Contracts accounted for in accordance with IAS 39 include those contracts to buy or sell non-financial items that can be settled net in cash, as if they were financial instruments (i.e., they are in substance similar to financial derivatives). Many commodity purchase and sale contracts meet the criteria for net settlement in cash because the commodities are readily convertible to cash.
However, such contracts are excluded from the scope of IAS 39 if they 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. This is commonly referred to as the own use scope exception of IAS 39.
Own use contracts are accounted for as normal sales or purchase contracts (i.e., executory contracts), with the idea that any fair value change of the contract is not relevant given the contract is used for the entity’s own use. However, some participants of certain industries enter into contracts for own use and similar financial derivatives for risk management purposes and manage all these contracts together. In such a situation, own use accounting leads to an accounting mismatch as the fair value change of the derivative positions for risk management purposes cannot be offset against fair value changes of the own use contracts.
To eliminate the accounting mismatch, an entity could apply hedge accounting by designating an own use contract as the hedged item in a fair value hedging relationship. However, hedge accounting in these circumstances is administratively burdensome. Furthermore, entities enter into large volumes of commodity contracts and, within the large volume of contracts, some positions may offset each other. An entity would therefore typically hedge on a net basis.
By way of a consequential amendment to IAS 39, the IASB introduced a fair value option for own use contracts. At the inception of a contract, an entity may make an irrevocable designation to measure an own use contract at fair value through profit or loss (the fair value option). However, such designation is only allowed if it eliminates or significantly reduces an accounting mismatch.
On transition to IFRS 9, entities can apply the fair value option on an all-or-nothing basis for similar types of (already existing) own use contracts.
Some entities, especially in the power and utilities sector, enter into long-term own use contracts, sometimes for as long as 15 years. The business model of those entities would often be to manage those contracts together with other contracts on a fair value basis. However, there are often no derivatives available with such long maturities, while fair values for longer-dated contracts may be difficult to determine. Hence, a fair value-based management approach might only be used for the time horizon in which derivatives are available. The fair value option is, however, only available on the inception of the own use contract. Consequently, the fair value option will mainly be useful for entities that apply a fair value-based risk management strategy for entire contracts, which is more likely to be the case for shorter-term own use contracts.