Memo No. Issue Summary No. 1, Supplement No. 1 * Issue Date June 4, Meeting Date(s) EITF June 18, EITF Liaison

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1 Memo Issue Date June 4, 2015 Memo No. Issue Summary No. 1, Supplement No. 1 * Meeting Date(s) EITF June 18, 2015 Contact(s) Mark Pollock Lead Author Ext. (203) Jennifer Hillenmeyer EITF Coordinator Ext. (203) John Althoff EITF Liaison Project Project Stage Dates previously discussed by EITF Previously distributed Memo Numbers EITF Issue No. 15-A, Application of the Normal Purchases and Normal Sales Scope Exception to Certain Electricity Contracts within Nodal Energy Markets Redeliberations January 22, 2015 EITF Educational Meeting, March 19, 2015 Issue Summary No. 1, dated March 5, 2015 Purpose or Objective of This Memo 1. At the March 19, 2015 EITF meeting, the Task Force reached a consensus-for-exposure that the use of locational marginal pricing by an independent system operator to determine transmission charges (or credits) does not constitute net settlement of a contract for the purchase or sale of electricity on a forward basis for delivery to a location within a nodal energy market, even in scenarios in which legal title to the associated electricity is conveyed to the independent system operator during transmission. Consequently, the use of locational marginal pricing by the independent system operator would not cause that contract to fail to meet the physical delivery criterion of the normal purchases and normal * The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. Page 1 of 11

2 sales (NPNS) scope exception to derivative accounting. If the physical delivery criterion is met, along with all of the other criteria of the NPNS scope exception, an entity may elect to designate that contract as a normal purchase or normal sale. 2. A proposed Update was issued on April 23, 2015, with a May 18, 2015 comment letter deadline. 3. At the June 18, 2015 EITF meeting, the Task Force will have the opportunity to consider the feedback received through comment letters and the FASB staff s outreach as it redeliberates the consensus-for-exposure. The Task Force will then be asked whether it wishes to affirm its consensus-for-exposure on this Issue as a final consensus. Summary of Comment Letters 4. Five comment letters were received on the proposed Update. The breakout of respondents by stakeholder type is as follows: Stakeholder Type Number of Comment Letters Preparers 1 Electricity industry associations 1 Professional accounting associations 1 Accounting firms 1 Individual 1 Total 5 Scope 5. The proposed Update included the following question for respondents on scope: Page 2 of 11

3 Question 1: Is the scope of the proposed amendments sufficiently clear about the type of contracts to which the proposed amendments apply? Should the scope of the proposed amendments be limited to entities that enter into contracts for the purchase or sale of electricity on a forward basis for delivery to a location within an electricity grid operated by an independent system operator whereby one of the contracting parties incurs charges (or credits) for the subsequent transmission of that electricity based in part on locational marginal pricing differences payable to (or receivable from) the independent system operator? If not, please explain why. 6. All respondents agreed that the scope of the proposed amendments is sufficiently clear. 7. Respondents had differing views about whether the scope should be limited to what is described in the proposed Update. The accounting firm stated that the scope should be more principles based to minimize the need to amend GAAP as the electricity industry continues to evolve and to address similar issues in other industries. The preparer suggested expanding the scope to address wheeling-through transactions and internal bilateral transactions (IBTs), which they say are similar to the transactions addressed by the proposed amendments (see paragraphs 8 through 9 below). The professional accounting association stated that, although there may be other types of similar transactions, each of those transactions is sufficiently different to warrant separate consideration apart from the proposed amendments. The electricity industry association agreed with the proposal for limiting the scope of the proposed amendments as described in the proposed Update. The individual respondent did not respond to this part of the question. 8. The preparer suggested that the scope be expanded to include two types of wheelingthrough transactions. A wheeling-through transaction provides a means for a market participant to move electricity from one jurisdiction, through an electricity grid operated by an Independent System Operator (ISO), to another jurisdiction. Wheeling refers to the transportation of electricity over transmission lines. The first type of wheelingthrough transaction identified by the preparer is a single transaction that is linked so that if the inflow of electricity to the ISO is interrupted, the corresponding outflow of electricity from the ISO will be similarly interrupted. In these linked wheeling-through Page 3 of 11

