nonfinancial asset that is not readily convertible to cash
  • The price or value of a nonfinancial liability if the liability does not require delivery of an asset that is readily convertible to cash
  • Specified volumes of sales or service revenues of one of the parties to the contract
The scope exceptions that commonly apply to utilities and power companies are further discussed below.
Question 3-25
Can the scope exception related to contracts not traded on an exchange be applied if a contract contains more than one variable?
PwC response
It depends. Some contracts may contain both a financial variable and a variable that qualifies for one of the scope exceptions in ASC 815-10-15-59 through 15-62. In accordance with ASC 815-10-15-60, in such cases, a reporting entity needs to look to the predominant characteristics of the contract. If the underlyings in the contract, when combined, behave in a manner that is highly correlated to any of the variables that do not qualify for a scope exception, then the contract would be subject to the requirements of the derivatives guidance.

3.3.2.1 Climatic, geological, or other physical variables

ASC 815-10-15-59 provides a specific scope exception for non-exchange-traded contracts with an underlying based on a climatic or geological variable.

Excerpt from ASC 815-10-15-59(a)

A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale.

To qualify for this exception, the contract cannot be exchange-traded and the underlying must be a variable related to weather or other geological or physical variable. Physical variables are items such as temperature, wind speed, or other weather-related factors. For example, a power contract with pricing based on cooling-degree days would meet the exception. Market-related volumes of a commodity (e.g., the total volume on NYMEX) would not qualify for this exception because the volume on an exchange or other market is not a physical variable. As noted above, ASC 815-10-55-135 contains examples of how to apply this exception.
Derivative accounting, however, would apply to weather-related contracts traded on an exchange. In addition, ASC 815-45 provides specific nonderivative guidance on accounting for non-exchange-traded weather derivatives (note that the guidance refers to this type of contract as a derivative although it does not meet the accounting definition). The guidance includes two different accounting models, depending on the reporting entity’s purpose for executing the contracts. See UP 3.6.8 and ASC 815-45 for further information on the accounting models for non-exchange-traded weather derivatives.

3.3.2.2 Specified volumes of sales or service revenues

ASC 815-10-15-59 also provides a scope exception for non-exchange-traded contracts with an underlying based on specified volumes of sales or service revenues of one of the parties to the contract.

ASC 815-10-15-59(d)

Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

This exception applies only when settlement may be affected by changes in the volume of sales, not by changes in market price. This exception may also be extended to net income or earnings before interest, taxes, depreciation and amortization, unless the income measure is due predominantly to fair value movements. As an example, a contract issued by a reporting entity to pay a counterparty 3% of its net sales of natural gas would not be subject to the requirements of ASC 815. Furthermore, because this guidance is not intended to apply to contracts with settlements based on changes that are due principally to changes in market prices, a contract to pay the counterparty a 3% price increase in the price of natural gas would not qualify for the exception.
Question 3-26
Can the sales or service revenue exception be applied to contracts that settle based on a combination of volume and market price changes?
PwC response
Yes. Based on discussions with the FASB staff, we understand that the phrase “changes in sales or revenues due to changes in market prices” is not intended to preclude royalty agreements wherein the payment is based on changes in sales or revenues due to changes in market prices, when those changes are applied to the volume of items sold or services rendered. We understand from the staff that the intention of the FASB was to prohibit applying the scope exception to (1) contracts that used as their sole variable the change in sales or revenues due to changes in market price, and (2) contracts containing variables based on the change in market prices and a trivial change in the number of units.
As a result, if the pricing of the contract incorporates both market price and changes in units, the contract would still meet the conditions for the scope exception.
Application example — sales or services revenue scope exception
The following simplified example is provided to illustrate the application of the guidance of the sales or services revenue scope exception.
EXAMPLE 3-23
Application of the sales or service revenues scope exception — power contract
Ivy Power Producers (IPP) enters into a power sales agreement with Rosemary Electric & Gas Company (REG) to be serviced from the Maple Generating Station. The pricing in the contract comprises a fixed capacity payment, along with a pass-through of natural gas costs. In addition, the monthly payment will be adjusted by an imputed net revenue amount that is calculated based on the difference between market power prices and the imputed variable energy cost. Therefore, monthly settlements are in effect based on the difference between a specified net revenue amount and actual revenue generated by the Maple power plant.
Should the arrangement be accounted for as a derivative?
Analysis
The contract meets the definition of a derivative, but IPP would then need to consider whether the contract meets the scope exception in ASC 815-10-15-59(d). The contract inherently includes an element of market pricing because the Maple power plant will not dispatch if the cost of production is greater than the market price of power (given the imputed net revenue formula). In addition, the payout formula incorporates the market price of fuel, the market price of power, changes in the market heat rate, and the availability of the plant. As a result, monthly settlement is based on both the volume of sales from the plant and the market price of power.
The pricing formula in the contract is analogous to the royalty payment discussed above in Question 3-26, in which revenues are changing due to changes in market prices applied to the volume of items sold. Similar to the royalty agreement, settlement of this contract is based on sales, which are determined based on market price multiplied by volumes sold and incorporates both market prices and plant-specific elements. Therefore, consistent with the conclusion in Question 3-26, this contract qualifies for the scope exception because it settles based on a combination of market prices and other elements that are unrelated to the market.
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