Derivative

Accounting
Awareness
 SFAS 133 Accounting for Derivative
Instruments and Hedging Activities

 Objectives


• Gain understanding of the basic

concepts within the standard
• Enhance knowledge of financial
statement implications of credit
events on the typical derivative
transactions CER executes

3
3
Economics vs. Accounting

4
 Economics vs. Accounting
• The accounting framework often does not reflect
Management’s view of the economic substance of the
business
– Mixed attribute model combining FV and historical
cost concepts
• Many accounting rules are form-driven rather than
substance-driven and thus, different accounting
treatments can result from transactions with similar
economic ramifications
• Consequently,
– Companies must view the accounting portfolio
distinctly from the risk management (economic)
portfolio and understand the differences, and
– Consider accounting implications of various risk
management approaches and transaction
structures
• 5
 Economics vs. Accounting
The current accounting framework may not fit with the risk
management model of the integrated energy company.

Physical assets and contractual assets al

Centralized risk management
Risk Management Best viewed as MTM positions
Practices and transacting

Accounting Portfolio hedging difficult to accounting for physical assets and non
Different
Rules achieve / implement contracts versus derivatives

6
Sale of Generation Capacity
The Risk Management Portfolio may be
balanced.
Long Short
Production /
Supply
= Commodity Sales
Contract

While the Accounting Portfolio is not .

Physical Assets / Non - Derivative Financial /

Contracts / Supply Derivative
Contract

=
=

Accrual Accounting MTM Accounting

7
Gas Storage Optimization
The Risk Management Portfolio may be balanced.

Long Calendar Spread Short

( Storage Contract or = Winter / Long Summer
Facility ) Contracts

While the Accounting Portfolio is not .

Long Calendar Winter / Summer Gas

Spread Contracts
=

Accrual Accounting =
MTM Accounting

8
Gas Transportation Optimization
The Risk Management Portfolio may be balanced.

Long Location Spread Short

( Transportation = Loc A / Long Loc B
Contract ) Contracts

While the Accounting Portfolio is not .

Long Location Loc A and Loc B Gas

Spread Contracts
=

Accrual Accounting =
MTM Accounting

9
 Economics vs. Accounting
To avoid earnings volatility, an energy or commodity company must consider
the accounting implications of various risk management approaches and
transaction structures to balance between accrual and MTM positions. Scope
exceptions or hedge accounting can be used to help achieve this balance.
However, companies need to consider the complexity and requirements for
selecting alternative accounting, including the impact of imperfect hedges and
hedging strategies.
Hedge Accounting
MTM
Accrual Accountin
Accounting g
Normal Purchase / Sale

Additionally, the company must have the ability to understand the impact of
proposed new transactions on the risk management portfolio and the
accounting portfolio. This emphasizes the need for proactive accounting
involvement in deal structuring.
10
Background and Overview of
SFAS 133
SFAS 133 Accounting for Derivative Instruments and Hedging
Activities

11
 Accounting Evolution of
Derivatives
§ Prior to SFAS 133, little specific guidance
• Limited to futures contracts, some disclosures
• EITF 98-10 allowed “energy trading” entities to MTM all energy related
contracts
• Massive value associated with marking to models; increased scrutiny by
SEC
§ Derivatives Debacles of Mid – 1990’s led to SFAS 133
• MG
• P&G
• Orange County
• Others
§ SFAS 133 issued with primary objectives:
• Specify FV as only relevant measurement for derivatives
• Require all derivatives to be recorded on balance sheet
• Provide limited exceptions (reluctantly) for “normal” transactions and
hedge accounting
§ SFAS 133 Amendments/EITF Issues/DIG interpretations in
response
• MTM limited to derivatives 12
 History of SFAS 133

Initially issued in June 1998

FASB worked on the project for the

best part of ten years

It was the most ambitious project

undertaken by the FASB at the time

The Standard and related guidance

comprises approximately 1,000

pages of material
Has been subject to significant

subsequent interpretation by the SEC

Is and has been a ‘hot topic’ and

source of significant restatements by

the SEC registrant base 13
13

 Relevant Accounting Literature

Statement of Financial Accounting

Standards (“SFAS”) No. 133 –
‘Accounting for Derivative
Instruments and Hedging Activities’
SFAS 149 – ‘Amendment of Statement

133 on Derivative Instruments and

Hedging Activities’
SFAS 138 – ‘Accounting for Certain

Derivative Instruments and Certain

Hedging Activities – an Amendment
to Statement 133’
Statement 133 Implementation Issues
14
14
 SFAS 133 - Overview

All derivatives recorded on Balance



Sheet at fair value



All derivatives marked-to-market



through earnings in the Income

Statement


Limited exceptions to these principles:



 Cash Flow hedge accounting

 Normal purchase and normal sales
15
 15
 Why all the Fuss??

Highly technical – rules-based and

judgmental
There are no free passes
 No look backs
 No free options
 No mulligans!!
Getting it wrong is easy
Price of getting it wrong is significant

Fertile hunting ground for the SEC

 Huge area of focus
 Hindsight will be applied
FASB and SEC are both biased towards


derivatives being recorded on the

balance sheet at fair value with
changes reported in the income
16
16
Defining SFAS 133

Accounting for Derivative

Instruments and Hedging
Activities

17
 SFAS 133 - Definition of a Derivative -
Flowchart
For each contract that CER executes, the accounting treatment is largely determined by the answer to the following question:

Is the contract a
derivative?
Yes No

Accounting
Possibilities :

Cash Flow/Fair
NPNS Value Hedge Inventory
MTM Accrual (LCM)
(Accrual) (Quasi-
Accrual)

But subject
to these rules :

Inception Cash Accrual Inventory

Value NPNS Flow/Fair Accounting Accounting
Rules May Rules Apply Value Hedge Rules Apply Rules Apply
Apply Rules Apply

