EITF ABSTRACTS. Dates Discussed: June 19 20, 2002; September 11 12, 2002; October 25, 2002; November 21, 2002; March 20, 2003

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1 EITF ABSTRACTS Issue No Title: Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities Dates Discussed: June 19 20, 2002; September 11 12, 2002; October 25, 2002; November 21, 2002; March 20, 2003 References: FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities FASB Statement No. 157, Fair Value Measurements FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises APB Opinion No. 20, Accounting Changes APB Opinion No. 22, Disclosure of Accounting Policies Accounting Research Bulletin No. 43, Chapter 4, Inventory Pricing AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties AICPA Audit and Accounting Guide, Brokers and Dealers in Securities SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements SEC Financial Reporting Release No. 61, Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies ISSUE 1. Issue No , Accounting for Contracts Involved in Energy Trading and Risk Management Activities, Issue No , Measuring the Fair Value of Energy-Related Contracts in Applying Issue No , and Topic No. D-105, Accounting in Consolidation for Energy Trading Contracts between Affiliated Entities When the Activities of One but Not Both Affiliates Are within the Scope of Issue No , address various aspects of the accounting for contracts involved in energy trading and Page 1

2 risk management activities. The purpose of this Issue is to address certain issues related to energy trading activities, including (a) gross versus net presentation in the income statement, (b) whether the initial fair value of an energy trading contract can be other than the price at which it was exchanged, and (c) additional disclosure requirements for energy trading activities. Reporting Gains and Losses on Energy Trading Contracts 2. In Issue 98-10, the Task Force reached a consensus that energy trading contracts should be marked-to-market (that is, measured at fair value determined as of the balance sheet date) and that gains and losses (realized and unrealized) related to energy trading contracts could be shown either gross or net in the income statement. The Task Force had previously reached a tentative conclusion that gains and losses on energy trading contracts should be reported net in the income statement. However, in reversing that tentative conclusion on income statement presentation, the Task Force considered comment letters from several energy trading companies contending that a gross presentation was appropriate in certain circumstances in which settlement of energy trading contracts required physical delivery of the underlying commodity (instead of net cash settlement). The Task Force was asked to reconsider the consensus in Issue that allows companies to use either the gross or the net method of presentation for reporting gains and losses on energy trading activities in the income statement. Recognition of Unrealized Gains and Losses at Inception of an Energy Trading Contract 3. Issue defines the fair value of an energy contract in footnote 2 (consistent with Statements 107, 125, and 133) as the amount at which that contract could be bought or sold in a current transaction between willing parties, that is, other than in a Page 2

3 forced or liquidation sale (emphasis added). For some energy contracts that are required to be recorded at fair value, no quoted market prices or similar current transactions exist on which to base a fair value measurement. In Issue 00-17, the Task Force reiterated this point by stating that the price at which an energy contract is exchanged normally is its initial fair value. The Task Force further noted that valuation models, including option-pricing models, should be used only when market transactions are not available to evidence fair values (emphasis added). 4. Questions have been raised about whether unrealized gains or losses may be reported at inception of energy trading contracts, absent evidence from quoted market prices or other current market transactions with similar terms and counterparties. The FASB staff questions the appropriateness of such gains, in light of the guidance in Issue 00-17, in transactions for which fair value is determined in a manner other than by reference to quoted market prices or current market transactions for similar contracts. In particular, the FASB staff notes that while the Task Force observed that fair value should be based on the best information available in the circumstances, the consensus also notes that current market transactions also may provide evidence for recognition of dealer profit.... The FASB staff interprets the Task Force s consensus to indicate that a dealer profit, or unrealized gain or loss at inception of the contract, may not be recognized unless it is evidenced by quoted market prices or other current market transactions. Disclosure 5. Issue does not address disclosure, other than an SEC Observer comment requiring registrants to disclose their policy for presentation of gains and losses in the Page 3

4 income statement, including presentation on a gross or net basis. However, other accounting literature provides guidance that should be followed by entities involved in energy trading activities. For example, Opinion 22 requires a description of all significant accounting policies of the reporting entity, and SOP 94-6 requires disclosures about estimates used in the determination of the carrying amounts of assets and liabilities if those estimates are particularly sensitive to change in the near term. The Task Force was asked to clarify the application of Opinion 22 and SOP 94-6 to an entity's energy trading operations and provide for any other disclosures that may be useful to financial statement users. 6. The issues are: Issue 1 Whether gains and losses on energy trading contracts should be reported gross or net in the income statement Issue 2 Whether recognition of unrealized gains and losses at inception of an energy trading contract is appropriate in the absence of quoted market prices or current market transactions for contracts with similar terms Issue 3 What disclosure requirements of energy trading activities should be. EITF DISCUSSION 7. At the June 19 20, 2002 meeting, the SEC Observer requested that the Task Force address additional issues relating to the application of Issue 98-10, Issue 00-17, and Topic D-105, including the use of mark-to-market accounting for contracts that physically settle and the recognition of revenues from changes in fair value when fair Page 4

