No. 2015-27
24 April 2015
To the Point
FASB — proposed guidance
Applying the normal purchases
normal sales exception to power
contracts in nodal energy markets
The proposal
would likely reduce
diversity in practice
on accounting
for contracts to
purchase and sell
electricity in nodal
energy markets.
What you need to know
• The FASB proposed specifying that entities are not precluded from applying the normal
purchases and normal sales exception to derivative accounting to certain forward
contracts for the delivery of electricity in nodal energy markets.
• The proposal would apply only to contracts for the physical delivery of electricity in
nodal markets where one of the parties incurs transmission charges or credits based on
the spot prices at the locations between which the electricity is transmitted.
• The proposal states that these transmission charges or credits would not, by
themselves, result in a forward contract for the purchase or sale of electricity in a nodal
energy market being deemed net settled.
• Comments are due by 18 May 2015.
Overview
The Financial Accounting Standards Board (FASB) proposed 1 specifying that entities would
not be precluded from applying the normal purchases and normal sales (NPNS) exception to
derivative accounting to forward contracts for the physical delivery of electricity in nodal energy
markets that result in parties incurring locational marginal pricing (LMP) charges or credits.
Under the proposal, the use of LMP by an independent system operator (ISO) to determine a
transmission charge or credit in a nodal energy market 2 would not constitute a net settlement
of a forward contract for the purchase or sale of electricity, even when legal title to the
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electricity is conveyed to the ISO during transmission. As a result, these contracts could meet
the physical delivery criterion in Accounting Standards Codification (ASC) 815 3 and qualify
for the NPNS exception to derivative accounting if they meet all of the other criteria.
The proposal, which was developed by the Emerging Issues Task Force (EITF), would likely reduce
diversity in practice and allow more of these contracts to qualify for the NPNS scope exception.
Background
ASC 815 defines a derivative broadly and requires contracts that meet the definition to be
measured at fair value, with changes in fair value recognized in net income. The guidance
provides a number of scope exceptions, including the NPNS scope exception, which can be
applied if a nonfinancial underlying item will be delivered in quantities expected to be used or
sold by the reporting entity over a reasonable period in the normal course of business. 4
Physical delivery of the underlying item is a key criterion.
Electric utilities have long entered into forward contracts to buy and sell electricity, and many
historically elected the NPNS scope exception. As markets have evolved and ISOs began
managing the flow of electricity in nodal markets, questions have arisen about whether certain
forward contracts to deliver electricity meet the physical delivery criterion for the NPNS scope
exception. That’s because the ISO generally takes title to the electricity during transmission and
invoices entities on a gross basis using LMP. This raises questions about whether an entity has
effectively transacted with the ISO (not the counterparty to the forward contract) for the physical
purchase or sale of electricity or simply engaged the ISO to perform transmission services.
While some entities currently apply the NPNS exception to these contracts, others do not
believe they meet the physical delivery criterion in ASC 815 because, in their view, the sale to
the ISO of the electricity received under the forward contract results in net settlement of the
forward contract. The EITF took on this issue in an effort to eliminate diversity in practice.
Key considerations
ISOs operating in nodal markets aim to promote the efficient generation and transmission of
electricity. The amounts they charge market participants to transmit electricity between
delivery and withdrawal nodes on the grid is based on the difference between spot prices in
these nodes, which take into account physical resources and constraints on the system,
including supply, demand, transmission capacity and congestion at each location.
For example, if Company A wanted to purchase electricity on a forward basis from Supplier X
at Node 1 and sell it at Node 2, where Company A’s retail customers are located, Company A
would pay the ISO to transmit the electricity from Node 1 to Node 2. Company A would
generally incur a charge from the ISO that includes an amount based on the difference
between the spot prices at the two nodes.
Some constituents believe that because the transmission charges or credits that an ISO
receives or pays are based on the difference in spot prices between nodes, a net settlement of
the forward contract occurs pursuant to ASC 815. These constituents believe that, in addition
to its forward contract with Supplier X, Company A in the example above has entered into two
separate spot transactions with the ISO — a spot sale at Node 1 and a spot purchase at Node 2.
They therefore believe that the physical delivery criterion of ASC 815 would not be met for
the electricity delivered at Node 1 under the forward purchase contract because this electricity
is immediately sold to the ISO.
2 | To the Point Applying the normal purchases normal sales exception to power contracts in nodal energy markets 24 April 2015
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The proposal would amend US GAAP to state that the use of LMP to determine the transmission
charge or credit in a nodal market does not constitute a net settlement, even when legal title
to the electricity is conveyed to the ISO during transmission. The proposal also states that the
forward purchase or sale contract and the transmission services do not constitute a series of
sequential contracts intended to accomplish the ultimate acquisition or sale of a commodity
as discussed in ASC 815-10-15-41. In reaching its conclusion, the EITF observed that the
substance of the contracts in question requires the physical delivery of electricity and that the
intent of the parties to those contracts is to physically deliver the electricity, which is
consistent with the Board’s intent when it provided the NPNS exception.
How we see it
• The proposal addresses only the question of whether an ISO’s use of spot prices to
determine the charge or credit for transmitting electricity in a nodal market constitutes
a net settlement. Reporting entities would still need to evaluate all of the other NPNS
criteria, including the requirement that physical settlement is probable at contract
inception and throughout the term of a contract.
Entities would not
be able to apply the
proposed guidance
by analogy to other
commodities or
power contracts
outside nodal
markets.
• The proposed guidance would apply only to purchases and sales of electricity in nodal
markets. We do not believe entities would be able to apply it by analogy to electricity
contracts in other types of markets or to other commodities (e.g., natural gas). This is
consistent with the FASB’s belief that purchases and sales of power should be treated
differently than purchases and sales of other commodities because power cannot be
stored in significant quantities.
Disclosures, transition and effective date
The proposal would not require entities to make any additional ongoing disclosures, but they
would be required to make disclosures related to a change in accounting principle in the
period in which they adopt the proposed guidance.
The proposed guidance would be applied prospectively. Entities would be able to designate
qualifying contracts that are entered into on or after the effective date as normal purchases
or normal sales. In addition, because entities can elect the NPNS scope exception at contract
inception or at a later date, they would be able to designate qualifying contracts they entered
into before the effective date as normal purchases or normal sales on or after the effective date.
The proposed transition guidance would be consistent with how similar issues have been dealt
with in situations involving contracts that were no longer accounted for as derivatives under
newly issued implementation guidance.
The FASB will determine an effective date after it considers feedback on the proposal.
How we see it
Applying the proposed guidance to a contract that has been subject to fair value accounting
would essentially freeze the fair value as of the election date. Because there is no specific
guidance in US GAAP addressing the treatment of the “frozen” fair value amounts on the
balance sheet, there may be various acceptable methods to eventually recognize this
amount in earnings.
3 | To the Point Applying the normal purchases normal sales exception to power contracts in nodal energy markets 24 April 2015
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Endnotes:
1
2
3
4
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SCORE No. BB2975
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Proposed Accounting Standards Update, Derivatives and Hedging (Topic 815): Application of the Normal Purchases
and Normal Sales Scope Exception to Certain Electricity Contracts within Nodal Energy Markets.
The proposal describes a nodal energy market as an interconnected electricity grid operated by an ISO with
established price points at each node or hub location. The ISO’s objective is to promote the most efficient
generation and transmission of electricity within the nodal market.
ASC 815, Derivatives and Hedging.
See ASC 815-10-15-22.
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4 | To the Point Applying the normal purchases normal sales exception to power contracts in nodal energy markets 24 April 2015