18
18
 SFAS 133 - Definition of a
Derivative
 Financial instrument or other contract having:
– One or more underlyings and one or more notional amounts or payment
provisions or both
– No (or little) investment at inception
– Requires or permits net settlement or de facto net settlement


 If ALL 3 criteria exist, you have a derivative: FASB does offer exemptions,
but must still go through a process of identification


 In essence, a derivative is a contract for which you can obtain the “benefit
of your bargain” by either physical or financial settlement


 All derivatives are marked to market (MTM) through current period

earnings, unless they qualify for the normal purchases and normal sales
exception (accrual accounting) or qualify and are designated as cash
flow hedges (quasi-accrual)
19
19
 SFAS 133 - Definition of a
Derivative
Underlying


– An underlying is a:
 specified price or index
 a rate of an asset or liability, but not the asset or
liability itself
 It is the market price of the asset to be delivered, NOT the
price in the contract
 Most contracts contain an underlying


 Examples of underlyings:
 Commodity price / Market price (natural gas,
power, etc.)
 Spread (spark spread)
 Interest or exchange rate (LIBOR, USD/GBP) 20
20
 SFAS 133 - Definition of a
Derivative
• Notional
– A notional is a number of:
• MWh’s
• MMBtu’s
• Barrels
• Tons
• Or other units
• The underlying and the notional amount determine the
settlement amount
• General rule of thumb: If contractual quantities can be reduced
to zero without the selling party incurring penalties for non-
performance (unless this represents an economically
exercisable option), a reliably determinable notional likely
does not exist
• Note: A minimum determinable notional may be established by
a default clause regardless of whether damages are
symmetrical or not. 21
 Notional Issues
• Key considerations in determining whether a notional amount
exists include:
– Is there a minimum volume?
– Is the contract a “requirements” contract?
– If neither of the above, what are the remedies for non-performance
(i.e., reduction of capacity payment/premium only or liquidating
damages)?
• Contracts contain a notional if there is:
– A fixed volume
– A stated minimum volume
– A stated minimum to maximum volume
• Contracts may or may not contain a notional if there is:
– A stated maximum volume
– No stated volume, but is based on “actual needs” (requirements
contracts)
• DIG Issue A-6 provides interpretive guidance around
“requirements” contracts
22
 Notional Issues

• Difficulty encountered when:

– Contractual volumes are tied to actual production or output
– Contractual volumes are tied to actual needs or consumption
requirements
– Contractual volumes are tied to discreet systems or groups of
plants
– Liquidated damage provisions for nonperformance are
complex
§
• Existence or lack of a notional can make a radical difference in
accounting treatment
– Contracts without a notional must use accrual accounting
because they are not derivatives
– Contracts with a notional and that meet the rest of the criteria
to be a derivative require MTM accounting unless strict
criteria for an exception are met
23
 Requirements Contract
• What is a requirements contract?
– Requirements contracts generally have the following
characteristics:
• Specifies only for physical needs (“requirements”) of
buyer
• Prohibits resale
• Cannot be economically exercised
– Example
• LDC has a contract to buy as much as it needs for its
customer load up to 1 bcf/ day. Whether prices are
$2.00 / mmbtu or $20, it can only buy up to its
needs
– Contracts with volumetric optionality that CAN be
economically exercised are effectively financial options
and thus have a notional equal to the maximum quantity24
 Notional Determination

• DIG Issue A-6 provides relevant guidance either directly or by

analogy
• DIG A-6 addresses requirements contracts lacking a specified,
fixed number of units to be bought or sold.
• If the contract contains explicit provisions supporting the
calculation of a determinable amount, that amount
represents a notional.
• One common way to determine a notional is by reference to
damage provisions. Often the default provisions will refer to
anticipated quantities to be used to calculate damages in
the event of default.
• Contracts with a determinable minimum are deemed to have a
notional equal to that minimum
– The incremental volumes above the established minimum are
“ignored” for purposes of the derivative notional and
resulting accounting
25
•
 Notional Determination
• Examples of “Notional Complexity”
• Plant or system-specific contingencies Contracts tied to operations of specific plants or
systems. If plant doesn’t run, no deliveries or
settlements occur.


No notional

Asymmetrical, non-market based damage provisions Fixed penalties for non-performance may provide a
basis for determining a notional if computed off of a
benchmark quantity.


Notional exists if it can be computed from
historical data included or referenced by the
contract

Percentage-based off-take arrangements A form of plant-specific contingency in which the

quantity is stated as a specific percentage of
whatever is produced.


No notional

Combinations of the above

???

26
 SFAS 133 - Definition of a
Derivative
• Initial Net Investment
– A derivative requires either no initial net investment or a
smaller initial net investment than that required for
other contracts expected to have similar responses to
changes in the market
– An initial net investment should be less, by more than a
nominal amount, than the notional value of the contract
at inception
– A contract that requires an initial net investment may
contain an embedded derivative
– Examples of derivatives:
• Prepaid swaps – at-the-money swap and embedded
financing
• Options – usually contain a small initial net
investment
27
– Examples of non-derivatives:
 SFAS 133 - Definition of a
Derivative
Net Settlement


• There are three ways to meet the net settlement requirement

under paragraph 9:
a) An explicit or implicit net cash settlement provision in
contract;
b)Although contract requires delivery, there is a market
mechanism that facilitates net settlement of the
contract; or
c) Although contract requires delivery, that asset is
readily convertible to cash.


