PART 1 - CONTRACTS FOR NONTRADING PURPOSES
In this week's Learning Curve, we are presenting the Financial Accounting Standard Board's accounting standards for over-the-counter weather derivatives in connection with nontrading activities. Specific examples are provided. Next week we will discuss accounting for weather derivatives for trading or speculative purposes.
The FASB's Emerging Issues Task Force (EITF) last year released accounting rules for weather derivatives, which became effective July 22, 1999. They answer the question whether these contracts should be accounted for under accrual accounting, settlement accounting, insurance accounting, marked to fair value through earnings at each reporting date, or whether accounting should vary based on the type of contract. Nonexchange-traded weather derivatives are not covered under FAS 133. The task force looked into three issues:
* How should an entity account for a weather derivative based on an over-the-counter swap (two-directional risk)?
* How should an entity account for the purchase of a weather derivative based on an OTC option (one-directional risk)?
* How should an entity account for the sale of a weather derivative based on an OTC option?
WEATHER DERIVATIVES BASED ON OTC SWAP
Weather derivatives based on OTC swaps should be accounted for using the intrinsic value method. The intrinsic value method computes an amount based on the difference between the expected results from an upfront allocation of the cumulative strike and the actual results during a period, multiplied by the contract price, for example dollars per heating-degree day. It requires the entity to allocate the cumulative strike amount to individual periods within the contract term, reflecting reasonable expectations at the beginning of the contract term of normal or expected experience under the contract. The allocation should be based on data from external statistical sources, such as the National Weather Service.
The intrinsic value of the contract at interim dates would then be calculated based on cumulative differences between actual experience and the allocation through that date. The initial allocation of the cumulative strike amount should not be adjusted over the life of the contract to reflect actual results.
PURCHASING WEATHER DERIVATIVES BASED ON OTC OPTION
The entity purchasing weather derivatives based on an OTC option should amortize to expense the premium paid (or due) and apply the intrinsic value method above to measure the contract at each interim balance sheet date. The premium asset should be amortized in a rational and systemic manner.
SELLING WEATHER DERIVATIVES BASED ON OTC OPTION
The entity writing weather derivatives based on OTC options should initially recognize the premium as a liability and recognize any subsequent changes in fair value currently in earnings. The premium would not be amortized.
If the weather derivative purchased or sold contains an embedded premium or discount when the contract terms are not consistent with current market terms, the premium or discount should be quantified, removed from the calculated benchmark strike and accounted for as discussed above. This is the case if, for example, the cumulative strike amount referenced in the contract is not consistent with historical weather data adjusted for expected experience.
EXAMPLES OF THE APPLICATION OF THE EITF CONSENSUS ON ISSUE 99-2
Degree-Day Swap
Company A--for example, a construction materials company that has its sales decrease during cold winters or a chemical manufacturer that has its natural gas consumption costs increase during cold winters--enters a degree-day swap, a contract with two-directional risk, with Company B--for example, a natural gas distributor that experiences lower revenues during warm winters. Heating degree days (HDDs) is the winter measure of average daily temperature below 65 degrees Fahrenheit.
The contract requires no initial net investment and requires a payment by Company A to Company B if cumulative HDDs are less than 4,500 HDDs during the period from Nov. 1, 1999, to March 31, 2000. If cumulative HDDs exceed 4,500 HDDs during that same period, Company B will make a payment to Company A. The contract has a floor of 2,500 HDDs and a cap of 6,500 HDDs. The payment under the contract is equal to USD10,000 multiplied by the cumulative number of HDDs above or below 4,500 HDDs and is made on April 5, 2000.
Based on the foregoing terms, this contract carries a maximum payout limitation of USD20 million by Company A and USD20 million by Company B regardless of actual temperature levels experienced. Assume that neither Company A nor Company B is a dealer in weather derivatives (that is, the operations of both entities that entered into this contract are non-trading).
Degree-Day Option
Company A--for example, a construction materials company that has its sales decrease during cold winters or a chemical manufacturer that has its natural gas consumption costs increase during cold winters--purchases on Nov. 1, 1999, a degree-day option from Company B--for example, a natural gas distributor that experiences lower revenues during warm winters. The premium payment for the option is USD5.85 million. The option requires Company B to pay Company A USD10,000 for each HDD in excess of 4,500 HDDs--the strike level--cumulative during the period from Nov. 1, 1999, to March 31, 2000.
This contract specifies a maximum payout limitation of USD20 million regardless of the actual temperature levels experienced, thereby effectively stipulating a cap based on 6,500 HDDs. The contract is settled on April 5, 2000. Assume that neither Company A nor Company B is a dealer in weather derivatives (that is, the operations of both entities that entered into this contract are non-trading).
Derivatives Week is now accepting submissions from industry professionals for Learning Curve®, the tutorial for new or potential users of derivatives. For details and guidelines on writing a Learning Curve®, please call Elisabeth Bertalanffy in London at 44-171-303-1753 or Alice Cabotaje in Hong Kong at 852-2912-8097.
