Events in the past few months have again reminded us of the cardinal principle ?it is foolish to try and predict the future? and how true this is for the ?fuel prices?. Given the uncertainties in the global markets, it is nearly impossible to make any predictions about future oil prices. To give an example ? the price of crude oil, which hovered around $16 per barrel in 1999, hit an all-time high record of $147 per barrel in July 2008. Due to fears of ongoing global recession, prices have since plummeted to $45 per barrel. No one can bet safely where the fuel prices will be at the end of the next year ? Peter Drucker has rightly said ?Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window? !!
To mitigate the risk of price fluctuations, companies in the utilities sector generally enter into long-term contracts for purchase of oil, gas, coal and power so that they can fulfill their contractual obligations in turn to customers. Typically, these contracts are entered into for the purpose of the actual receipt of the commodity (oil, gas, coal or power) in accordance with an entity?s expected purchase, sale or usage requirements. These contracts are therefore, treated as ?executory? or ?own use? contracts. There is no significant challenge in accounting of these contracts as they are not within the scope of the International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement.
However, a utility company may take delivery of the commodity and sell it within a short span of time to earn quick profits through short-term price fluctuations. Also, these companies may settle the purchase contracts net in cash or enter into offsetting contracts. In such cases, IAS 39 prescribes that such contracts do not qualify for the ?own use exemption? as they are not entered into for the purpose of the receipt or delivery of the commodity in accordance with the company?s expected purchase, sale or usage requirements. Contracts that are within the scope of IAS 39 then become derivative contracts that trigger fair value measurement through the profit and loss account.
The above requirement under IAS 39 will pose some more questions for utility companies. How should a company classify such contracts at the time of entering into these contract ? whether it should be treated as a derivative contract or otherwise? Well, the classification will purely be based on ?intent?. Under IAS 39 one needs to take into account the intended use for such contracts for determining its accounting treatment. This may lead to an interesting scenario where a company enters into two contracts which are identical in form, but company intends to use them differently. In such case, these identical contracts may get accounted differently as per IAS 39. To avoid such ambiguities, it is recommended, as good governance practice that if the intended use is for normal purchase or sale, corporate bodies should document such intention at the inception of the contract itself.
There are some other issues which IAS 39 does not specifically address. For example ? there may be a commodity contract which is entered into based on entity’s expected purchase, sale or usage requirement but the value of the contract exceeds the expected usage requirement ? whether this single contract can or should be split into two contracts for accounting purposes? Another example could be of a contract which at inception, was entered into for the normal purchase or sale requirements. However, during the life of the contract, the requirements decreased and only a certain portion of the contract will be needed for the entity?s usage ? does this mean that entire contract will now fall within the scope of IAS 39 or only a portion thereof? Documentation requirements will therefore increase on adoption of IFRS for all utility companies.
In present times, a utility company often settles similar contracts in cash for varied reasons like re-optimisation of power plants or due to change in demand for power etc. However, once IFRS gets implemented, utility organisations will have to analyse their long-term purchase contracts very carefully to determine whether they qualify for the ?own-use exemption? or not. If the answer is NO, these long-term fuel purchase contracts will have to be fair valued, which is likely to increase income statement volatility and impact their financial statements significantly.
The writer is a senior professional in a member firm of Ernst & Young Global. The views expressed herein are the personal views of the author and do not necessarily represent the views of Ernst & Young Global or any of its member firms