4 transactions, market participants are charged a fixed transmission charge plus a congestion charge for wheeling electricity based on locational marginal pricing. The second type of wheeling-through transaction identified by the preparer requires the generator to sell electricity to the ISO at the point the electricity enters the grid and separately, but simultaneously, purchase electricity at the point the electricity exits the grid (that is, the two transactions are not linked ). 9. The preparer also suggested that the scope be expanded to include IBTs. IBTs are contracts between an electricity generator and a load serving entity (for example, a retail utility) that are used to fix the price of a future physical purchase and sale of electricity in the spot market. The staff understands that IBTs are financial contracts that are entered into separate and apart from, but in contemplation of, the physical spot market transaction. The execution and settlement of IBTs are facilitated by the ISO, and the preparer does not consider the ISO to be a principal in the transaction. The preparer said that IBTs should be eligible for the NPNS scope exception when the following conditions are met: a. The IBT is entered into in contemplation of the physical transaction b. The generator has to flow to the ISO almost the entire quantity of electricity referred to in the IBT c. The transactions are structured by an ISO d. The delivery point of the IBT and the physical transaction are the same or are highly correlated. Question 1 for the Task Force 1. Does the Task Force want to affirm the scope of the proposed amendments? Staff Recommendation 10. The staff recommends that the Task Force modify the scope of the proposed amendments to include contracts for the delivery of electricity through an electricity grid operated by an ISO that result in one of the contracting parties incurring charges (or credits) for the Page 4 of 11

5 transmission of the electricity based in part on locational marginal pricing differences. While this modification does not explicitly reference linked wheeling-through transactions, it would permit application of the NPNS scope exception to those types of contracts when locational marginal pricing is used to determine the transmission charge and all of the NPNS criteria are met. The staff understands that wheeling-through transactions are typically entered into on the day-ahead market; therefore, the term of any contracts determined to be derivatives would be limited to one day. Nevertheless, linked wheeling-through transactions are physical transactions and the proposed modification is consistent with the concept that the use of locational marginal pricing by the ISO to determine the transmission charge (or credit) does not constitute net settlement. The staff does not recommend explicitly referencing linked wheeling-through transactions because of the possible variations in contract terms and ISO regulations. 11. The proposed amendments to the physical delivery criterion of the general NPNS scope exception, updated for this modification, could be as follows (conforming amendments would be made to the NPNS scope exception related to power purchase or sale agreements): A Certain contracts for the purchase or sale of electricity on a forward basis for delivery through or to a location within an electricity grid operated by an independent system operator result in one of the contracting parties incurring charges (or credits) for the subsequent transmission of that electricity based in part on locational marginal pricing differences payable to (or receivable from) the independent system operator. For example, this is the case when the delivery location under the contract (for example, a hub location) is not the same location as the point of ultimate consumption of the electricity or the point from which the electricity exits the electricity grid for transmission to a customer load zone. Delivery to the point of ultimate consumption or the exit point is facilitated by the independent system operator of the grid. The 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 paragraph , and the use of locational marginal pricing to determine the transmission charge (or credit) does not constitute net settlement, even in situations in which legal title to the associated electricity is conveyed to the independent system operator during transmission. 12. The staff does not recommend addressing wheeling-through transactions that require generators to sell electricity to the ISO at the point the electricity enters the grid and separately, but simultaneously, purchase electricity at the point the electricity exits the Page 5 of 11