28
 SFAS 133 - Definition of a
Derivative
 Explicit or Implicit Net Settlement
§ An explicit or implicit net settlement provision in a contract:
– Swap, option or other financially settled instrument
• Liquidated damages/penalties for nonperformance that
settle the contract based on its fair value


• There are two primary types of default provisions:

– Symmetrical default provisions is where either
party can be compensated in the event of a
default
– Asymmetrical default provision is where only the
non-defaulting party can be compensated
– DIG A8 – asymmetrical default provisions do not
result in net settlement; symmetrical default
provisions do result in net settlement
• DIG A5 – contracts with significant penalty that would
make the possibility of nonperformance remote do not
result in net settlement
29
 SFAS 133 - Definition of a
Derivative
Market Mechanism


§ The existence of a market mechanism to sell or enter into an

offsetting contract that relieves the party of all of its rights
and obligations (including credit risk) under the contract.
• Need to be able to settle the contract itself, not just
offset the risks with another counterparty
§ Very rare in energy except for NYMEX contracts because
generally credit risk does not transfer

30
 SFAS 133 - Definition of a
Derivative
Readily Convertible to Cash (RCC)


§ Interchangeable (fungible) units

§ Quoted prices available in an active spot market
(continually assessed)
§ Spot market can rapidly absorb contract quantities without
significantly affecting the price
§ Cost to convert to cash must be less than 10% of the gross
sales proceeds that would be received in the most
economical active market (performed only at the
inception of the contract)
§ Assessment based on individual deliveries (not settlement
of the entire contract)

31
 SFAS 133 - Definition of a
Derivative
Determining RCC


§ Two key questions:

• What is the underlying asset to be delivered?
• Is the underlying asset RCC?
§ What is the asset to be delivered ?
– Gas/power/oil purchase or sale agreement – the
commodity
– Transportation/transmission/storage capacity deal – the
capacity
§ Thus, the next question must be…“Is the underlying asset (e.g.
commodity or capacity) at the applicable delivery
location(s) RCC?”

•
32
 SFAS 133 - Definition of a
Derivative
Determining RCC (continued)


§ Is the underlying asset RCC?

• Primary guidance is DIG A-10
• Must evaluate costs required to convert the asset to
cash only at inception of the contract
• If such costs are >10% of the sales price that could be
achieved in the nearest active market, asset is not
RCC
• DIG A19 points out that the existence of an active spot
market, even in absence of an active forward market,
would indicate the underlying asset is RCC
• Footnote in paragraph 57(c)(3) points out that the
evaluation of RCC should be performed throughout
the life of the contract

33
 SFAS 133 - Definition of a
Derivative
Evaluation of Market Mechanism/RCC


§ The DIG A10 “cost to convert” assessed at inception only

§ Market Mechanism and RCC should continually be assessed for
the duration of the contract (paragraph 57(c)(3)/DIG A18)
• Spot market develops
• Transacting activity over a period of time changes
• Market conditions change
• “Cost to convert” assessment not made subsequent
to inception
§ The company should look to changes in the market place as a
front-line indicator of when to reevaluate their conclusions

34
 SFAS 133 - Definition of a
Derivative
§ Specific RCC issues related to:
• Natural gas storage and transportation capacity
• Transmission contracts
• Ancillary services, ICAP
• Physical coal contracts
• Physical freight contracts
• LNG

35
 Accounting for Derivatives
§ All derivative instruments subject to SFAS 133 (i.e., not
scoped out) should be recognized as either assets or
liabilities
§ All derivative instruments should be measured at fair value
§ Changes in fair value should be recognized in earnings
immediately, unless they have been designated and
qualify for hedge accounting
§ SFAS 133 does not provide an exception to SFAS 133
accounting for derivative instruments due to inability to
obtain a quoted market price
§ An estimate of fair value must be made using the best
available information at the time
§

36
Normal Purchases and Normal
Sales Exception (NPNS)

Paragraph 10(b) of SFAS

133

37
 SFAS 133 - Definition of a Derivative -
Flowchart
For each contract that CER executes, the accounting treatment is largely determined by the answer to the following question:

Is the contract a
derivative?
Yes No

Accounting
Possibilities :

Cash Flow/Fair
NPNS Value Hedge Inventory
MTM Accrual (LCM)
(Accrual) (Quasi-
Accrual)

But subject
to these rules :

Inception Cash Accrual Inventory

Value NPNS Flow/Fair Accounting Accounting
Rules May Rules Apply Value Hedge Rules Apply Rules Apply
Apply Rules Apply

38
38
 SFAS 133 Scope Exceptions
§ SFAS 133 provides for a few scope exceptions which allow
contracts that might otherwise qualify as derivatives to
receive “non-derivative” accounting treatment (i.e., scoped
out from SFAS 133 application)
§ These exceptions are as follows:
– 10(a) – “Regular Way” Security Trades
– 10(b) – Normal Purchases and Normal Sales
– 10(c) – Certain Insurance Contracts
– 10(d) – Financial Guarantee Contracts
– 10(e) – Certain Contracts That Are Not Exchange Traded
– 10(f) – Derivatives That Serve as Impediments to Sales
Accounting
– 10(g) – Investments in Life Insurance
– 10(h) – Certain Investment Contracts
– 10(i) – Loan Commitments 39
 10(b) NPNS Exception
§ FAS 133 defines a normal contract as follows:
– Contract provides for the purchase or sale of something
other than a financial instrument or a derivative
– Must be probable that the contract will result in physical
delivery
– Quantities in the contract are consistent with normal
operational needs and are expected to be used or sold
in the “normal course of business”
– Net settlement of similar NPNS contracts should be rare
– If the contract requires cash settlements or otherwise
settles gains or losses on a periodic basis, it does not
qualify for this exemption
– The underlying price in the contract must be clearly and
closely related to physical product being delivered in
the contract
•

