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Scope of IAS 39
Contracts to buy or sell a non-financial item, such as a commodity, which
can be settled net in cash or another financial instrument, or by exchanging
financial instruments are within the scope of IAS 39R, unless the contracts
were entered into and continue to be held for the purpose of the receipt
or delivery of the non-financial item in accordance with the entity's expected
purchase, sale or usage requirements.
A contract to buy or sell a non-financial item can be net settled in any
of the following ways:
(a) the terms of the contract permit either party to settle it net in cash
or another financial instrument;
(b) the entity has a practice of settling similar contracts net, whether:
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with the counterparty; |
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by entering into offsetting contracts; or |
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by selling the contract before its exercise or lapse; |
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(c) the entity has a practice, for similar items, of taking delivery of
the underlying and selling it within a short period after delivery for the
purpose of generating a profit from short-term fluctuations in price or
dealer's margin; or
(d) the commodity that is the subject of the contract is readily convertible
to cash [IAS39R.6].
The practice of settling similar contracts net prevents an entire category
of contracts from qualifying for the own-use treatment (i.e. all similar
contracts must then be recognised as derivatives at fair value).
Application of 'own-use treatment'
Own-use treatment applies to those contracts that were entered into and continue
to be held for the purpose of the receipt or delivery of a commodity in accordance
with an entity's expected purchase, sale or usage requirements [IAS39R.5].
The ability to 'net settle' a contract may disqualify it from own-use treatment.
The net settlement criteria are broad - they include settlement net in cash
or another financial instrument or by exchanging financial instruments.
A contract to buy or sell a non-financial item can be net settled in any
of the following ways [IAS39R.6]:
(a) the terms of the contract permit either party to settle it net in cash
or another financial instrument;
(b) the entity has a practice of settling similar contracts net, whether:
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with the counterparty; |
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by entering into offsetting contracts; or |
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by selling the contract before its exercise or lapse; |
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(c) the entity has a practice, for similar items, of taking delivery of
the underlying and selling it within a short period after delivery for the
purpose of generating a profit from short-term fluctuations in price or
dealer's margin; or
(d) the commodity that is the subject of the contract is readily convertible
to cash.
A contract to which (b) or (c) above applies cannot qualify for own-use treatment.
Such contracts are accounted for as derivatives at fair value. Contracts subject
to the criteria described in (a) or (d) above are evaluated to see if they
qualify for own-use treatment, (i.e. whether they were entered into and continue
to be held for the purpose of the receipt or delivery of the non-financial
item in accordance with the entity's expected purchase, sale or usage requirements).
Contracts for commodities such as oil, gas, and electricity will meet criterion
(d) above (i.e. be readily convertible to cash) when an active market exists
for the commodity that is the subject of the contract. An active market
exists when prices are publicly available on a regular basis and those prices
represent regularly occurring arms length transactions between willing buyers
and willing sellers [IAS39R.AG71]. Consequently, sale and purchase contracts
for commodities in locations where an active market exists must be accounted
for at fair value unless own-use treatment can be applied. An entity's behaviour
is therefore critical in determining the appropriate treatment of its commodity
contracts.
Own-use treatment
Own-use contracts are defined as, "contracts that were entered into
and continue to be held for the purpose of the receipt or delivery of a
non-financial item in accordance with the entity's expected purchase, sale
or usage requirements" [IAS39R.5].
Must own-use treatment be applied?
Own-use treatment is not an election. A contract that meets the treatment
criteria is outside the scope of the standard and must be accounted for using
executory contract accounting. The contract can only be accounted for at fair
value if it contains an embedded derivative that:
(a) significantly modifies the cash flows of the contract;
(b) it is not clear with little or no analysis that separation of the embedded
derivative is prohibited; and
(c) the entity designates the contract as a contract at fair value through
profit or loss at inception [IAS39R.11A].