5 value is estimated based solely on internal valuation models (that is, where the inputs are not observable in the market place). The SEC Observer recommended that a working group be formed to assist the Task Force in resolving those issues and emphasized the need for resolution prior to the end of the calendar year. The Task Force agreed to form a working group. 8. On Issue 1, the Task Force reached a consensus that all gains and losses (realized and unrealized) on energy trading contracts should be shown net in the income statement whether or not settled physically. An entity should disclose the gross transaction volumes for those energy trading contracts that are physically settled. 9. The Task Force did not reach a consensus on Issue 2. Rather, the Task Force referred that Issue to the working group. The FASB staff indicated that until such time that the working group recommendations on Issue 2 are considered by the Task Force, the FASB staff will continue to hold the view that Issues and do not allow for recognition of dealer profit, or unrealized gain or loss at inception, unless evidenced by quoted market prices or other current market transactions for energy trading contracts with similar terms and counterparties. 10. The Task Force reached a consensus on Issue 3 that entities involved in energy trading activities also should disclose all of the following: a. The applicability of Issue b. The types of contracts that are accounted for as energy trading contracts c. The fair values of its energy trading contracts, aggregated by source or method of estimating fair value and by maturity dates of the contracts d. A description of the methods and significant assumptions used to estimate the fair value of its various classes of energy trading contracts Page 5

6 e. A reconciliation of the beginning and ending carrying values of its energy trading contracts, aggregated by source or method of estimating fair value, showing separately the changes attributable to (1) unrealized gains and losses recognized at inception of a contract, (2) unrealized gains and losses recognized as a result of changes in valuation techniques and assumptions, (3) other unrealized gains and losses recognized during the period, and (4) realized gains and losses recognized during the period f. The sensitivity of its estimates to changes in the near term The consensus on Issue 1 is effective for financial statements issued for periods ending after July 15, Upon application of the consensus, comparative financial statements for prior periods should be reclassified to conform to the consensus. The consensus on Issue 3 is effective for financial statements issued for fiscal years ending after July 15, The disclosures required by the consensus should be provided for all periods presented. Early application of the consensuses is permitted. 12. At the September 11 12, 2002 meeting, the Task Force was provided with an update of Working Group discussions to date. The Task Force discussed some of the issues being deliberated by the Working Group, including whether Issue should be retained given that Statement 133 addresses the accounting for most energy trading contracts. The Task Force requested that the Working Group further explore the implications of rescinding Issue and addressing any residual energy trading issues within the context of Statement 133. The Task Force also requested that the Working Group continue its efforts to provide guidance for measuring the fair value of energy trading contracts in the absence of quoted market prices or current market transactions with similar terms and counterparties. 1 Paragraph 14 of SOP 94-6 provides that the disclosure should indicate the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term (footnote references omitted). Page 6

7 13. Additionally, the Task Force discussed the transition requirements relating to its consensus reached at the June 19 20, 2002 meeting that all gains and losses (realized and unrealized) on energy trading contracts should be shown net in the income statement whether or not settled physically. The Task Force did not change its prior consensus including the transition requirements. However, the Task Force clarified that that consensus applies to all energy trading contracts subject to the consensus in Issue 98-10, including those contracts that are also derivatives subject to Statement 133. The Task Force declined to discuss the issue of whether gains and losses (realized and unrealized) should be shown gross or net in the income statement for contracts that are not subject to the consensuses in Issue but are derivatives subject to Statement At the October 25, 2002 meeting, the Task Force reached a consensus to rescind Issue (and related interpretive guidance of Issue and Topic D-105) and preclude mark-to-market accounting for energy trading contracts that are not derivatives pursuant to Statement The Task Force discussed physical inventories included in energy trading activities and noted that those inventories are often carried at fair value based on current industry practice. The Task Force agreed that its decision to rescind Issue will eliminate any basis for recognizing physical inventories at fair value, except as provided by other guidance under higher categories of the GAAP hierarchy. 16. The Task Force chairman noted that the consensus to rescind Issue effectively supersedes the Task Force consensuses reached at the June 19 20, 2002 meeting on Issues 1 and 3. The Task Force discussed the income statement presentation Page 7