40
 10(b) NPNS Exception
§ A company must establish what is “normal course of business” under
the guidelines of normal as defined by FASB
§ A company must assess the probability of physical delivery
(Probability is not specifically defined by FASB)
§ “Normal” does not explicitly or implicitly relate to using the non-
financial asset (i.e. commodity) in some operational process (like
generating electricity from natural gas) but could also involve the
physical resale of a commodity
§ Trading activity not considered “normal”
§ To obtain NPNS, a company must document the designation of the
contract
§ A contract cannot be bi-furcated to obtain “normal” for one part and
mark-to-market for the other part, but a contract could be split into
two separate contracts, one that receives NPNS accounting and
one that requires MTM or hedge accounting
§ Once elected “normal” a contract cannot be elected mark-to-market
41
or hedge; however a mark-to-market or hedge contract can
 10(b) NPNS Exception
§ The following should be considered in applying paragraph
10(b):
• 10(b)(1) – Forward contracts (non-option based
contracts)
• 10(b)(2) – Freestanding option contracts
• 10(b)(3) – Forward contracts that contain optionality
features
• 10(b)(4) – Power purchase or sales agreements

42
 10(b)(1) NPNS Exception For
Forwards
§ 10(b)(1) permits forward contracts to purchase or sell a non-financial
instrument to qualify for the NPNS exception
§ Must result in physical delivery
§ May not contain 9(a) or 9(b) net settlement unless it is probable that
the contract will not settle net and will result in physical delivery
§ Contract cannot be subject to unplanned netting
• Effectively prohibits NPNS for most wholesale gas and
electricity contracts under 10 (b) (1)
§ Contract may be considered subject to unplanned netting if:
• An offsetting position (to the contract) exists at the same
delivery location/time period bucket
• Offsetting position does not need to be with the same
counterparty (e.g. multiple party bookouts may
occur).
• Offsetting contract does not need to have identical
quantity and delivery period terms.
– An external mechanism exists that can require netting of
physical positions resulting in reduced or eliminated physical
flow

43
 10(b)(2&3) NPNS Exceptions
For Options
§ Under 10(b)(2) freestanding options do not qualify for NPNS
except under 10(b)(4)
§ Under 10(b)(3) forward contracts that contain optionality
features may qualify for the NPNS exception if:
• No optionality on quantity
• Or if optionality modifies the quantity, the additional
quantities are at market at the date of delivery (no
economic value)
• Must meet criteria in 10(b)(1) to qualify
•

44
 10(b)(4) NPNS Exception For
Power
§ 10(b)(4) permits power purchases and sales to qualify for the
NPNS exception
§ Can be a forward, option, or combination of both
§ Must be a capacity contract (as defined in SFAS 133)
§ Must meet the criteria in paragraph 58(b) to qualify
§ Can be subject to unplanned netting
§ No other commodities such as gas, oil, or coal qualify under
this exception

45
 10(b)(4) NPNS Exception For
Power
§ Paragraph 58(b) requires the following for both the buyer
and the seller:
• Physical delivery of electricity (no 9(a) net settlement)
• The contract is a capacity contract under paragraph 540
– For forward contracts look to Deloitte/PwC white
paper
– For option contracts look to DIG C15 Appendix
§ Forward contracts qualify as a capacity contract under
Deloitte/PwC white paper as follows:
• Buyer is purchasing to meet its obligations
• Seller has capacity to back the contract
§ The Appendix in DIG C15 assists in distinguishing between a
capacity contract and a traditional option with economic
exercise
–

46
 DIG Issues - C15 Appendix
Option Contract That Is a Capacity Contract Financial Option Contract on Electricity
1 The contract usually specifies the power plant or group of power plants No reference is made to the generation origination of the electricity.
providing the electricity.
2 The strike price (paid upon exercise) includes pricing terms to compensate The strike price is structured based on the expected forward prices of
the plant operator for variable operations and maintenance costs power.
expected during the specified production periods.
3 The specified quantity is based on individual needs of parties to the The specified quantity reflects standard amounts of electric energy,
agreement. which facilitate market liquidity (for example, exercise in increments of
10,000 KwH).
4 The title transfer point is usually at one or a group of specified physical The specified index transfer point is a major market hub (liquid trading
delivery point(s), as opposed to a major market hub. hub), not seller- or buyer-site specific.

5 The contract usually specifies certain operational performance by the No operational performance is specified (not plant specific).
facility (for example, the achievement of a certain heat rate).
6 The contract sometimes incorporates requirements for interconnection None specified.
facilities, physical transmission facilities, or reservations for transmission
services.
7 The contract may specify jointly agreed-to plant outages (for example, for Penalties for outages are not specified (not plant specific).
maintenance) and provide for penalties in the event of unexpected
outages.
8 Damage provisions upon default are usually based on a reduction of the Damage provisions upon default are based on market liquidating
capacity payment (which is not market based). If default provisions damages.
specify market liquidating damages, they usually contain some form of
floor, ceiling, or both. The characteristics of the default provision are
9 The contract’s
usually termexpected
tied to the is usuallygeneration
long (one facility.
year or more). The contract’s term is not longer than 18 to 24 months because financial
options on electricity are currently illiquid beyond that period.

47
 10(b)(4) NPNS Exception for
Power
§ Seller only – in addition to the requirements for both the
buyer and seller previously mentioned, the electricity to be
delivered under the contract must involve quantities that are
expected to be sold in the seller’s normal course of business
§ Buyer only– in addition to the requirements for both the
buyer and seller previously mentioned, the buyer must meet
one of the following criteria:
• Must involve quantities expected to be used or sold in
the buyer’s normal course of business
• Must be engaged in selling electricity to retail or
wholesale customers and must maintain sufficient
capacity to meet these obligations
• The buyer is obligated to maintain sufficient capacity to
meet regulatory standards or grid operator provisions

48
10(b)(1) vs. 10(b)(4)

49
 Ongoing Hurdles – Physical
Delivery?
§ Commodity contracts designated as normal must physically
deliver!!!
– Ongoing monitoring is key
– “Planned” netting might cause “tainting”; such tainting
could call into question our ability to elect normal in
the future
•
§ Normal Course of Business Changes?
– Change in Business, Markets, Customers
•
•

