There would be many instances where a long term commodity purchase or sale agreement are being entered between the parties where there is a quantity to be delivered which is mentioned in the contract and it gives certain flexibility to avoid (if required) taking agreed quantity by paying cash (adjustment of movement in commodity values together with some penalty if any). These kind of agreements are very common in Oil and Gas Industry, Infrastructure and other manufacturing industries. These type of arrangement normally provide kind of assurance to the party supplying the commodity that price risk will be borne by the purchaser and in case purchaser does not want to take delivery then it will be settled net in cash (difference between agreed price and market price and /or some penalty). These types of contracts are called TAKE or PAY contracts.
There is nothing specific under current accounting system about such contracts and are being treated/ accounted as like other normal sale and purchase agreements/ transactions.
Now,
After the applicability of Ind-AS/ IFRS for such companies, one has to ensure about the applicability of the relevant accounting references in order to have correct accounting treatment in the books of accounts.
There are some IMPORTANT extracts from the relevant standards which will be defining proper accounting treatment of such TAKE or PAY contracts.
Ind-As 109 - "Financial Instruments" para 2.4 talks about the "Non-financial assets for own use/ for physical delivery purposes"-
2.4 -This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard shall be applied to those contracts that an entity designates as measured at fair value through profit or loss in accordance with paragraph 2.5.
Ind-As 32 - "Financial Instruments - Presentation" para 8 and 10A talks about "Contract for non-financial items settled in cash/ another financial instrument"-
8 -This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.
10A -written option to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, in accordance with paragraph 9(a) or (d) is within the scope of this Standard. Such a contract cannot be entered into for the purpose of the receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.
Definition of Derivative (as per Ind-As 109) - A financial instrument or other contract within the scope of this Standard with all three of the following characteristics.
i. its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
ii. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
iii. it is settled at a future date.
Now,
Let's have a practical insight about this concept so that one can have a very easy understanding over the matter -
- When an entity enters into a contract which is of its own usage or expected to be taken physically then normal accounting (trade date or settlement date) will be used to record these type of contracts,
- There are some situations where it is specifically mentioned in the contract which provides purchaser an option to either take physical delivery or can be settled at net (to be paid in cash or in other financial assets) then as per the requirement of new standard these will be treated as derivative (to the extent it is expected to be settled in cash/ FI) and accordingly its fair value accounting will follow,
- There would be another situations where nothing specific mentioned in the contract however there is practice within the business of buyer to settle the quantities in NET by avoiding physical delivery then also derivative accounting will follow,
- Reader can look at the definition of derivative as mentioned above which talks about the contract to be called as derivative where there should be some underlying reference by which value of the contract changes then in this case it will be "volume X price per unit", Secondly there should not be any initial investment to enter into such contracts then one can see that there is nothing required to enter into such contracts (Take or Pay) and Thirdly this should settle in future then one can see these volume flexibility contracts will be settled in future only,
- If there are substantial evidences which talks about the physical delivery of goods rather to getting into Net cash settlement then derivative accounting will not follow and instead trade date or settlement date accounting will follow,
- When a supplier is agreeing to provide agreed quantities at an agreed prices through the contract then it will be like writing an option by the supplier IF net settlement is allowed & happened in practice and accordingly this will be treated as derivative ,
- Further, the standard says even if these type of long term commodity (non- financial) items contracts are meant for delivery, an entity can designate (a choice) such type of contract to be values under the category of "Fair value through profit and loss" and accordingly mark to market accounting will follow,
- As a broader perspective if there is a options/ future available for such commodity which are done for physical delivery then it will not be covered under Financial Instruments accounting as there is no contractual right to received any cash and/or other financial assets/ exchanging financial assets.
One can visualize that TAKE or PAY kind of contract need to be evaluated in line with the requirements as mentioned and accordingly management needs to change processes/ system to ensure Ind-AS compliant financial statements. Valuation of the written options will be valued accordingly with the help of certified valuers and will be shown separately in the notes to accounts and Balance sheet.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
The author can also be reached at anuj@gyanifrs.com
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