Utilities and power companies often enter into power purchase or other agreements that include multiple products and/or services. For example, a contract may require the delivery of capacity, energy, and other items such as ancillary services or renewable energy credits. Typically, this type of contract does not meet the net settlement criterion in its entirety; therefore, further evaluation under the embedded derivative guidance is required. The evaluation of whether the products are clearly and closely related is a key question in the analysis.
In accordance with ASC 815-15-25-1
, the determination of whether the embedded derivative is clearly and closely related to the host contract should be based on an analysis of economic characteristics and risks of the potential embedded derivative and host contract. Said differently, the clearly and closely related criterion considers whether the attributes of the derivative behave in a manner similar to the attributes of the host contract. The economic characteristics and risks are generally measured by reference to the cost or market value of the derivative and host.
In evaluating the application of clearly and closely related to a typical power purchase agreement, in general, we believe that separate products delivered in a single contract will not qualify as clearly and closely related (and thus further evaluation of whether the embedded derivative should be separated is required). This conclusion is based on the following primary factors:
- Separate products
The concept of clearly and closely related in ASC 815-15 is focused on pricing features that change the cash flows of an arrangement and are expected to settle concurrently with settlement of the host contract. The ASC 815-15 guidance generally does not address contracts with multiple products or services. However, the risks and characteristics of a contract with multiple products or services that have different deliverables and settlement dates (e.g., timing of delivery of energy may not coincide with delivery of ancillary services or renewable energy credits) are not analogous to a contract with cash flow variations due to pricing features. Furthermore, for contracts with more than one deliverable (e.g., debt and equity, such as convertible debt) the embedded derivative typically is not clearly and closely related.
In a power purchase agreement containing multiple products, the buyer is paying for delivery of more than one item. Although the prices of the products in the contract may be interrelated (i.e., there could be some benefit by bundling the products into one contract as compared to stand-alone selling prices), the price of one product does not represent a price adjustment but instead represents a payment for a different deliverable.
- Periodic settlement
A contract for more than one physically delivered product requires settlement (payment) for each of those products on a periodic basis. Each product represents a different cash flow under the contract and the settlement of one product does not result in settlement of the remaining products or obligations under the contract. ASC 815-15-25-41 provides an example of call and put options that do not accelerate the repayment of principal on a debt instrument but rather force a cash settlement that is equal to the price of the option at the date of exercise. The guidance in that paragraph states that the option, which has an independent settlement feature, would not be considered clearly and closely related to the debt host.
- Nonfinancial products
ASC 815 provides limited guidance on how to perform this analysis for nonfinancial contracts; almost all of the application examples in ASC 815 pertain to financial hybrid instruments. In discussing one of the few nonfinancial hybrid examples, the response to DIG Issue B14, Embedded Derivatives: Purchase Contracts with a Selling Price Subject to a Cap and a Floor (DIG Issue B14), states, in part:
However, when deciding whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the host contract for other nonfinancial hybrid contracts, it may not be appropriate to analogize to the guidance in paragraph 61 [now ASC 815-15-25-23
to 25-51]. The guidance in paragraph 61 is not meant to address every possible feature that may be included in a hybrid instrument but, instead, that paragraph covers common features present in financial hybrid contracts.
The DIG Issue B14 response indicates that, in general, the guidance provided on clearly and closely related in ASC 815
is applicable for financial hybrid contracts but not necessarily for nonfinancial hybrid contracts.
Based on these factors, we believe that multiple deliverables in a single contract are usually not clearly and closely related to the nonderivative host contract; therefore, further evaluation is required to determine if separation is required from the host contract (see UP 3.4.2
). See further discussion of the application of the embedded derivative guidance to power contracts in Question 3-30 and the simplified examples that follow.
How does the interpretation of clearly and closely related for embedded derivatives relate to the clearly and closely related criterion applied in the normal purchases and normal sales scope exception?
through 15-34 establish a qualitative and quantitative approach for assessing whether a pricing feature is clearly and closely related in application of the normal purchases and normal sales scope exception. However, it also clarifies that the phrase conveys a different meaning than in the embedded derivative analysis.