50
Documentation Requirements
§Basis for concluding that the contract is probable of physical delivery
§Quantities are consistent with normal operational needs
§Underlying price is clearly and closely related to the product being
purchased or sold
§Net settlement is rare
§Special documentation requirements for power contracts designated as
“capacity”
§Normal election can be made any time, however it cannot be changed
later
§
•NOTE: Contracts designated in “buckets” which fail one of the above
run the risk of “tainting” the entire population

51
 Accounting for Contracts
Elected NPNS
§ Contracts determined to be derivatives and elected NPNS
should be accounted for on a settlement (accrual) basis
§ Contract is not recorded to the balance sheet (i.e., off-
balance sheet)
§ Changes in value are not recorded in earnings prior to
settlement
§ Derivative contracts elected NPNS subsequent to the
inception date must carry the pre-election fair value on
the balance sheet with future changes remaining off-
balance sheet (balance sheet rolls off via settlement)
§
§

52
Hedge Accounting

Paragraphs 19-45 of SFAS

133

53
 SFAS 133 - Definition of a Derivative -
Flowchart
For each contract that CER executes, the accounting treatment is largely determined by the answer to the following question:

Is the contract a
derivative?
Yes No

Accounting
Possibilities :

Cash Flow/Fair
NPNS Value Hedge Inventory
MTM Accrual (LCM)
(Accrual) (Quasi-
Accrual)

But subject
to these rules :

Inception Cash Accrual Inventory

Value NPNS Flow/Fair Accounting Accounting
Rules May Rules Apply Value Hedge Rules Apply Rules Apply
Apply Rules Apply

54
54
 Accounting
• Hedge Classification
§ Once contracts are determined to be derivatives, they
must be carried at fair value, with the change in fair
value recorded through income, unless:
• The contract qualifies for a scope exception and
the exception is elected
• The contract is designated as a cash flow
hedging instrument
§ If the contracts are designated as hedging instruments,
a determination of the type of hedge needs to be
made
• This classification will impact the accounting
treatment
• The contract will always be recorded at fair value
on the balance sheet
55
 Hedge Accounting
• Hedge Classification (cont.)
§ There are 3 types of accounting hedges
• Cash Flow Hedges
• Fair Value Hedges
• Net investment in a foreign subsidiary
–

56
 SFAS 133 - Cash Flow
Overview

Hedging
• These are the most common hedges in the commodity
industries
• Generally used to hedge the exposure of price movements in
future cash flows (i.e., lock the price of a forecasted
transactions)
• Designation must be well documented, specific and
contemporaneous (no retroactive designation)
• Essentially, a cash flow hedge converts a “floating” cash flow
stream (i.e. forecasted future transaction) into a “fixed”
stream

57
 SFAS 133 - Cash Flow
Hedging
• Accounting
– The fair value of the derivative is recorded on the
balance sheet and the effective changes are recorded
through “Accumulated Other Comprehensive Income”
(AOCI) (which is an equity account)
– Hedge ineffectiveness is recorded currently through the
income statement
– Only the change in fair value of the hedging instrument
is recorded; the hedged item is not recorded until
settlement/delivery
– Amounts recorded to a OCI are reclassified to income
when the forecasted transaction (hedged item)
affects earnings

58
 SFAS 133 - Cash Flow Hedging

General Rules


 Hedges must be derivative instruments

 Hedges of forecasted transactions
 forecasted transactions must be probable of occurring
 Mark to market the hedge transaction on the balance sheet
(PRM asset or liability) with effective changes in fair value
reported in Other Comprehensive Income (OCI)


 OCI is reported on the Comprehensive Income Statement:

 Net income
 +/- Other comprehensive income
 = Comprehensive income


Accumulated OCI (AOCI) is reported as a component of stockholder’s



equity below accumulated earnings on the balance sheet 59

59

 SFAS 133 - Cash Flow
Hedging
 Hedge Documentation Requirements
§ To qualify for hedge accounting, the Company must do
the following:
• Put in place appropriate and sufficient
documentation at inception of the hedging
relationship (no retroactive designation)
• Document why the hedging relationship is
expected to be highly effective
• Document and monitor the probability of the
forecasted transaction

60
 SFAS 133 - Cash Flow Hedging

 Hedge Designation
Designate an entire derivative or a “horizontal” portion


 cannot separate a derivative into components representing different

risks
 Example: Contract to buy 100MW of cal ‘05 energy (cash flow
hedge). Not allowed to designate the Jan ‘05 to Mar ‘05
portion as a cash flow hedge and treat the Apr ‘05 to Dec ‘05
portion as a MTM derivative


 can designate a percentage of the total across the entire duration

 Example: Contract to buy 100MW of cal ‘05 energy. It is
allowable to designate 75MWs of the entire cal ‘05 contract
as a cash flow hedge and account for the 25MWs as a MTM
derivative.


 can designate a percentage of the total or a specified quantity that

represents a portion of all the risks in the contract across the entire
duration of the contract

61
61

 SFAS 133 - Cash Flow
Hedging
Hedged Item (Forecast)


§ Hedged Item examples

• The forecasted transaction (hedged item) could
be identified as:
– The first 15,000 units purchased/sold
during a specified 3-month period
– The first 5,000 units purchased/sold in
each of the 3 specified months
• The forecasted transaction (hedged item) cannot
be identified as:
– The last 15,000 units purchased/sold
during a specified 3-month period
» These could not be identified until
after the period has ended
62
 SFAS 133 - Cash Flow
Hedging
Forecasted Purchase and Sales