6 grid. Those types of transactions are not contingent upon one another and could be considered individual contracts that are part of a series of sequential contracts intended to accomplish ultimate acquisition or sale of a commodity and not eligible for the NPNS scope exception. Furthermore, as noted in paragraph 10 above, the terms of any contracts determined to be derivatives would typically be limited to one day. 13. The staff does not recommend expanding the scope of the proposed amendments to address IBTs because the staff understands that IBTs are financial contracts that do not require the physical delivery of electricity. Consequently, allowing IBTs to be eligible for the NPNS scope exception would be inconsistent with the Board s intent when it provided the NPNS scope exception in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (Statement 133), for contracts for the physical delivery of nonfinancial assets that are not unlike binding purchase orders. Furthermore, Topic 815 generally does not allow entities to combine separate financial instruments to be evaluated as a unit; therefore, it may not be appropriate to combine the IBT with the spot market transaction in order to meet the physical delivery criterion of the NPNS scope exception. 14. The staff considered whether a broad principle could be created that would mitigate the need to amend GAAP in the future as the electricity industry continues to evolve, or to address similar issues in other industries. However, the staff cautions that that type of approach could lead to unintended consequences resulting in application of the NPNS scope exception in circumstances that are not consistent with the Board s intent when it deliberated Statement 133. Furthermore, because of the unique transmission pricing constructs of nodal energy markets (that is, the use of locational marginal pricing), the staff does not recommend that the scope of the proposed amendments should extend to contracts for transactions in other types of industries. The Board has considered the unique characteristics of the electricity industry in past standards setting activities. For example, in Derivatives Implementation Group Statement 133 Implementation Issue C15, Scope Exceptions: Normal Purchases and Normal Sales Exception for Certain Option- Type Contracts and Forward Contracts in Electricity, the Board provided relief from derivative accounting for certain capacity contracts that contain volumetric optionality. Its basis for providing that relief was because electricity cannot be readily stored in Page 6 of 11

7 significant quantities and the entity selling electricity is obligated to maintain sufficient capacity to meet the electricity needs of its customer base (therefore, electricity contracts often necessarily provide flexibility in determining when to take electricity and in what quantity in order to match power to fluctuating demand). Given the unique characteristics of the electricity industry and nodal energy markets, the staff does not recommend creating a broad principle to address this Issue. Application of the NPNS scope exception to certain electricity contracts within nodal energy markets 15. The proposed Update included the following question for respondents on the application of the NPNS scope exception to certain electricity contracts within nodal energy markets: Question 2: Do you agree that the use of locational marginal pricing by an independent system operator to determine the transmission charge (or credit) should not constitute net settlement of a contract for the purchase or sale of electricity, even in scenarios in which legal title to the associated electricity is conveyed to the independent system operator during transmission? If not, please explain why 16. All respondents agreed that the use of locational marginal pricing by an independent system operator to determine the transmission charge (or credit) should not constitute net settlement of a contract for the purchase or sale of electricity, even in scenarios in which legal title to the associated electricity is conveyed to the independent system operator during transmission. Question 2 for the Task Force 2. Does the Task Force want to affirm the application of the NPNS scope exception to certain electricity contracts within nodal energy markets described in the proposed amendments? Staff Recommendation 17. The staff recommends that the Task Force affirm the application of the NPNS scope exception to certain electricity contracts within nodal energy markets as described in the proposed Update. Page 7 of 11

8 18. The staff believes that the proposed amendments are consistent with the Board s intent when it provided the NPNS scope exception for contracts for the physical delivery of nonfinancial assets. 19. Disallowing those types of contracts from being eligible for the NPNS scope exception could result in a significant number of routine physical transactions being accounted for as derivatives because in order to purchase or sell electricity in a nodal energy market, at least one company must incur transmission charges (or credits) based in part on locational marginal pricing differences. For some companies, that would result in derivative gains (or losses) being recognized in earnings before physical delivery. For regulated companies within the scope of Topic 980, Regulated Operations, that could result in a balance sheet gross up of derivative assets (liabilities) and regulatory assets (liabilities) before physical delivery. The staff does not believe that this accounting is consistent with the nature and economics of a physical transaction. Furthermore, users have indicated that remeasuring contracts for routine physical transactions at fair value is not decision-useful. Transition and Transition Disclosures 20. The proposed Update included the following question for respondents on transition: Question 3: Should the proposed amendments be applied prospectively? If not, what transition method should be applied and why? 21. Four respondents agreed that the proposed amendments should be applied prospectively. The individual respondent did not agree with prospective application; however, that individual did not state their rationale or provide alternative solutions. 22. The proposed Update also stated that an entity shall provide the disclosures in paragraphs (a) and 50-2, as applicable, in the period of adoption. Those paragraphs would require disclosure of the nature of and reason for the change in accounting principle in both the interim and annual period of the change for entities that issue interim financial statements. Page 8 of 11

