Transcript Accounting For Leases NARUC Staff Subcommittee on Accounting and Finance Spring 2008 Conference Michael (Casey) Herman, Partner Mia DeMontigny, Senior Manager PwC.

Accounting For Leases
NARUC Staff Subcommittee on Accounting and Finance
Spring 2008 Conference
Michael (Casey) Herman, Partner
Mia DeMontigny, Senior Manager
PwC
Agenda/Contents
Overview
Identifying a lease
Classification of leases
Regulatory accounting
Sale-leaseback transactions
Lease considerations in construction
Standard-setting activities
Accounting For Leases
Overview
The application of lease accounting to contracts has become and
continues to be more common as a result of EITF 01-8 and
related long-term procurement programs
• EITF 01-8 model is based on the right to use property, plant
and equipment and not the form of the arrangement (i.e., the
contract does not need to be called a “lease” to be a lease)
• Often, purchase arrangements that would be accounted for as
executory contracts prior to the issuance of EITF 01-8 will be
accounted for as leases today
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March 31, 2008
Slide 3
Accounting For Leases
Accounting for power purchase agreements
Is the contract a
lease
(EITF 01-08)?
No
Is the contract a
variable interest
(FIN 46R)?
Yes
Yes
No
Yes
Determine if the
contract is a
capital or
operating lease
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Is the entity the
primary
beneficiary?
Consider FAS
133
(including
embedded
derivatives)
Consolidate
Disclose
Today we will focus on lease determination
and issues only
March 31, 2008
Slide 4
Accounting For Leases
Is the contract a lease?
Is the contract a lease?
The contract is a lease if:
• The contract is dependent on a
particular plant (may be explicit or
implicit), and
• The buyer has the right to control the
plant through any of the following:
– Ability to operate the plant while
obtaining more than a minor amount
of the output, or
– Ability to control physical access
while obtaining more than a minor
amount of the output, or
– Remote that another purchaser will
take more than 10% of output
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What does this mean?
• A contract for more than 90% of the
output of a plant will be a lease
• A contract for less than 90% of the
output could be a lease if it is
remote that another purchaser will
take any output
March 31, 2008
Slide 5
Accounting For Leases
What type of lease is it (lessee)?
What type of lease is it?
• The contract is a capital lease if:
– The purchaser has a bargain purchase
option or title is transferred at the end
of the lease
– Lease term is more than 75% of the
estimated economic life
– Present value of minimum lease
payments >= 90% of the fair value of
the leased property
• The contract is an operating lease if:
– The property is in the last 25% of its
useful life (unless there is a bargain
purchase option or title transfer)
– If is not a capital lease
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What does this mean?
• A short-term contract (< 5 years) will
often be classified as an operating lease
• A lease of old equipment (in the last
25% of its economic life) will also
generally be classified as an operating
lease
• A long-term purchase power agreement
(> 20 years) will typically be a capital
lease
• Additional analysis will be required to
assess medium term contracts
March 31, 2008
Slide 6
Accounting For Leases
What type of lease is it (lessor)?
What type of lease is it?
• Consider FIN 43 and EITF 00-11
• The contract is a sales-type lease only if
title is transferred at the end of the lease
• The contract is a direct financing lease if:
– There is no manufacturer’s or dealer’s
profit; i.e., fair value of the plant at the
inception of the lease = its fair value
– Any of the criteria for a capital lease are
met and both:
• Collectibility of minimum lease
payments is predictable
• No important uncertainties of
costs to be incurred by lessor
• The contract is an operating lease if the
above criteria are not met
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What does this mean?