§ A forecasted transaction is eligible if all of the following

criteria are met:
• The forecasted transaction is specifically
identified as a single transaction or group of
individual transactions
• The occurrence of the forecasted transaction is
probable
– DIG G-16 states that as long as the
transaction remains probable of
occurring by the end of the designated
range (or within an additional 60 day
period), it still qualifies
• With exception of foreign currency cash flow
hedges, the forecasted transaction must be
with a party external to the reporting entity 63
 SFAS 133 - Cash Flow
Hedging
Probability


§ At each reporting date, evaluate whether the hedged

transaction is still probable.
• If still probable and all other hedge requirements
are met, continue hedge accounting
• If probability is uncertain, freeze OCI and
discontinue hedge accounting prospectively
• If probable of not occurring:
– Amounts recorded in OCI should be
reclassified into earnings immediately
– Changes in the fair value of the derivative
should be recorded through earnings
prospectively

64
 SFAS 133 - Cash Flow
Hedging
 Probability (cont.)
§ If the expected date is missed, but the transaction is
still probable of occurring:
• Extend the original expected date up to 60 days
and continue hedge accounting
• In rare circumstances, time periods may be
extended beyond the additional 60 days
• Ineffectiveness “catch-up” adjustment for change
in expected future cash flows (due to new time)
– DIG -16

65
 SFAS 133 - Cash Flow
Hedging
Sources of Ineffectiveness


§ The following are all potential sources of

ineffectiveness:
• Basis (location and grade)
• Cross-commodity/cross-currency
• Delta hedging
• Timing (difference between period in item and
period in instrument)
• Time value
– Option exists to exclude time value from
effectiveness assessment and
measurement (would go to income
statement)
– If terms don’t match, it may be necessary
to exclude time value
66
 SFAS 133 - Cash Flow
Hedging
 Assessing Effectiveness
§ The assessment of hedge effectiveness is required to be
performed on both a prospective and retrospective
basis at both:
• The inception of the hedge, and
• At the end of each reporting period (at least
quarterly)
•
§ Assessment Consideration
• Counterparty creditworthiness
• Other variable components

67
 SFAS 133 - Cash Flow
Hedging
Measuring Ineffectiveness


§ Effectiveness Assessment determines whether the

hedging relationship will be highly effective
§ Ineffectiveness Measurement quantifies the results of
the Effectiveness Assessment
• Some hedges can be “all-in-one” hedges
– If a forward commodity contract is a
derivative, qualifies for hedge
accounting treatment, is documented as
a hedge and has “matched terms”, it
can be assumed to be 100% effective
– Contracts subject to bookout may pose
problems; as a result, this convention is
fairly limited in practice
§ Measurement of ineffectiveness to be recorded in
earnings is always based on Dollar Offset 68
 SFAS 133 - Cash Flow
Hedging
 Measuring Ineffectiveness (cont.)
§ Recording Ineffectiveness
• Amounts included in AOCI are limited to the
lesser of:
– The cumulative change in fair value of the
derivative from inception OR
– The portion of the cumulative change on
the derivative necessary to offset the
expected future cash flows of the
hedged item from inception
§ Examples
• Derivative increases $100, expected future cash
flows decrease by $90
– How much is recorded to AOCI?
– How much is recorded in earnings as
ineffectiveness?
• Derivative increase $90, expected future cash 69
flows decrease by $100
 SFAS 133 - Cash Flow
Hedging
Roll-out of AOCI


• Hedge Instrument Termination

§ What happens if the derivative hedging instrument is
terminated?
• If the forecasted transaction is still probable
 *Reclassify AOCI to earnings when the
hedged item impacts earnings
• If the forecasted transaction is probable of not
occurring
 *Reclassify AOCI to earnings immediately
§ AOCI Reclass Triggers
• Forecasted transaction affects earnings
• Probability considerations
• Probable/Reasonably Possible/Remote
70
 SFAS 133 - Cash Flow
Hedging
Roll-out of AOCI


• Other Considerations
§ Reclassification from AOCI due to improbability
• In order to reclassify amounts previously
recorded to AOCI, the forecasted transaction
has to be proven to be PROBABLE of NOT
OCCURRING, which is a VERY HIGH hurdle to
clear

71
 SFAS 133 - Cash Flow
Hedging
 Other Items To Think About:
Lack of required documentation would invalidate the election
Can’t retroactively make hedge designations; although you can

designate a MTM position as a hedge at any time.

If we are over hedged and we do not have another forecasted

transaction to point the hedge against, the hedge will be pushed

to MTM at day 1 marks.
Need to be consistent between our delta files and our ineffectiveness

calculations as to what is our forecasted transaction for a specific

trade
Back testing must be done at the book level to support that we are

not overhedged. Is our forecasted transaction equal to what we

actual bought or sold?
Changes in the probability of the forecasted transaction

 probable of occurring – continue hedge accounting

 probable of not occurring – discontinue hedge accounting and reclass
the AOCI balance into earnings
 no longer probable of occurring – hedge positions need to be
dedesignated as hedges.
Importance of knowing what your hedge books are hedging and


ensuring you have a hedge policy for every risk CER is hedging
72
72
 SFAS 133 - Cash Flow Hedging

 Other Items To Think About:

• Discontinue the “all-in-one” hedges; establish controls to better
identify “match term” hedges. Ensure “match term” hedges
are reviewed every quarter for changes.
• Ensure each hedge book has only one forecasted transaction
mapped to it and that the underlying deal makes sense under
the mapping developed .


