Note 14 — Fair Value Measurements and Derivative Instruments

Fair Value Measurements

Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability (an exit price) in Penford’s principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy was established that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources outside the reporting entity. Unobservable inputs are inputs that reflect Penford’s own assumptions based on market data and on assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The three levels of inputs that may be used to measure fair value are:

•

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

•

Level 2 inputs are other than quoted prices included within Level 1 that are observable for assets and liabilities such as (1) quoted prices for similar assets or liabilities in active markets, (2) quoted prices for identical or similar assets or liabilities in markets that are not active, or (3) inputs that are derived principally or corroborated by observable market date by correlation or other means.

•

Level 3 inputs are unobservable inputs to the valuation methodology for the assets or liabilities.

Presented below are the fair values of the Company’s derivatives as of August 31, 2012 and 2011:


As of August 31, 2012	(Level 1)			(Level 2)		(Level 3)		Total
	(in thousands)
Current assets (Other Current Assets):
Commodity derivatives ⁽¹⁾	$	(1,422	)	$	—	$	—	$	(1,422	)

(1)	On the consolidated balance sheets, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $2.6 million at August 31, 2012.


As of August 31, 2011	(Level 1)			(Level 2)		(Level 3)		Total
	(in thousands)
Current assets (Other Current Assets):
Commodity derivatives ⁽¹⁾	$	(3,153	)	$	—	$	—	$	(3,153	)

(1)	On the consolidated balance sheets, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $5.1 million at August 31, 2011.

Other Financial Instruments

The carrying value of cash and cash equivalents, receivables and payables approximates fair value because of their short maturities. The Company’s bank debt interest rate reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

In fiscal 2010, the Company received two non-interest bearing loans from the State of Iowa. The carrying value of the debt at August 31, 2012 was $1.4 million and the fair value of the debt was estimated to be $1.2 million. See Note 7.

Interest Rate Contracts

The Company used interest rate swaps to manage the variability of interest payments associated with its floating-rate debt obligations. The interest payable on the debt effectively became fixed at a certain rate and reduced the impact of future interest rate changes on future interest expense. Unrealized gains and losses on interest rate swaps were included in accumulated other comprehensive income. The periodic settlements on the swaps were recorded as interest expense. At August 31, 2012 and 2011, the Company had no outstanding interest rate swaps and no gains or losses remaining in other comprehensive income (loss). See Note 15.

Commodity Contracts

For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting gain or loss on the hedged firm commitments and/or inventory are recognized in current earnings as a component of cost of sales. For derivative instruments designated as cash flow hedges, the effective portion of the gain or loss on the derivative instruments is reported as a component of other comprehensive income (loss), net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of sales in the period when the finished goods produced from the hedged item are sold. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, then the changes in fair value would be recognized in current earnings as a component of cost of goods sold.

To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford uses readily marketable exchange-traded futures as well as forward cash corn purchases. Penford also uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges.

Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures contracts to hedge exposure to natural gas price fluctuations. These futures contracts were designated as hedges prior to fiscal 2012. In September 2011, the Company discontinued hedge accounting treatment for natural gas futures contracts as the hedging relationship no longer met the requirements for hedge accounting. Through August 31, 2011, the gains and losses on natural gas futures contracts were deferred in accumulated other comprehensive income. At the time hedge accounting was discontinued, $0.5 million of pretax losses continued to be deferred in accumulated other comprehensive income for these natural gas futures contracts. These losses were reclassified to cost of sales during fiscal 2012 as the originally forecasted cash flows occurred. Gains and losses on natural gas futures contracts since August 31, 2011 have been recognized in cost of sales in the Consolidated Statement of Operations.

Selling prices for ethanol fluctuate based on the availability and price of manufacturing inputs and the status of various government regulations and tax incentives. To reduce the risk of the price variability of ethanol, Penford enters into exchange-traded futures contracts to hedge exposure to ethanol price fluctuations. These futures contracts have been designated as hedges.

Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred gain (loss), net of tax, recorded in other comprehensive income at August 31, 2012 that is expected to be reclassified into income within 12 months is $1.6 million.

As of August 31, 2012, Penford had purchased corn positions of 6.5 million bushels, of which 3.7 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 2.8 million bushels.

As of August 31, 2012, the Company had the following outstanding futures contracts:


Corn Futures	3,050,000	Bushels
Ethanol Swaps	3,625,000	Gallons

The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of August 31, 2012 and 2011.


	Assets					Liabilities
		Fair Value August 31					Fair Value August 31
In thousands	Balance Sheet Location	2012		2011		Balance Sheet Location	2012		2011

Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures	Other Current Assets	$	12	$	137	Other Current Assets	$	126	$	—
Natural Gas Futures	Other Current Assets		—		—	Other Current Assets		—		454
Ethanol Futures	Other Current Assets		—		—	Other Current Assets		706		1,289
Fair Value Hedges:
Corn Futures	Other Current Assets		—		—	Other Current Assets		602		1,547

		$	12	$	137		$	1,434	$	3,290

The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the fiscal years ended August 31, 2012, 2011 and 2010.


	Amount of Gain (Loss) Recognized in OCI								Amount of Gain (Loss) Reclassified from AOCI into Income									Amount of Gain (Loss) Recognized in Income
	Year Ended August 31								Year Ended August 31									Year Ended August 31
In thousands	2012		2011			2010			2012			2011			2010			2012			2011			2010
Derivatives designated as hedging instruments:

Cash Flow Hedges:
Corn Futures ⁽¹⁾	$	2,067	$	(4,949	)	$	384		$	1,500		$	(7,418	)	$	349		$	36		$	(162	)	$	(194	)
Natural Gas Futures ⁽¹⁾		—		(579	)		(3,170	)		(492	)		(1,332	)		(2,168	)		—			(85	)		—
Ethanol Futures ⁽¹⁾		1,667		(4,180	)		(590	)		1,263			(3,075	)		(493	)		—			—			—
Interest Rate Contracts ⁽³⁾ ⁽⁴⁾		—		—			(395	)		—			—			(662	)		—			—			(1,562	)
FX Contracts ⁽¹⁾		—		—			—			—			—			(26	)		—			—			—

	$	3,734	$	(9,708	)	$	(3,771	)	$	2,271		$	(11,825	)	$	(3,000	)	$	36		$	(247	)	$	(1,756	)

Fair Value Hedges:
Corn Futures ^(1) (2)																		$	98		$	28			85

Derivatives not designated as hedging instruments:

Natural Gas Futures ⁽¹⁾																		$	(1,082	)	$	—		$	—
FX Contracts ⁽¹⁾																			6			—			—
Soybean Oil Futures ⁽¹⁾																			12			—			—
Soybean Meal Futures ⁽¹⁾																			(14	)		—			—

																		$	(1,078	)	$	—		$	—

(1)	Gains and losses reported in cost of goods sold

(2)	Hedged items are firm commitments and inventory

(3)	Gains and losses reported in interest expense

(4)	Amount of loss recognized in income was reported in non-operating income (expense)