Own-use treatment and embedded derivatives
Commodity contracts which cannot be net settled or that qualify for own-use
treatment are outside the scope of the Standard and, therefore, are non-derivative
contracts. Any embedded derivatives in these non-derivative contracts shall
be assessed to determine if they need to be separated and fair valued [IAS39R.11].
Volume flexibility
Own-use treatment cannot be applied to a written option to buy or sell a
commodity that can be settled net either because the [IAS39R.7]:
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terms of the contract permit net settlement [IAS39R.6(a)]; or |
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commodity, which is the subject of the contract, is readily convertible
to cash [IAS39R.6(a)]. |
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Commodity contracts frequently offer the counterparty flexibility in relation
to the quantity of the commodity to be delivered under the contract and,
therefore, do not qualify for own-use treatment.
Measurement of long-term contracts
If a contract does not fall within own-use treatment and meets the definition
of a derivative, it shall be carried at fair value using the valuation guidance
in IAS 39R [IAS39R.AG71-AG76A]. Long-term commodity contracts in the E&U
industry may extend for periods of up to 30 years and cover periods when quoted
prices are not available for the commodity to be delivered under the contract.
In the absence of an active market for the entire contract term, these contracts
are valued using valuation techniques [IAS39R.AG74].
The valuation technique is intended to establish what the transaction price
would have been on the measurement date in an arm's length exchange motivated
by normal business considerations [IAS39R.AG75]. Therefore it:
(a) incorporates all factors that market participants would consider in
setting a price, making maximum use of market inputs and relying as little
as possible on entity-specific inputs;
(b) is consistent with accepted economic methodologies for pricing financial
instruments; and
(c) is tested for validity using prices from any observable current market
transactions in the same instrument or based on any available observable
market data [IAS39R.AG75-AG76].
For an input to be objective, it must be public knowledge and not entity
specific. For example, a generator which plans to construct a new power
station may not use that information in deriving its price curve unless
other market participants are aware of the new plant and include it in their
valuation models. The valuation techniques must not include the establishment
of a valuation reserve for the portion of the contract which extends beyond
the active market period.
Recognition of dealer profit
For those commodity contracts that do not fall within own-use treatment
and are carried at fair value, a profit or loss may be recognised at initial
recognition (i.e. a 'day 1 profit or loss'), only if the fair value of the
contract:
(1) is evidenced by other observable market transactions in the same instrument;
or
(2) is based on valuation techniques whose variables include only data from
observable markets.
Observable market transactions must be in the same instrument (i.e. without
modification or repackaging and in the same market where the contract was
originated [IAS39R.AG76]. In the context of long-term commodity contracts
this requires prices to be established for transactions with different counterparties
for the same commodity and for the same duration at the same delivery point.
Any day 1 profit or loss that is not recognised at initial recognition
is recognised subsequently only to the extent that it arises from a change
in factor (including time) that market participants would consider in setting
a price. As commodity contracts include a volume component, energy companies
are likely to recognise the day 1 profit or loss as the volumes are delivered,
or as observable market prices become available for the remaining delivery
period.
Hedge accounting
Energy companies may designate hedging relationships between hedging instruments,
including commodity contracts that are not treated as own-use contracts,
and hedged items. In addition to hedges of foreign currency and interest
rate risk, energy companies primarily hedge the exposure to variability
in cash flows arising from commodity price risk in forecast purchases and
sales. Such forecast transactions can be designated as the hedged item only
if they are 'highly probable' to occur [IAS39R.88(c)].
If the hedged item is a non-financial asset or non-financial liability,
it shall be designated as a hedged item either (a) for foreign currency
risks or (b) in its entirety for all risks, because of the difficulty of
isolating and measuring the appropriate portion of the cash flows or fair
value changes attributable to specific risks other than foreign currency
risks [IAS39R.82] .
Embedded derivatives
Long-term commodity purchase and sale contracts frequently contain a pricing
clause (i.e. indexation) based on a commodity other than the commodity deliverable
under the contract. Such contracts contain embedded derivatives that may have
to be separated.
