IAS39: Patricia Teixeira Lopes Examines the Complexities of the Standard Using the Example of Accounting for Hedging Strategies in the Electricity Futures Market of Spain and Portugal

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IAS39, the international accounting standard for the recognition and measurement of financial instruments, is widely viewed as causing particular implementation difficulties. It has caused controversy that's far from being resolved. Electricity derivative users are among those who find this standard a big challenge and have doubts about the effect it has on income statement amounts--namely, in hedging strategies.

This area is complex for two main reasons: electricity is a non-financial item and it is not always clear whether it is covered by IAS39 or not; and it is a non-storable commodity, which creates unique issues concerning the physical delivery of the contracts compared with other commodity contracts.

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The first question to consider is: do commodity contracts actually fall within the scope of IAS39? The standard applies to "contracts to buy or sell a non-financial item" if that contract can be net settled. But IAS39 allows an exemption for contracts that are entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the firm's expected purchase, sale or usage requirements. There are strict criteria governing this exemption: the contracts are designated for "own use" purposes from inception; they are settled by physical delivery; and the firm does not normally net settle similar contracts. The adoption of this exemption for exchange-traded derivatives must be assessed on a case-by-case basis and most of the time it depends on business practices, control objectives and management's intentions about physical delivery. Besides, electricity futures clearly meet the definition of a derivative and meet the intention of the International Accounting Standards Board regarding the scope of IAS39 (see IAS39 basis for conclusions, paragraph 221). Additionally, electricity is a commodity that's actively quoted in both spot and futures markets, so it always meets the "readily convertible to cash" criterion. The IAS39 accounting rules for derivatives will, therefore, affect most companies involved with electricity futures.

As a general rule, IAS39 requires that all derivatives are measured at fair value, with movements in fair value recognised immediately through the income statement. But it also allows hedge accounting for certain hedging relationships, overriding the normal accounting treatment of IAS39.

Hedge accounting mitigates the volatile impact of derivative adoption in the income statement by matching the timing of recognition of gains and losses on both the hedged item and the hedging instruments. In order to apply hedge accounting rules, the transactions must meet strict requirements, usually seen as onerous and complex, that relate to the formal documentation of the transaction since inception, including prospective and retrospective effectiveness tests. Yet, when hedges are accomplished with standard exchange-traded futures, as in the case of Mibel electricity futures, compliance with IAS39's hedge accounting rules is quite straightforward (see panel, left).

The Mibel derivatives market was launched on July 3, 2006 (see panel on the right of page 39) and was a fundamental step in the Iberian electricity market-building process. There are two basic types of Mibel futures contracts: one has a physical delivery and the other foresees a purely financial settlement at maturity, with the peculiarity that both types of contracts benefit from a common order book. The remaining characteristics are common to both types of contracts: they are "baseload" contracts; the contract unit is 1MW x contract number of hours and the quotation and tick is in euros per MWh, with a 0.01 euros per MWh tick; delivery periods are weeks, months, quarters and years; there's daily cash settlement (mark-to-market); and the spot reference price used for settlement at maturity for both types of contracts is the monetary value of the "Spel base" index, representing an average price of electric energy in the Spanish zone, based on values in the cash market managed by Omel, the Iberian electricity spot market. …