Using Physical Commodity Contracts to Avoid Earnings Volatility

Abstract

FASB Statement 133 provides a strong incentive for corporate risk managers to use physical commodity contracts in place of financial derivatives to manage commodity price risk. Under the new standard, by structuring the physical commodity contract so that it qualifies for the normal-purchase-and-sale exception, a company can effectively hedge its price risk and avoid earnings volatility without having to qualify for hedge accounting and comply with all of the other burdensome requirements of FAS 133—effectiveness testing, for example. The normal-purchase-and-sale exception offers significant flexibility for structuring these contracts to retain the financial benefits, but not the accounting and regulatory burdens, of using financial derivatives.