10—FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

Fair Value Measurements

Presented below are the fair values of the Company’s derivatives as of May 31, 2013 and August 31, 2012:


As of May 31, 2013	(Level 1)			(Level 2)		(Level 3)		Total
	(in thousands)
Current assets (Other Current Assets):
Commodity derivatives ⁽¹⁾	$	(636	)	$	—	$	—	$	(636	)

(1)	On the condensed consolidated balance sheet, 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 $1.2 million at May 31, 2013.


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 condensed consolidated balance sheet, 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.

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 data by correlation or other means.

•

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

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 reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

The Company has two non-interest bearing loans from the State of Iowa. The carrying value of the debt at May 31, 2013 was $1.3 million and the fair value of the debt was estimated to be $1.2 million. See Note 5. The fair values of these loans were calculated utilizing Level 2 inputs to a discounted cash flow model. The most significant input is the discount rate which was determined by comparing yields on corporate debentures for debt issuers with financial characteristics similar to Penford’s non-interest bearing loans.

Commodity Contracts

The Company uses forward contracts and readily marketable exchange-traded futures on corn and natural gas to manage the price risk of these inputs to its manufacturing process. The Company also uses futures contracts to manage the variability of the cash flows from the forecasted sales of ethanol. The Company has designated the derivative instruments on corn and the forecasted sales of ethanol as hedges.

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, future 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. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. Penford also uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts. Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred loss, net of tax, recorded in other comprehensive income at May 31, 2013 that is expected to be reclassified into income within 12 months is $0.6 million.

As of May 31, 2013, Penford had purchased corn positions of 7.4 million bushels, of which 1.8 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 5.6 million bushels.

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. In September 2011, the Company discontinued hedge accounting treatment for natural gas futures as the hedging relationship no longer met the requirements for hedge accounting. Gains and losses on natural gas futures contracts are recognized in current earnings in cost of sales.

As of May 31, 2013, the Company had the following outstanding futures contracts:


Corn Futures	4,465,000	Bushels
Natural Gas Futures	420,000	mmbtu (millions of British thermal units)
Ethanol Futures	3,780,000	Gallons

The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of May 31, 2013 and August 31, 2012.


	Assets					Liabilities
In thousands		Fair Value					Fair Value
	Balance Sheet Location	May 31 2013		Aug 31 2012		Balance Sheet Location	May 31 2013		Aug 31 2012
Derivatives designated as hedging instruments:

Cash Flow Hedges:
Corn Futures	Other Current Assets	$	50	$	12	Other Current Assets	$	323	$	126
Ethanol Futures	Other Current Assets		—		—	Other Current Assets		567		706

Fair Value Hedges:
Corn Futures	Other Current Assets		125		—	Other Current Assets		—		602

Derivatives not designated as hedging instruments:
Natural Gas Futures	Other Current Assets		56		—	Other Current Assets		—		—
Natural Gas Options	Other Current Assets		23		—	Other Current Assets		—		—

		$	254	$	12		$	890	$	1,434

The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the three- and nine- month periods ended May 31, 2013 and 2012.


In thousands	Amount of Gain (Loss) Recognized in OCI						Amount of Gain (Loss) Reclassified from AOCI into Income						Amount of Gain (Loss) Recognized in Income
	3 Months Ended May 31						3 Months Ended May 31						3 Months Ended May 31
	2013			2012			2013			2012			2013			2012
Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures ⁽¹⁾	$	530		$	(1,075	)	$	596		$	91		$	(474	)	$	(138	)
Natural Gas Futures ⁽¹⁾		—			—			—			(37	)		—			—
Ethanol Futures ⁽¹⁾		(557	)		—			(355	)		(18	)		—			—

	$	(27	)	$	(1,075	)	$	241		$	36		$	(474	)	$	(138	)

Fair Value Hedges:
Corn Futures ^(1) (2)													$	143		$	(21	)

Derivatives not designated as hedging instruments:
Natural Gas Futures ⁽¹⁾													$	294		$	(34	)
FX Contracts ⁽¹⁾														—			(3	)
Natural Gas Options ⁽¹⁾														(20	)		—
Soybean Meal Futures ⁽¹⁾														—			(14	)

													$	274		$	(51	)

(1)	Gains and losses reported in cost of sales

(2)	Hedged items are firm commitments and inventory


In thousands	Amount of Gain (Loss) Recognized in OCI						Amount of Gain (Loss) Reclassified from AOCI into Income						Amount of Gain (Loss) Recognized in Income
	9 Months Ended May 31						9 Months Ended May 31						9 Months Ended May 31
	2013			2012			2013			2012			2013			2012
Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures ⁽¹⁾	$	(43	)	$	(1,825	)	$	4,087		$	2,035		$	(589	)	$	(317	)
Natural Gas Futures ⁽¹⁾		—			(41	)		—			(531	)		—			—
Ethanol Futures ⁽¹⁾		429			1,150			(71	)		39			(11	)		—

	$	386		$	(716	)	$	4,016		$	1,543		$	(600	)	$	(317	)

Fair Value Hedges:
Corn Futures ^(1) (2)													$	127		$	89

Derivatives not designated as hedging instruments:
Natural Gas Futures ⁽¹⁾													$	(16	)	$	(1,082	)
FX Contracts ⁽¹⁾														—			6
Natural Gas Options ⁽¹⁾														(20	)		12
Soybean Meal Futures ⁽¹⁾														—			(14	)

													$	(36	)	$	(1,078	)

(1)	Gains and losses reported in cost of sales

(2)	Hedged items are firm commitments and inventory