Standard challenges

Early signs suggest European energy companies may, like their US counterparts,have problems complying with a new derivatives-accounting standard. But theydo have newguidelines to help interpret the rules. By Joe Marsh

For their 2005 accounts – and 2004 accounts, if they so choose – Europeancompanies trading energy will have to complywith a new standard governing accounting forderivative contracts. In light of the problemsUS companies have faced over the equivalentUS rules – Financial Accounting Standard 133(Fas 133 – see box), their Europeancounterparts may have a hard time ahead withInternational Accounting Standard Board’s(IASB’s) IAS 39. However, a trade body set uplast year – the International EnergyAccounting Forum – recently finalised bestpracticeguidelines to help energy-tradingcompanies in Europe.

Oil major BP has given an indication of things to come in its first-quarter 2005 report, the first it has filed under IAS 39.The company posted $160 million of non-cash losses on long-term sales contracts it had set up that contain ‘embedded derivatives’. Under IAS 39, by selling a energy commodity (in BP’s case, North Sea natural gas) based on the price of one or more other commodities (in BP’s case, oil and electricity), BP had effectively bought a gas derivative. Such embedded derivatives are likely to be a big issue, given that before the formation of liquid energy markets, many commodities were oftenpriced off similar or substitute commodities.

Other recent events have also demonstrated the difficulties of accounting for derivatives contracts generally – and the potentially huge cost of mistakes. According to China Aviation Oil’s auditors, the Singapore-listed firm’s $550 million loss involvedincorrect accounting andfinancial treatment for options on crude oil.

Even companies as large and sophisticated as Fannie Mae have got things wrong.The US mortgage firm will have to make an estimated $9 billion restatement of its financials for its failure to comply with Fas 133 with regard tointerest-rate derivatives.

The main thrust of IAS 39 and Fas 133 is that companies must determine ‘fair values’ by performing mark-to-market (MtM) valuation for derivative contracts, showing these as assets or liabilities in their balance sheets; profits and losses are shown in the result for the current period. In addition, firms can apply hedge accounting – which also relies on fair-value determination using MtM valuation – to those derivative contracts that qualify for it. Under Fas 133’s complex hedge-accounting rules, any unrealised gains or losses are generally deferred in ‘other comprehensive income’, until the hedge and related hedgeditem are settled.

There are differences between IAS 39 and Fas 133, but companies will face broadly the same challenges in terms of MtM and hedge accounting, says Ian Francis, utilities IFRS International Financial Reporting Standards) and assurance head at consulting firm Ernst & Young in London.

But IAS 39 could throw up more issues over interpretation of its rules than Fas 133, says Lorna Stewart, spokeswoman for the International Energy Accounting Forum IEAF) and group IAS 39 manager at UK utility ScottishPower.The IASB tends tosetout broad principles, while the FASB setsdown more specific rules, she explains. Forinstance, says Stewart, the FASB has a specificprovision setting out in what circumstances anatural gas storage contract would be aderivative, whereas the IASB simply defineswhat a derivative is and leaves the energycompany to make further interpretation.This was why three European utilities –Centrica, ScottishPower and RWE – set up theIEAF in June 2004 to develop collectiveprinciples and interpretations for energycompanies when using IAS 39.The forummeets every six weeks and now has 21 membersacross Europe, and is also working withcompanies in Australia and New Zealand. Itinternally published final papers in Februarysetting out best practice on six of the sevenissues it sees as the main areas energy companiesneed guidance on, while the final paper is dueout soon, says Stewart – probably in May.

The IEAF is currently lookingat how it will disseminate the guidelines more widely: posting them on a website being the most likely option, says Stewart.The ‘big four’ accounting firms – Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers – are already referring interested parties amongtheir clients to the guidelines, she says.

The seven papers seek to provideclarification of the following areas:

o embedded derivatives;
o application of the ‘own-use’ exemption to energy contracts. (Own-use contracts are equivalent in substance – but not identical in practice – to the ‘normal purchase and sales exemption’ in Fas 133, says Stewart);
o the impact of volumetric flexibility on own-use contracts;
o what makes a contract ‘readily convertible to cash’; - the applicability of IAS 39 with respect to capacity contracts;
o valuation of the illiquid part of the curve (the as-yet unpublished paper); and

hedge accounting.As an example, Stewart outlines the problems companies face in determining whether a contract is readily convertible to cash. IAS 39 sets out that if a contract is ‘ readily convertible to cash’ and not for a company’s ‘own use’, it is a derivative contract. But it does not set out how a contract might be readily convertible to cash, while Fas 133 does, she says.

“ For example, consider a contract traded in the US on an illiquid trading hub,” says Stewart. “Fas 133 says that if you can move that contract to a liquid trading hub for less than 10% of the value of the contract, it is readily convertible.” Hence, the IEAF paper on this issue sets out its own list of criteria based, among other things, on US Generally Accepted Accounting Principles.

Ernst & Young’s Francis says:“Companies trading energy are putting a lot of effort and resources into getting things right on IAS 39. It’s certainly a big deal for them.”The IEAF may make their task that little bit easier.

The trouble with Fas 133

“Given the complexity of Fas 133, it is easy enough for even the most well-intentioned companies to get it wrong,” says Shannon Burchett, chief executive of risk management consultancy Risk Limited Corp in Dallas, Texas. “Firms have had to comply with the US standard since 2001, but the fact that the US Financial Accounting Standards Board is still looking at making changes to the standard indicates how hard it has been to clarify the evolving rules.” Indeed, a survey of financial professionals at the end of February by National Mortgage News Online showed that 97% of respondents felt Fas 133 is too complex, 89% felt the costs of the standard are greater than the benefits, and 63% felt the rules either need to be withdrawn or replaced. There are two main problems energy companies have complying with Fas 133 and related accounting literature, says John England, Houstonbased head of the global energy markets practice at consulting firm Deloitte & Touche. The main one is that companies may have to use different accounting methods for physical assets and energy-related contracts than they do for the derivatives related to them – and this can lead to significant volatility on the financial statements. For example, a firm would use standard historical accrual accounting for gas transport or storage contracts, but must apply fair-value or mark-to-market (MtM) accounting to any futures contracts it uses to hedge those gas assets. This creates economic versus accounting imbalances, in that the company might be economically flat but will still have MtM volatility, says England. Randy Kruger, controller at Calpine Energy Services in Houston,Texas – part of energy company Calpine – supports England’s view. “The mixedattributes model is the biggest challenge of Fas 133,” he says. The other main issue is the complexity around implementing hedge accounting, says England. The processes required to achieve hedge accounting are very burdensome from a systems and controls perspective, he says. Such things as documenting hedge relationships, measuring hedge effectiveness and assessing the probability of forecasted hedge items take significant effort and require robust systems and controls.