An embedded derivative is a derivative instrument that is combined with
a non-derivative host contract (the 'host' contract) to form a single hybrid
instrument. An embedded derivative causes some or all of the cash flows
of the host contract to be modified, based on a specified variable [IAS39R.10].
An embedded derivative can arise through market practices or common contracting
arrangements.
An embedded derivative is separated from the host contract and accounted
for as a derivative if [IAS39R.11]:
(a) the economic characteristics and risks of the embedded derivative are
not closely related to the economic characteristics and risks of the host
contract;
(b) a separate instrument with the same terms as the embedded derivative
would meet the definition of a derivative; and
(c) the hybrid (combined) instrument is not measured at fair value with
changes in fair value recognised in the profit or loss (i.e. a derivative
that is embedded in a financial asset or financial liability at fair value
through profit or loss is not separated).
Embedded derivatives that are not closely related must be separated from
the host contract and accounted for at fair value with changes in fair value
recognised in the income statement [IAS39R.11].
If such an embedded derivative cannot be measured separately, the entire
combined contract must be measured at fair value with changes in fair value
recognised in the income statement [IAS39R.12] .
An embedded derivative that is required to be separated may be designated
as a hedging instrument, in which case the hedge accounting rules are applied.
A contract which contains an embedded derivative that:
(a) significantly modifies the cash flows of the contract; and
(b) it is not clear with little or no analysis that separation of the embedded
derivative is prohibited,
can be designated as a contract at fair value through profit or loss at
inception. [IAS39R.11A].
Assessing closely related
All embedded derivatives must be assessed to determine if they are 'closely
related' to the host contract at the inception of the contract. A pricing
formula that is indexed to something other than the commodity delivered under
the contract could introduce a new risk to the contract.
The assessment of whether an embedded derivative is closely related is
primarily qualitative rather than quantitative, and requires an understanding
of the economic characteristics and risks of both instruments .
In the absence of an active market price for a particular commodity, management
should consider how other contracts for that particular commodity are normally
priced. It is common for a pricing formula to be developed as a proxy for
market prices. When it can be demonstrated that a commodity contract is
priced by reference to an identifiable industry 'norm' and contracts are
regularly priced in that market according to that norm, the pricing mechanism
does not modify the cash flows under the contract and is not considered
an embedded derivative .
When an active market price for a particular commodity exists, the inclusion
of indexation in the contract price results in an embedded derivative. Such
an embedded derivative is not closely related to the host contract if it
introduces a new risk to the contract ) .
Contracts denominated in a foreign currency that is not:
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the functional currency of any substantial party to that contract; |
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a currency in which prices of the relevant commodity are routinely
denominated in commercial transactions around the world (for example
oil); or |
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a currency that is commonly used in contracts to purchase or sell
non-financial items in the economic environment in which the transaction
takes place (for example, a relatively stable and liquid currency that
is commonly used in local business transactions or external trade) [IAS39R.AG33(d)] |
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contain a foreign currency embedded derivative that is not closely related
to the host contract .
Timing of assessment of embedded derivatives
All contracts need to be assessed for embedded derivatives at the later
of the date when the entity first becomes a party to the contract and the
adoption of IAS 39 [IFRS1.IG55]. In some cases, the assessment of whether
a contract contains an embedded derivative that is required to be separated
will depend on external market circumstances that could change over time.
Subsequent reassessment of embedded derivatives is prohibited unless there
is a significant change in the terms of the contract, in which case reassessment
is required. A significant change in the terms of the contract has occurred
when the expected future cash flows associated with the:
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embedded derivative; |
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host contract; or |
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hybrid contract |
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have significantly changed relative to the previously expected cash flows
under the contract [IFRIC9.7].
The same principles apply to an entity that purchases a contract containing
an embedded derivative. In this case the date of purchase is treated as
the date when the entity first becomes party to the contract.
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