Excerpt from ASC 815-10-15-31
The phrase not clearly and closely related…with respect to the normal purchases and normal sales scope exception is used to convey a different meaning than in paragraphs 815-15-25-1(a) and 815-15-25-16 through 25-51 with respect to the relationship between an embedded derivative and the host contract in which it is embedded.
In general, the normal purchases and normal sales scope exception establishes a more structured approach compared to the analysis performed in the embedded derivative evaluation. Specifically, the clearly and closely related analysis for purposes of applying the normal purchases and normal sales scope exception requires a qualitative and quantitative analysis of pricing features within the contract. To apply the exception, at contract inception the price adjustment should be expected 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 the contract under then-existing conditions. In contrast the analysis of potential embedded derivatives does not require explicit comparison of the pricing but instead focuses on the overall economic risks and characteristics of the potential embedded derivative and the host.
See UP 3.3.1
for further discussion of the normal purchases and normal sales scope exception, including application of the exception to embedded derivatives.
How is the host contract determined when assessing a hybrid contract?
Identification of the host contract is a key question when determining whether a hybrid instrument requires bifurcation. There is little specific guidance on the identification of the host and we are aware that different methodologies are discussed. For example, some believe that the host contract should represent the “predominant characteristic(s)” within the hybrid, while others look to separate the derivative and nonderivative elements.
The Basis for Conclusions of FAS 133 discusses some of the FASB’s considerations in developing the hybrid approach. The FASB considered evaluating potential embedded derivatives based on predominant characteristics or yield, but concluded that those approaches would scope in instruments that were not the intent of the guidance and may not be operational. The FASB also initially considered requiring that the entire instrument be measured at fair value when a contract included both derivative and nonderivative elements. However, the FASB decided to only require the embedded derivative to be measured at fair value, except in limited circumstances, such as when the embedded derivative cannot be reliably identified and measured. The FASB believed that this approach was most consistent with the objective of measuring derivative instruments at fair value.
In evaluating the appropriate accounting, we further consider the guidance of ASC 815-15-05-1
Excerpt from ASC 815-15-05-1
The effect of embedding a derivative instrument in another type of contract (the host contract) is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent on the occurrence of a specified event, will be modified based on one or more underlyings.
We also consider the accounting for the host contract discussed in ASC 815-15-25-54
If an embedded derivative is separated from its host contract, the host contract shall be accounted for based on GAAP applicable to instruments of that type that do not contain embedded derivatives.
Considering the FASB’s objectives and related guidance, we believe the appropriate approach for determining the host contract is to identify those elements (cash flows) of a contract that meet the definition of a derivative separately from the nonderivative elements (cash flows) of the contract. Any nonderivative elements should be considered together as a single host contract and the potential derivative elements should be evaluated for separation from the single host contract. Because the host contract follows other applicable U.S. GAAP, we do not believe any of the derivative elements can be the host contract. This approach is consistent with the FASB’s overall objectives of measuring only derivative elements at fair value.
Is energy and capacity considered clearly and closely related for purposes of assessing whether a hybrid contains an embedded derivative?
Generally, no. As described above, we believe that the clearly and closely related exception for embedded derivatives was not intended to apply to contracts with separate products and deliverables with different pricing and settlements. Therefore, when evaluating capacity and energy combined in the same contract, we generally believe that they are not clearly and closely related (with a limited exception if these products are bundled in the area of the United States where they are being transacted).
Some may hold an alternative view that energy and capacity, or other products that could be combined in a power purchase agreement, should be subject to a quantitative and/or qualitative evaluation when performing the clearly and closely related analysis. Because of the nature of the markets (e.g., pricing of the products is sometimes correlated with each other), the source of the products (e.g., energy and capacity originating from the same plant or location), or the interrelationship within the contract (e.g., default provisions, pricing), proponents of this view believe that a clearly and closely related conclusion could be reached based on this type of analysis.
However, the intent (and examples that demonstrate the objective) of the ASC 815
guidance on clearly and closely related is to provide reporting entities with a practical accommodation for prepayment, pricing, and other features that modify the cash flows of a host contract; it is not to combine different products within the same contract. Therefore, we believe that separate deliverables under a contract are generally not clearly and closely related when the contract includes separate performance obligations, separate pricing, or multiple settlement dates for the products. In many cases, the energy portion within these contracts meets the definition of a derivative and so separate accounting for the energy and capacity portions of the contract would result.