73
73
 SFAS 133 – Fair Value Hedging

• Fair Value Hedging

 - Used to hedge the exposure to
changes in Fair Value of a recorded
asset/liability or unrecorded firm
commitment (e.g. fixed rate debt,
inventory, etc.)
 - Most commonly applied in the
energy industry to hedge
physical inventory
 - CCG used fair value hedging to
74
74
 SFAS 133 – Fair Value Hedging
 Hedge Classification
§ Accounting:
• The fair value of the derivative is recorded
on the balance sheet with the offset
recorded in the income statement
•
• Instead of recorded at the lower-of-cost-or-
market (LCM), the hedged item is
adjusted to changes in its respective fair
values
• As a result, both the hedge and the
hedging instrument are adjusted to fair
values through the income statement
• The hedge ineffectiveness is recorded
currently through the income statement,
the difference, if any, between changes 75
in the fair value hedge and the hedged 75
 SFAS 133 – Fair Value Hedging
 Hedge Documentation Requirements
§ To qualify for hedge accounting, the Company must do
the following:
• Put in place appropriate and sufficient
documentation at inception of the hedging
relationship (no retroactive designation)
• Determine that the hedging relationship will be
highly effective


76
76
 SFAS 133 – Fair Value Hedging
 Hedged Item
§ All or a specific portion of a recognized asset or liability
or an unrecognized firm commitment
§ Presents exposure to changes in the fair value that
could affect earnings
§ Cannot be an asset or liability that is re-measured with
changes in fair value reported currently in earnings

77
77
 SFAS 133 – Fair Value Hedging
 Assessing Effectiveness
§ The assessment of hedge effectiveness is required to be
performed on both a prospective and retrospective
basis at both:
• The inception of the hedge, and
• At the end of each reporting period (at least
quarterly)


§ Same as Cash Flow Hedging Requirements for

assessment of effectiveness

78
78
 SFAS 133 – Fair Value Hedging
 Key Similarities to Cash Flow Hedge Accounting:
 Fair value of derivative contract is reflected on the balance
sheet
 Strict documentation requirements
 Assessment of effectiveness requirements
•
 Key Differences to Cash Flow Hedge Accounting
 Measurement of Effectiveness – changes in fair value of
both the derivative contract and the hedged item are recorded
through earnings: No OCI
 Hedged Item: Recognized asset/liability or “unrecognized
firm commitment” (par.21) vs. forecasted transaction (par. 29)
 Hedged item recorded on balance sheet at “hybrid” value –
book value +/- changes in fair value while being hedged
79
79
Fair Value Accounting
SFAS 133 and SFAS 157

80
 Supporting Fair Value
Guidance
• SFAC Concept 7, Paragraph 24
• Fair value captures five elements using the estimates and
expectations that marketplace participants would apply in
determining the amount at which an asset (or liability)
could be bought (or incurred) or sold (or settled) in a
current transaction between willing parties.
•
• Those five elements include (Con 7, Paragraph 23):
 1. An estimate of the future cash flow, or in more
complex cases, a series of future cash flows at
different times
 2. Expectations about possible variations in the
amount or timing of those cash flows
 3. The time value of money, represented by the risk-
free rate of interest
 4. The price for bearing the uncertainty inherent in
the asset or liability
 5. Other, sometimes unidentifiable, factors including
81
illiquidity and market imperfections.
 Supporting Fair Value
Guidance
• FAS 133, Paragraph 540
• The amount at which an asset (liability) could be bought
(incurred) or sold (settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation
sale.
• Examples of valuation techniques include the present value of
estimated expected future cash flows using discount rates
commensurate with the risks involved, option-pricing
models, matrix pricing, option-adjusted spread models, and
fundamental analysis.
• Those techniques should incorporate assumptions that market
participants would use in their estimates of values, future
revenues, and future expenses, including assumptions
about interest rates, default, prepayment, and volatility.
•
82
 Current State of Fair Value
• Fair value is determined by readily available market
information, modeling estimates, and management
estimates
• Readily available market information is obtained via broker
relationships, publications, or exchanges
• Modeling estimates are derived using:
– Readily available market information
– Weather forecasts
– Economic forecasts
– Physical system constraints
• Management estimates include valuation adjustments for
items such as:
– Present value
– Market liquidity
– Counterparty creditworthiness
– Administrative costs
– Modeling inaccuracies
83
 SFAS 157 Impacts
• Fair value should represent the
transactions “exit price”
• Exit price may result in zero inception
value unless:
– Transaction is outside of principle market

• Valuation Adjustments
– Credit adjustment is required to be applied to liability
positions using own credit rating
– Change from prior practices of reserving credit risk
associated with asset positions
– Credit downgrade will result in increased earnings
84
 Valuation Adjustments
Defined
• Overriding principle of valuation adjustments:
– To state the fair value of open positions in a manner
reflecting what the market would pay in a reasonable
process of valuing and bidding for those positions.
– Support for the use of valuation adjustments can be
traced to Derivatives: Practices and Principles issued by
Ø the Group of Thirty in 1993.
– Valuation Adjustments (Contra-Assets) vs. Reserves
Ø

85
 Types of Valuation
Adjustments
• Discount Adjustment
– Established to consider the opportunity costs
associated with receiving cash on a future date
(alternatively known as discounting cash flows).
– The risk-free rate (e.g. T-bill rates or LIBOR) is most
commonly used to discount cash flows.

86
 Types of Valuation
Adjustments
• Credit Spread Adjustment
– Established to reduce the value of the forward open
positions to reflect the credit and performance risk
associated with the transaction.
– “Counterparty basis” is most common - Credit
exposures by counterparty multiplied by the
related default probabilities and factoring in
expected recoveries.
– Default probabilities have different rates for different
tenors and these should be used. However, some
companies use weighted average life of book and
apply this default rate to the net asset position.
– Realized uncollected positions should be factored
into adjustment
–
87
 Types of Valuation
Adjustments
• Close-out Adjustment (Liquidity Adjustment)
– Established to reduce the value of any forward open
position to the more conservative end of the bid-
ask spread (i.e. longs to the bid, shorts to the ask).
– Reserve adjust transaction value for the illiquidity in
the market.
– Assumes the price to exit the contract will be other
than the mid-point, but does not attempt to adjust
for a true liquidation of the business.
– “Portfolio basis” is most common:
Ø Initially mark positions to mid-price
Ø Then calculate the valuation adjustment by
applying ½ bid/ask to positions by discrete
risk bucket (time and location)

