PART 2 - CONTRACTS FOR TRADING OR SPECULATIVE PURPOSES
All weather derivative contracts for trading or speculative purposes should be accounted for at their fair value, with subsequent changes in fair value reported in earnings. An entity is considered to be involved in trading or speculative activities if it enters into weather derivative contracts with the objective of generating profits on or from exposures to shifts or changes in climatic or geological conditions. If an operation's trading activities are not segregated either organizationally or by legal entity, but a portion of the operation's activities are trading, then only the trading activities should be accounted for at fair value.
Determining whether or when an entity is involved in trading or speculative activities is a matter of judgement that depends on the relevant facts and circumstances. The framework in which such facts and circumstances are assessed should be based on an evaluation of the various activities of an entity, rather than solely on the terms of the contracts. Inherent in that framework is an evaluation of its intent for entering into the weather derivative contract.
The following factors should be considered in evaluating whether an entity's weather derivative contracts are entered for trading or speculative purposes.
Category A lists the fundamental indicators to be considered to determine whether a entity that enters into weather derivative contracts isinvolved in trading activities. The presence of indicators from only Category B may indicate that such activities are trading.
A. FUNDAMENTAL INDICATORS
The operation's primary business is not inherently exposed to the specific weather-related risk stated as a variable (for
example, temperature, wind velocity and humidity) in the weather derivative contract it holds.
* The volume of weather derivative contracts exceeds a reasonable or supportable level of weather-related risk inherent in the operation's primary business.
* The change in value of the weather derivative contract (for example, based on a temperature variable) is expected to move in a direction that does not mitigate or offset the risk of the underlying exposure (for example, fuel consumption).
* The operation develops and utilizes its own proprietary models to price the weather derivative contracts it offers and trades.
B. SECONDARY INDICATORS--MANAGEMENT AND CONTROLS
* Compensation and/or performance measures are tied to the short-term results generated from weather derivative contracts (that is, the operation is measured based on trading profits or changes in the market values of its positions as opposed to profitable management of income-producing assets).
* The operation communicates internally in terms of "trading strategy" (that is, management reports identify contractual positions, fair values, risk exposure, etc.)
* The word "trading" is in the name of the operation for internal or external purposes.
* Employees of the operation are referred to as "traders" or have prior experience in derivative trading or risk-management activities.
* Assessment of net market positions of the operation is done on a regular basis.
Infrastructure of the operation is similar to that of a trading operation of a bank or
investment bank--front office, middle office, back office (that is, there is a segregation of back-office
processing and front-office trading functions).
An infrastructure exists that enables the operation to
capture price and other risks on a real-time basis.
* The activities are managed on a portfolio or "book" basis.
In last week's Learning Curve, we presented theFinancial Accounting Standard Board's accounting standards for over-the-counter weather derivatives in connection with nontrading activities. This week we discuss accounting for OTC weather derivatives for trading and speculative purposes, according to the FASB.
This week's Learning Curve was written based on the Financial Accounting Standards Board's EITF Abstracts Issue No. 99-2, 'Accounting for Weather Derivatives.' Permission to reprint EITF Abstracts Issue No. 99-2 in Derivatives Week was obtained from the FASB, 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116, U.S.A.