Own use scope exemption under IFRS® Accounting Standards

From the IFRS Institute – March 7, 2024

Companies frequently buy and sell nonfinancial items, e.g. commodities such as crude oil or metals, in the ordinary course of business. These contracts can sometimes be roped into the accounting for financial instruments, thereby causing unintended volatility in earnings. In this article, we discuss how consumers and producers can apply the ‘own use exemption’ under IFRS Accounting Standards to potentially avoid this and how that compares to the ‘normal purchases and normal sales scope exception’ under US GAAP. We also discuss challenges involved in power purchase agreements (PPAs) and standard setting efforts in this area.

If a contract to buy or sell nonfinancial items can be settled net in cash or another financial instrument, derivative accounting under IFRS 9¹ generally applies even though the nonfinancial item itself is outside the scope of IFRS 9. The contract is recognized at fair value through profit or loss (FVTPL), which requires recognition of fair value changes in the income statement. This may also affect revenue or cost of sales when the contract is a sale to a customer or purchase of inventory respectively.

A contract to buy or sell a nonfinancial item is considered settled net in cash or another financial instrument when any of the following criteria is met (‘net settlement criteria’):

a. the terms of the contract permit either party to settle net;

b. the company has a past practice of settling similar contracts net (including entering into offsetting contracts);

c. for similar contracts, the company has a past practice of taking delivery of the underlying and selling it within a short period after delivery to generate profit from short-term fluctuations in price or dealers’ margin (trading the underlying); or

d. the nonfinancial item that is subject to the contract is readily convertible into cash.

Conversely, a contract to buy or sell nonfinancial items is exempt from derivative accounting (i.e. is not in the scope of IFRS 9) when it cannot be settled net in cash or by exchanging financial instruments – e.g. because none of the criteria for net settlement is met.

Under the own use exemption, a contract that can be settled net in cash because it meets net settlement criterion (a) or (d), may still be exempt from derivative accounting if it has been entered into and continues to be held to receive or deliver the nonfinancial item in accordance with the company’s expected purchase, sale or usage requirements. IFRS 9 does not provide further guidance on how to make this assessment. In practice, this can be demonstrated as long as the company has no past practice of settling similar contracts net or trading the underlying. In our view, ‘past practice’ should be interpreted narrowly. Therefore, any regular or foreseeable events leading to net settlements or closing out of contracts would taint a company’s ability to apply the own use exemption to other similar contracts whereas infrequent historical incidences of net settlement in response to events that could not have been foreseen at inception of a contract would not.

Companies are required to reassess whether derivative accounting may be required if the own use exemption ceases to apply because of (1) decreases in expected sales, purchases or usage, (2) expected net settlements arise from supply chain disruptions, or (3) repeated instances of net settlements.

The own use exemption is not an election; it must be applied to qualifying contracts. However, to eliminate or significantly reduce any recognition inconsistency (known as an ‘accounting mismatch’) that would arise from applying the exemption, a company could elect the FVTPL designation at contract inception.

Applying the own use exemption instead of derivative accounting can create different accounting outcomes as explained in the below example.

Company A enters into a contract with Company B to buy 100 tons of cocoa beans at 1,000 per ton for delivery in 12 months. On the settlement date, the market price for cocoa beans is 1,500 per ton, and Company A pays Company B 100,000.

As provided in the examples above, applying the own use exemption can affect not only the timing of profit and loss recognition, but also how profit and loss activity is presented. Further, the IFRS Interpretations Committee has clarified⁴ that when the exemption does not apply, the total derivative gain or loss previously recognized cannot be reversed at the settlement date to adjust revenue or inventory as applicable. However, companies should determine how to best present amounts related to the remeasurement of derivatives in their income statement, by applying the general presentation principles of IAS 1⁵.

The normal purchase and sale scope exception is the US GAAP equivalent to the own use exemption but there are differences with IFRS Accounting Standards, some of which are discussed below.

Under US GAAP, a contract to buy or sell a nonfinancial item cannot be separated into one or more components, such that one component qualifies for the NPNS scope exception while others do not. Although this is also generally true under IFRS Accounting Standards, there are exceptions for certain written option components and hybrid contracts.
Unlike the own use exemption, FVTPL accounting is not available under the NPNS scope exception. However, because the NPNS scope exception is an election (unlike the own use exemption), accounting mismatch can also be avoided under US GAAP simply by not electing the exception.

PPAs are increasingly popular for procuring renewable energy. They are part of companies’ commitments to mitigate the effects of climate change and to decarbonize production processes, products and services. Additionally, power and utility companies frequently enter into PPAs to purchase and sell power to service their end users.