88
 Types of Valuation
Adjustments
§ Administrative Adjustment
§ An adjustment for expenses expected to be incurred in the
future relative to managing the forward positions
§ 2 main components:
• Future transacting costs covering processing,
scheduling, settlement, etc.
• Overhead costs (e.g. payroll) to handle the
requirements of complex transactions
§ The cost to service the contract would be reflected by the
market in valuing the contract
§ Example methodology: $cost/unit multiplied by the number
of forward positions by “transacting activity”

89
 Types of Valuation
Adjustments
§ Model Adjustment
§ Established to reduce the value of a position to reflect the
uncertainty of the forward markets and the range of
values that can be derived using different modeling
techniques

90
Financial Statement Implications
of Credit Events
SFAS 133 Accounting for Derivative Instruments and Hedging
Activities

91
 SFAS 133 - Definition of a Derivative -
Flowchart
For each contract that CCG executes, the accounting treatment is largely determined by the answer to the following question:

Is the contract a
derivative?
Yes No

Ac c ou nti ng
Po s si bil iti es :

Cash Flow/Fair
NPnS Value Hedge Inventory
MTM Accrual (LCM)
(Accrual) (Quasi-
Accrual)

B u t subject
t o t hese ru les :

Cash Accrual Inventory

Day One gain NPnS Flow/Fair accounting accounting
rules apply rules apply Value Hedge rules apply rules apply
rules apply

92
92
 Mark-to-market (including hedge of accrual)

• Contract is a derivative
• Recorded on the Balance Sheet at Fair
Value
• Full changes in fair value reported
through the income statement
• Changes in creditworthiness of
counterparty to the transaction
must be reflected in the
valuation under SFAS 157
• A derivative carried at fair value 93
93
 Normal Purchase Normal Sales

• Contract is a derivative
• Scope exemption allows for accrual
treatment
• Not recorded on the Balance Sheet at
outset
• No income statement impact until the
contract matures
• No immediate income statement
impact from deterioration in
credit worthiness of counterparty 94
94
 Cash Flow Hedge

• Contract is a derivative
• Recorded on the Balance Sheet at Fair
Value
• Changes in the fair value of the
effective portion of the hedge are
reflected in equity (OCI)
• Changes in creditworthiness of
counterparty to the hedge must
be taken into consideration in
the effectiveness assessment
• Significant deterioration would 95
95
 Fair Value Hedge

• Contract is a derivative
• Recorded on the Balance Sheet at Fair
Value
• Changes in the fair value are reflected
in the income statement
• The hedged item is accounted for on
the same basis thus mitigating the
income statement impact
• Depending on which contract is in-
the-money, changes in 96
96
 Non-Derivative Accrual

• Contract is not a derivative

• Not recorded on the Balance Sheet at
outset
• No income statement impact until the
contract matures
• No immediate income statement
impact from deterioration in
credit worthiness of counterparty
• Backlog and future economics are
impacted 97
97
 Modeling Books

• Transactions are not legally binding

• Not recorded on the Balance Sheet or
Income Statement until the
transaction becomes legally binding
• No immediate income statement
impact from deterioration in
credit worthiness of counterparty
• Certain modeling transactions can be
the hedged item in a hedge
relationship. As such, the 98
98
 Financial Statement Implications of Credit
Events - Summary

• Accounting designations are significant

in making the assessment
• Cash flow hedges may be quasi accrual
from an accounting perspective, but
credit events will have an immediate
impact
• Fair value hedges do not result in
symmetrical offset under SFAS 157
• Be aware of the implications of
deteriorations in counterparty credit 99
99
 Accounting Designations
Non derivative Normal Purchase Cash Flow Hedge Fair Value Hedge M-T-M Modeling books
 accrual Normal Sale
Is the contract a No Yes - however scope Yes Yes Yes No
derivative? exemption allows for
 accrual treatment
B/S Impact Off-balance sheet Off-balance sheet Recorded on balance Recorded on Recorded on Not recorded until
until contract until contract sheet at Fair Value balance sheet at balance sheet at the transaction
 matures matures Fair Value Fair Value becomes legally
binding
I/S Impact No impact until No impact until No impact - Changes Full changes in fair Full changes in fair Not recorded until
contract matures contract matures in fair value of the value reflected in value reflected in the transaction
effective portion of the earnings. earnings becomes legally
hedge are reflected in Treatment of binding
Equity (OCI) hedged item in a FV
hedge is
symmetrical
Credit No immediate impact No immediate impact Deterioration in Changes in Changes in No immediate
considerations from deterioration in from deterioration in creditworthiness is creditworthiness of creditworthiness of impact from
credit worthiness of credit worthiness of reflected in earnings. counterparty are counterparty are deterioration in
counterparty - See counterparty - See Previous amounts in reflected in valuation reflected in credit worthiness of
related issue below related issue below OCI are not re- valuation counterparty - See
assessed. related issue below

Related issues Transaction could be Transaction could be A derivative cannot A derivative cannot A derivative cannot Transaction could
the hedged item in a the hedged item in a be the hedged item in be the hedged item be the hedged be the hedged item
hedge relationship. hedge relationship. a hedge relationship. in a hedge item in a hedge in a hedge
As such, the As such, the relationship. relationship. relationship. As
deterioration in the deterioration in the such, the
credit worthiness of credit worthiness of deterioration in the
the counterparty the counterparty credit worthiness of
could result in CCG could result in CCG the counterparty
being over-hedged being over-hedged could result in CCG
which could have which could have being over-hedged
immediate earnings immediate earnings which could have
implications implications immediate earnings
100
implications
 Hedge Accounting

 Questions ?????

101
101