• Often, a PPA resulting in a lease of the
plant will be an operating lease for the
lessor unless title transfers to the lessee
at the end of the lease
• The analysis should be performed at
lease inception
– Lease inception is the time that the
lease arrangement or written
commitment is signed
• Classification as direct financing is
considered rare: may possibly qualify if
lease inception is at or very shortly after
the construction of the plant
March 31, 2008
Slide 7
Accounting For Leases
Regulatory accounting
• FAS 71 concludes that the regulator cannot affect the
classification of a lease liability on the balance sheet –
classification is governed by FAS 13
- If lease is capital, but treated as operating for ratemaking
purposes, must still reflect the lease asset and lease
obligation on the balance sheet
• However, the income statement expense recognition should
follow recovery pattern (paragraph 42 of FAS 71)
- Amortization of leased asset modified so that total of
interest on lease obligation + amortization of leased asset =
rental expense allowed for ratemaking
- Effectively forces the amortization of the leased asset to
equal the reduction of the obligation / no change in interest
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March 31, 2008
Slide 8
Accounting For Leases
Impact of regulatory treatment
• Generally results in smaller amortization expense in early years as
compared to a non-regulated entity
- Utilities do not usually earn a rate of return on capitalized lease
obligations as would be the case for owned assets in rate base
- However, capitalized lease assets may have an impact on cost of
capital (borrowing rate) due to the lease obligation
• Difference between GAAP lease expense and ratemaking lease
expense reported as a regulatory asset or liability
- By including lease payments as an allowable expense, the
regulator sets rates that result in recovery of approximately the
combined amount of the capitalized lease asset and interest on
the obligation over the lease term
- Results in reasonable assurance of an asset (paragraph 9 of
FAS 71)
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March 31, 2008
Slide 9
Accounting For Leases
Example: lease expense recognition patterns for a utility under
FAS 13 and FAS 71
FAS 13
A utility leases an asset
costing $1,000 for a
term of ten years, which
is also the asset’s
useful life
• The interest rate
implicit in the lease
is 12%
• Rate recovery
occurs as rental
payments are made
Year
1
$100
Interest
exp.
$120
2
100
108
208
58
108
166
3
100
96
196
70
96
166
4
100
84
184
82
84
166
5
100
72
172
94
72
166
6
100
60
160
106
60
166
7
100
48
148
118
48
166
8
100
36
136
130
36
166
9
100
24
124
142
24
166
10
100
12
112
154
12
166
$1,000
$ 660
$1,660
$1,000
$ 660
$1,660
Total
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Depreciation
FAS 71
Total
Depreciation Interest
exp.
$ 220
$46
$120
Total
$166
March 31, 2008
Slide 10
Accounting For Leases
Sale-leaseback transactions: utility plant
• Sale of property and a lease of all or part of the property, for all or
part of the property’s remaining economic life, back to the seller
• Sale-leaseback transactions continue to be seen in the industry
- Method to raise capital – e.g. sale later in the plant’s life
- Utility/lessee may seek to do a sale-leaseback on a major capital
addition to ease “rate shock” to its customers
- Buyer/lessor receives tax benefits of the major plant
• Seller/lessee objective usually to record a sale and operating lease
- Lowers burden on balance sheet
- Recognition of profit on sale
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March 31, 2008
Slide 11
Accounting For Leases
Sale-leaseback transactions
• Sale-leaseback transactions are primarily governed by FAS 98
• Accounted for as follows:
- Purchaser-lessor: as a purchase of the asset and
classification of the lease in accordance with FAS 13
- Seller-lessee: as a sale (if sale criteria are met), removal of
property and related liabilities from the balance sheet, and
classification of the lease in accordance with FAS 13
• If sale criteria are not met for real estate, including
integral equipment, then as a borrowing or deposit
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March 31, 2008
Slide 12
Accounting For Leases
Sale-leaseback transactions: utility plant
• There are many considerations when determining whether sale
accounting involving real estate (including “integral equipment”) can
be accomplished, and it can be very difficult to achieve under FAS
98
- Key issue is usually lack of transfer of risks and rewards, and
continuing involvement on the part of the seller-lessee
- E.g., nuclear facilities would not qualify if the seller-lessee
responsible for decommissioning
• Guidance outlining types of continuing involvement can be found in:
- FAS 98, paragraphs 11-13
- FAS 66, paragraphs 25-39 and 41-43
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March 31, 2008
Slide 13
Accounting For Leases
Sale-leaseback transactions: continuing involvement
Examples of provisions prohibiting sale accounting under FAS 98
• Obligation or option to repurchase the property, including contingent puts
• Seller-lessee guarantee of the buyer-lessor’s investment or a return on that
investment
• Requirement at the end of the lease to pay the buyer-lessor for a decline in
the fair value of the property below estimated residual value
• Seller-lessee providing nonrecourse financing to the buyer-lessor (e.g.
