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Power & Gas: Complex Financial Reporting: Power Contracts

A large foreign multinational corporation (the Company) invests in power plants and renewable energy ventures in addition to its businesses in the manufacturing, trading, and financial services.  The Company had recently invested in a U.S.-based wind powered electricity generation facility (the windfarm).  To finance this project, the Company had executed a series of contracts to forward sell 100% of the power generated from the windfarm, along with all its environmental attributes.  These agreements included several physical fixed-price sales contracts for a portion of the offtake along with a contract for differences, which contained a cap on the cumulative payout related to several agreements.  The complex agreements spanned over 20 years and contained an option to extend the agreement for an additional five years.  Given the complicated nature of these structured power agreements, the Company engaged Opportune for assistance with their accounting treatment, including analyzing them for derivatives and implementing cash flow hedge accounting where applicable.  If the contracts were derivatives, the default accounting treatment would be to record the fair value of these contracts on their balance sheet each reporting period with all changes in their fair value recognized currently in earnings, thereby increasing the Company’s earnings volatility.  Cash flow hedge accounting treatment would allow the Company to defer the effective portion of the changes in fair value in other comprehensive income until the underlying power transaction impacted earnings.

The Company was faced with a number of accounting issues not the least of which was the fact that it is required to prepare its financial statements under both U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financials Reporting Standards (IFRS) requirements. Consequently, Opportune had to assess each of the contracts separately for U.S. GAAP and IFRS requirements with possibly different accounting implications under each.  Opportune determined whether the contracts were derivatives, which was a point of contention between the auditors and the Company, given that the contracts were for the sale of 100% of the windfarm’s offtake and did not specify a notional amount. For the contracts determined to be derivatives, Opportune assisted the Company with determining if they qualified for the “Own-Use” or “normal purchases normal sales” (NPNS) exemption.  If the contracts did qualify for the Own-Use or NPNS exemptions, then they would be exempt from the default derivative accounting.  Conversely if the contracts did not qualify for Own-Use or the NPNS exemptions, then the Company would need assistance electing cash flow hedge accounting treatment under both U.S. GAAP and IFRS.

Opportune worked with the Company and its auditors to determine the correct accounting treatment for each agreement.  Opportune then prepared the contemporaneous documentation for each provision, either specifying the Own-Use exemption and electing the NPNS exemption or designating the agreements in cash flow hedge relationships.  There are number of complexities that go along with forecasting the cash flows associated with a 20-year power deal with a five-year extension option, the biggest being the lack of observable market data beyond three years.  Opportune extrapolated market data for the unobservable period using market participant assumptions and developed an appropriate model based on a 20-year swap with a 5-year swaption.  Subsequent to the initial set up, every quarter Opportune performs the required quarterly effectiveness testing, ineffectiveness measurement, and balance sheet remeasurement calculations for maintaining the cash flow hedge relationship and accounting treatment.

Opportune uses its deep experience to help companies achieve hedge accounting.   Our experts work closely with management to reduce complexities and audit risk.  Our strategic methodology is designed to support our clients’ business objectives, including driving profitability while meeting applicable reporting standards.  For more information click here.

Charlie Palmer

Managing DirectorOpportune LLP