8 of gains and losses on derivative instruments subject to Statement 133 when the gains or losses are realized by physically settling the derivative instrument. The Task Force reached a consensus that gains and losses (realized and unrealized) on all derivative instruments within the scope of Statement 133 should be shown net when recognized in the income statement, whether or not settled physically, if the derivative instruments are held for trading purposes. 2 A derivative held for trading purposes may be designated as a hedging instrument, prospectively, if all of the applicable criteria in Statement 133 have been met. The Task Force also generally agreed that additional guidance from the Board is needed with respect to measuring fair value in the absence of quoted market prices or current market transactions with similar terms and counterparties The SEC Observer noted (and the FASB staff concurred) that this consensus prohibiting mark-to-market accounting for nonderivative energy trading contracts is equally applicable to brokers and dealers, as the Guide for brokers and dealers in securities does not afford brokers and dealers special treatment in that regard. 18. The SEC Observer also reminded registrants of the requirements to provide disclosures identified in Item 303 (Management's Discussion and Analysis) of Regulations S-K and S-B and in guidance provided by FRR The consensus to rescind Issue is effective for all new contracts entered into (and physical inventory purchased or produced) after October 25, The consensus 2 The determination of what constitutes trading purposes is based on the intent of the issuer or holder and shall be consistent with paragraph 12(a) of Statement 115 which characterizes trading as active and frequent buying and selling... with the objective of generating profits on short-term differences in price. On an ongoing basis, reclassifications into and out of trading should be rare. 3 [Deleted 9/06 because of Statement 157. See STATUS section.] Page 8

9 is effective for fiscal periods beginning after December 15, 2002, for energy trading and Page 9

10 energy-related contracts that existed on or before October 25, 2002, that remain in effect at the date this consensus is initially applied. The effect of this consensus shall be reported in a manner similar to a cumulative effect of a change in accounting principle in accordance with Opinion 20 (the pro forma disclosures described in paragraph 21 of Opinion 20 are not required). Application of the consensus, as it relates to restating the carrying value of physical inventories, may be applied prospectively 4 if there is insufficient information to report the change in accounting for physical inventories in a manner similar to a cumulative effect of a change in accounting principle, as described in the preceding sentence. Early application of the consensus is permitted as of the beginning of periods for which financial statements have not been issued The consensus relating to the presentation of gains and losses on derivative instruments held for trading purposes is effective for financial statements issued for periods beginning after December 15, Upon application of the consensus, comparative financial statements for prior periods should be reclassified to conform to the consensus. 7 For gains and losses on energy trading activities that are not derivatives pursuant to Statement 133 (for example, spot market purchases and sales), entities are encouraged to reclassify prior periods presented for gross presentation in the income 4 The carrying value of physical inventories on the effective date becomes the new cost basis and other applicable generally accepted accounting principles apply going forward. 5 Statement 133 precludes retroactively designating a derivative as a hedging instrument in a fair value or cash flow hedge. 6 At the June 19 20, 2002 meeting, the Task Force reached a consensus that all gains and losses (realized and unrealized) on energy trading contracts should be shown net in the income statement. That consensus was effective for financial statements issued for periods ending after July 15, Derivative instruments previously included in energy trading activities pursuant to Issue are presumed to have been held for trading purposes. Page 10

11 statement if that presentation is consistent with the guidance provided in Issue No , "Reporting Revenue Gross as a Principal versus Net as an Agent." Early application of the consensus is permitted as of the beginning of periods for which financial statements have not been issued. STATUS 21. A related issue was discussed in Issue No , Reporting Realized Gains and Losses on Derivative Instruments That Are Subject to FASB Statement No. 133 and Not Held for Trading Purposes as Defined in Issue No Statement 157 was issued in September The guidance in Statement 157 applies for derivatives and other financial instruments measured at fair value under Statement 133 at initial recognition and in all subsequent periods and, therefore, nullifies the guidance previously included in footnote 3 of this Issue. Statement 157 shall be applied retrospectively to the following financial instrument as of the beginning of the fiscal year in which Statement 157 is initially applied (a limited form of retrospective application): A financial instrument that was measured at fair value at initial recognition under Statement 133 using the transaction price in accordance with the guidance in footnote 3 of this Issue prior to initial application of Statement No further EITF discussion is planned. Page 11

12 Suggested Index Entries for Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities DERIVATIVE INSTRUMENTS Energy Trading.. Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities 02-3 FAIR VALUE Energy Trading.. Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities 02-3 FINANCIAL INSTRUMENTS Energy Trading.. Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities 02-3 HEDGES Energy Trading.. Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities 02-3 OPTIONS Energy Trading.. Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities 02-3 Page 12