Commodity-Based Fluctuations Require Proper Accounting in Financial Statements

Decisions are better informed and more reliable when volatility is accounted for in a consistent, documented manner.
By Sara DeRoo | May 20, 2014

Looking at quarterly financial statements of SEC reporting companies shows a wide disparity of financial performance for companies in the same industry, operating in the same geographic area, with the same capacity. Such similar companies would seem to have the same operating economics. So why is there such a disparity in financial performance? Certainly, each plant has a different risk management philosophy and other variables that separate one plant from another. But reading these financial statements more closely, are other potential differences more related to adaptations of their accounting policies?  To address these questions, we will examine how facilities with the same general economics can report a vastly different financial performance, when intuition would suggest their financial performance should be relatively consistent.

Let’s look at a common example of a plant that considers itself a basis trader. The management practice is to enter into forward contracts for a significant portion of commodity inputs and outputs, including feedstocks, ethanol and coproducts. At the same time, the company uses board positions to offset the risk of market price fluctuations, which effectively locks in a margin on its production. The company’s goal in this situation is to maintain a minimal balance between long and short positions.
In a hedge’s most basic form, during periods of market price fluctuations, the change in value of inventories, including forward contracts, is offset by a net change in the short board positions, with the net bottom line effect of these price fluctuations only attributable to basis changes. If forward contracts are not brought to market, however, and if physical inventory is carried at cost, the financial statements will reflect the full variability of the market value changes in the board positions.
As a result of this volatility in net income, which may not be reflective of the economics of the market price fluctuations, companies have considered changing their methods of reporting forward contacts and inventory to better reflect the economics of the hedging relationship.

Typical manufacturing businesses encounter minimal fluctuation in month-to-month financial reporting. Businesses that rely heavily on commodity pricing are a different story, whether commodities factor in on the cost side or the revenue side of the profitability equation. Renewable fuels producers encounter highly volatile prices for feedstock and energy purchases as well as product sales, so a true picture of real-time or monthly financial performance requires understanding of a fairly complex picture. That picture encompasses not only commodity pricing for completed purchases and sales, but also must include consistent means of accounting for such factors as forward contracts, inventory valuation and hedging positions.

It’s certainly possible to keep relatively simple account of these factors affecting commodity pricing, of course, since volatility in monthly statements can be explained and annotated as needed, but when it’s desirable to consistently document a comprehensive picture of a plant’s finances at any point in time, three major areas can be reviewed for possible modifications to accounting strategy: contract valuation, inventory valuation and revenue recognition.

Contracts Marked to Market
Forward purchase and sale contracts an ethanol plant enters into with a third party are by definition derivative instruments.  Under generally accepted accounting principles (GAAP), derivative instruments must be recorded at fair value in the plant’s balance sheet. 

However, certain contracts may be exempted from this reporting as “normal purchases and sales.” Normal purchases and sales are those that provide for the purchase or sale of something, other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period of time in the normal course of business. In many cases, forward purchase and sales contracts fall into this exemption. Analysis should be performed at the inception of each contract to determine whether it meets the criteria for normal purchases and sales.

Contracts exempted as normal purchases and sales are not recorded on the balance sheet and no gain or loss is recognized on the income statement until the contract is fulfilled. Contracts not meeting the normal purchases and sales exemption, or which the company elects to consider derivative instruments, are measured at fair value on the company’s balance sheet, and any gain or loss on the contracts could be recognized in the company’s income statement.

Because a company may elect to consider a contract a derivative instrument even when an exemption applies, some flexibility exists in the way a company handles contract valuation. It’s important to note, however, that once a company has made a determination on the recording of a contract (which is typically done at the inception of the contract), the company is not permitted to change that election at a later date.

Inventory at Net Realizable Value
When commodity inventories are recorded at the lower of cost or market, the market price fluctuations of this inventory are not recognized in the financial statements; however, the offsetting board position protecting the physical inventory on hand is recorded at market, thus resulting in a net change to the income statement as market prices fluctuate.

Valuing inventory at net realizable value (versus the lower of cost or market), is yet another important strategy to consider in creating a less volatile short-term financial picture.
A number of important factors must be kept in mind when considering an inventory valuation change. First, a switch to net realizable value (NRV) is considered a change in accounting principle. Changes in accounting principle are permitted only if a company justifies the use of an alternative acceptable accounting principle on the basis that it is preferable.

Rationale for such a justification can be summed up as follows: during periods of market price fluctuations, change in market value of physical inventory is not reflected in the income statement. However, the offsetting board position protecting the physical inventory on hand is recorded as market values change, resulting in swings to the income statement as market prices fluctuate; thus, such an income statement fails to show the true economics of the commodities purchase and production process.

A second consideration is that NRV must be determined to be an acceptable method of accounting for inventory. It is generally recognized that income accrues only at the time of sale and that gains may not be anticipated by reflecting assets at current sales prices. However, only in exceptional cases may inventories properly be stated above cost, and must be justifiable by all of the following three items: 1) inability to determine appropriate approximate costs (whether such an inability truly exists typically needs to be discussed and analyzed in detail between company management and their auditor); 2) immediate marketability at quoted market price; 3) the characteristic of unit interchangeability. When such inventories meet these three tests, they should be reduced by disposal costs.

Last, a change in accounting principle should be reported through retrospective application to all prior periods, unless it is impracticable to do so. Retrospective application is the application of a different accounting principle to previously issued financial statements (or to the opening balances of the current statement of financial position) as if the different principle had always been used.

Revenue Recognition
One final area to consider is to analyze how revenue recognition might affect reported income volatility. Even if shipped, ethanol and coproducts may not be recognized in the current month’s income statement and may be required to be recognized in the following month. Certainly, we are not suggesting that contract terms are dictated by accounting rules and those terms need to be changed, but we still need to understand that contract terms could have a material effect on reported net income.

In order for revenue to be recognized, it has to be both realized and realizable. To be recognized, it has to be realized when goods or services are exchanged for cash or claims to cash. Revenue and gains are realizable when assets are readily convertible to cash. In order for the revenue to be realizable, the pricing must be fixed or determinable at that time. To determine whether promised pricing (revenue) is fixed or determinable (thus whether revenue should be recognized), first look at each factor that can affect pricing. Next, evaluate who controls these factors that could alter price. Finally, evaluate if a future event affecting any those factors could increase or decrease price.

Revenue being earned must also be reviewed. The earnings process includes delivering or producing goods, rendering services or other activities that constitute an entity’s major operations. The earnings process is complete when an entity has accomplished what it needs to do to be entitled to benefits of revenues.

It’s important to analyze contracts to determine whether revenue recognition criteria has been met. Revenue recognition standards will change in 2017, when revenue recognition will be based on fulfilling performance obligations. Keep this in mind for long-range planning, as it will be important to reevaluate current contracts to determine whether any changes are present compared to the current revenue recognition process.

Over time, of course, commodity-based fluctuations in profitability will smooth out regardless of accounting methodology, as long as those methods follow GAAP and are applied consistently, but it can be useful for a variety of reasons to employ record-keeping practices that provide a true, complete picture of commodity prices as they affect the final bottom line. Executive-level and board decisions can become better informed and more reliable when volatility is accounted for in a consistent, documented manner on monthly statements, and buyers and hedging managers can confidently review the results of their coordinated efforts to execute optimal risk management strategy.

Author: Sara DeRoo, CPA
Assurance and Advisory Services Manager,
Christianson & Associates PLLP
[email protected]