9 Questions 3 and 4 for the Task Force 3. Does the Task Force want to affirm that the proposed amendments should be applied prospectively? 4. Does the Task Force want to affirm that the disclosures in paragraphs (a) and 50-2, as applicable, should be required? Staff Recommendation 23. The staff recommends that the Task Force affirm that the proposed amendments should be applied prospectively. 24. Prospective transition is consistent with the transition framework established by the Derivatives Implementation Group in Statement 133 Implementation Issue K5, Miscellaneous: Transition Provisions for Applying the Guidance in Statement 133 Implementation Issues, for contracts that were previously accounted for as derivatives but are not accounted for as derivatives under newly issued implementation guidance. 25. Because the NPNS scope exception is an election that can be made at inception of the contract or at a later date, under prospective transition, entities would have the ability on or after the effective date to designate qualifying contracts that were entered into before the effective date as normal purchases or normal sales. 26. The staff also recommends that the Task Force affirm that the disclosures in paragraphs (a) and 50-2, as applicable, should be required. The staff believes that those disclosures would sufficiently explain the change in accounting principle. 27. The staff does not believes that the disclosures in paragraphs (b) through 50-1(c) and 50-3 related to the effect of the change on the financial statements should be required. Those disclosures would result in incremental preparer costs to determine the fair value of contracts that were designated as NPNS during the period of adoption. Those incremental costs may not be justified because users have said that mark-to-market information for routine transactions is not decision-useful. Page 9 of 11

10 Effective date 28. The proposed Update included the following questions for respondents on effective date: Question 4: How much time would be needed to implement the proposed amendments? Should early adoption be permitted? Question 5: Do entities other than public business entities (that is, private companies and not-for-profit entities) need additional time to apply the proposed amendments? Why or why not? 29. All respondents believe that the proposed amendments could be implemented in a short amount of time and that early adoption should be permitted. 30. Three respondents stated that entities other than public business entities do not need additional time to apply the proposed amendments. Two respondents did not respond to Question 5. Questions 4 and 5 for the Task Force 4. What should the effective date be? 5. Should early adoption be permitted (if the Task Force does not agree with the staff recommendation that the amendments should be effective upon issuance)? Staff Recommendation 31. The staff recommends that the proposed amendments be effective upon issuance for all entities. The staff does not believe that a transition period is necessary because the NPNS scope exception is an election that can be made at inception of the contract or at a later date. That is, entities can choose to designate or to not designate qualifying contracts as normal purchases or normal sales. There are currently differing views about whether these types of contracts qualify for the NPNS scope exception, therefore making the proposed amendments effective upon issuance also would eliminate the diversity in practice resulting from those differing views in the shortest period of time. Furthermore, comment letter respondents stated that early adoption should be permitted. Because the NPNS scope exception is elective and can be applied at any point in time, making the Page 10 of 11

11 proposed amendments effective upon issuance has the same effect as establishing a future effective date and allowing early adoption. 32. The Private Company Decision-Making Framework indicates that, generally, private companies should be given more time to adopt new accounting standards due to resource limitations and their learning cycle. Although private companies could require more time to implement the proposed amendments, the staff does not believe that a delayed effective date for private companies is necessary for the reasons discussed in paragraph 31 above. Page 11 of 11