PPAs can be broadly grouped into physical PPAs and virtual PPAs, each with their own accounting challenges. The accounting depends on the nature of the rights and obligations in a PPA, in particular, whether the electricity purchased under the PPA is physically delivered to the purchaser or net settled in cash. To understand the rights and obligations, it is important to understand how a particular electricity market operates.

All electricity markets must continuously be balanced between supply and demand to ensure system security and stability. The system creates an imbalance when demand or production levels change unexpectedly. Given that there will always be a compulsory financial settlement system for imbalances in the power grid, the wholesale electricity market design can be broadly allocated into two major categories –‘net pool’ and ‘gross pool’ electricity markets. It is however important to note that within each category, there are variations between markets over how imbalances are managed and calculated, how contracts are structured and settled and how energy transactions are fulfilled. Therefore, it is still important to understand the specific terms and conditions of the electricity market design when working through energy transactions.

A net pool market design is a decentralized structure. All bilateral contracts are physically deliverable via the grid and the energy producer credits the customer’s account with the volume delivered. Only imbalances between the energy purchased and consumed arising from bilateral arrangements are transacted at spot prices through a voluntary pool mechanism. In a net pool arrangement, there is a settlement mechanism directly between the producer and customer where the imbalance is transacted at the spot prices, so contractually, there is always physical delivery.

The main accounting challenge with physical PPAs is that these contracts may need to be accounted for as derivatives unless they qualify for the own use exemption in IFRS 9. However, assessing if the own use exemption applies can be challenging. Due to the unique characteristics of the energy market and related features of the long-term physical delivery arrangements, it may be unclear if the electricity purchased under the PPA is physically delivered to the purchaser or net settled in cash.

Applying the own use exemption requires interpreting terms such as ‘delivery’, ‘net settlement’ and ‘a company’s own usage requirements’ in the context of the facts and circumstances. Such interpretations can be particularly challenging under the following scenarios:

When the underlying nonfinancial item cannot be stored and has to either be consumed or sold within a short time in accordance with the market structure in which the item is bought and sold;
When there is a mismatch between the demand profile of the company and the supply profile of the supplier and there will be times when the company is unable to consume the energy when it is delivered;
When there are no feasible options to store the energy and the company has to sell unused amounts from its account to third parties. The process of selling and repurchasing is delegated to a service provider for a fixed or formula-based fee and is designed to be on autopilot that acts without the intention of trading to realize profits. There is generally no explicit net settlement option in the contract.

IFRS 9 does not provide sufficient specific guidance on how to assess whether companies satisfy the requirements for the own use exemption for these uniquely characterized contracts. This lack of specific guidance may cause diversity in practice.

A gross pool market design is a centralized structure, with all sales and purchases transacted via the market operator, who acts like a clearing house for energy transactions. Separate bilateral fixed-price contracts between producers and customers settle the difference between spot price and contract price. Hence, PPAs in a gross pool market are most likely to be a virtual PPA.

Because there is no physical delivery of power and the contract is settled based on differences in prices, these contracts are accounted for as derivatives.

The main accounting challenge with virtual PPAs is how to designate them as a hedging instrument in a cash flow hedging relationship that better reflect the results of the company’s risk management strategy.

In 2023, the International Accounting Standards Board (IASB) added a project to research whether narrow-scope amendments to IFRS 9 could be made to better reflect how financial statements are affected by PPAs (both physical and virtual). After a number of outreach discussions, the IASB is now considering amending guidance relating to the application of the own use exemption and hedge accounting. An exposure draft is expected to be issued in May 2024.

For more details about the project, check the IASB’s website here.

When contracting to buy and sell nonfinancial items in the ordinary course of business, companies should consider whether derivative accounting applies or can be avoided under the own use scope exemption in IFRS 9. Companies that enter into PPAs should follow the activities of the IASB as it considers potentially amending IFRS 9 to address accounting challenges for physical and virtual PPAs with regards to the application of the own-use exemption requirements to physical PPAs and to the hedge accounting requirements for virtual PPAs.

	Debit	Credit
Inventory	100,000
Cash		100,000
To recognize purchase of cocoa beans.

	Debit	Credit
Cash	100,000
Revenue		100,000
To recognize revenue from sales of cocoa beans.

	Debit	Credit
Derivative asset	50,000
Profit and loss account		50,000
To recognize derivative asset and fair value gain in profit and loss account.

	Debit	Credit
Inventory	150,000
Cash		100,000
Derivative asset		50,000
To recognize purchase of inventory at market price and derecognition of derivative asset on settlement date.

	Debit	Credit
Profit or loss account	50,000
Derivative liability		50,000
To recognize derivative liability and fair value loss in profit and loss account.

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