This excerpt taken from the GXP 10-K filed Mar 7, 2005.
Strategic Energy Energy and Energy-related Contract Accounting
Strategic Energy primarily purchases power under forward physical delivery contracts to supply electricity to its retail energy customers under full requirement sales contracts. Both the forward purchase contracts and the full requirements sales contracts meet the accounting definition of a derivative; however, on a majority of the forward purchase derivative contracts and all of the full requirement sales contracts, Strategic Energy applies the normal purchases and normal sales exception (NPNS) accounting treatment. Accordingly, Strategic Energy records receivables and revenues generated from the sales contracts as energy is delivered and consumed by the retail customer. Likewise, a liability and purchase power expense are recorded when the energy under forward physical delivery contracts is delivered to Strategic Energys retail customers.
An inability to sustain the NPNS accounting treatment for forward purchase derivative contracts could result in asymmetrical accounting, whereby the timing of the impact on operating income would differ if NPNS accounting treatment was applied to the full requirements sales contracts, but the forward purchase derivative contracts no longer qualified for NPNS accounting treatment.
For forward purchase contracts that do not meet the qualifying criteria for NPNS accounting treatment, Strategic Energy elects cash flow hedge accounting where appropriate. Under cash flow hedge accounting, the fair value of the contract is recorded as a current or long-term derivative asset or liability. Subsequent changes in the fair value of the derivative assets and liabilities are recorded on a net basis in OCI and subsequently reclassified as purchased power expense in Great Plains Energys consolidated statement of income as the power is delivered and/or the contract settles. Additionally, in the future, OCI may have greater fluctuations than historically because of a larger number of derivative contracts designated for cash flow hedge accounting, but these fluctuations would not affect current period operating income or cash flows.
Changes in fair value of forward purchase derivative contracts that do not meet the requirements for the NPNS accounting treatment or cash flow hedge accounting are recorded in operating income and as a current or long-term derivative asset or liability. The subsequent changes in the fair value of these contracts could result in operating income volatility as the fair value of the changes in the associated derivative assets and liabilities are recorded on a net basis in purchased power expense in Great Plains Energys consolidated statement of income.
Derivative assets and liabilities consist of a combination of energy and energy-related contracts. While some of these contracts represent commodities or instruments for which prices are available from external sources, other commodities and certain contracts are not actively traded and are valued using modeling techniques to determine expected future market prices. The market prices used to determine fair value reflect management's best estimate considering time, volatility and historical trends. However, future market prices will vary from those used in recording energy assets and liabilities at fair value, and it is possible that such variations could be significant.
Market prices for energy and energy-related commodities vary based upon a number of factors. Changes in market prices will affect the recorded fair value of energy contracts. Changes in the fair value of energy contracts will affect operating income in the period of the change for contracts under fair value accounting and OCI in the period of change for contracts under cash flow hedge accounting, while changes in forward market prices related to contracts under accrual accounting will affect operating income in future periods to the extent those prices are realized. Strategic Energy cannot predict whether, or to what extent, the factors affecting market prices may change, but those changes could be material and could be either favorable or unfavorable.