accelerated lease payments that are not justified by estimated increases in the
cost of using the leased property)
• Any provision that allows the seller-lessee to participate in any future profits of
the buyer-lessor or appreciation of the leased property
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March 31, 2008
Slide 14
Accounting For Leases
Lease considerations in construction
• Current resurgence in construction bears consideration of potential
issues for lessees
• A lessee could be deemed the owner of a construction project in
certain instances
• Guidance is in EITF 97-10 and issue is whether the lessee has
substantially all of the construction period risks – applies specifically,
but is not limited to “build-to-suit” real estate
• If deemed the owner during construction, effectively a saleleaseback of the asset occurs when the asset is complete and the
lease term begins
- Subject to FAS 98 sale-leaseback considerations previously
discussed
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March 31, 2008
Slide 15
Accounting For Leases
Lease considerations in construction
Generally, there are three scenarios that could cause a lessee to be
deemed the owner of a construction project:
1. Construction commences before lease agreement is executed
2. Lessee exposed to paying 90% or more of the costs of a
construction project – the “maximum guarantee test” of EITF 97-10
• Similar to the “90% test” in paragraph 7d of FAS 13
• If lessee could be required, at any point of time during the
construction period, to pay 90% or more of total project costs
• Test performed only once
3. Lessee assumes qualitative characteristics of construction project
ownership under EITF 97-10
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March 31, 2008
Slide 16
Accounting For Leases
Qualitative characteristics of construction ownership
EITF 97-10 qualitative considerations demonstrating construction
ownership by the lessee
• In-substance equity investment in the lessor-owner (e.g. loan that is in-substance an
investment)
• Direct payments to suppliers for certain costs of the project
• Lessee indemnification of the owner-lessor or its lenders for pre-existing environmental
risks, and risk of loss is more than remote
• Lessee indemnifications or guarantees to any party other than the owner-lessor for
costs arising from third-party damage claims
• Lessee takes title to the real estate at any time during the construction period or
provides certain supplies or other components used in constructing the project
• Lessee owns the land and does not lease it OR leases the land and does not sublease it
to the owner-lessor before construction commences
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March 31, 2008
Slide 17
Accounting For Leases
Leases: standard setting activities
EITF 08-3: Accounting by Lessees for Maintenance Deposits under
Lease Agreements
• Addresses advance nonrefundable deposits made by the lessee to
the lessor that will be reimbursed to the lessee upon completion of
maintenance of a leased asset
• Tentative decision in March 2008 that lessee should treat the
deposit as a receivable; uncollectible amounts would be additional
rent expense
• Cost of maintenance should be expensed or capitalized (according
to the lessee’s accounting policy) when maintenance performed
• Will be effective in fiscal periods beginning after December 15, 2008
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March 31, 2008
Slide 18
Accounting For Leases
Leases: standard setting activities
• EITF 08-2: Revenue Recognition by Lessors on Maintenance
Payments in Lease Arrangements
- Addresses how revenue should be recognized by lessors
that perform maintenance services
- No decision yet
• Joint project by FASB and IASB on lease accounting
- FASB took project on due to concerns that current model
does not result in an accurate reflection of the resources
and obligations resulting from lease transactions
- Project is addressing FAS 13 and IAS 17 and related
amendments and interpretations
- Significant long-term project
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March 31, 2008
Slide 19
Questions?
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