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Once a reporting entity determines that an arrangement contains a lease and it identifies and allocates the consideration between lease and nonlease elements, it needs to assess the appropriate lease classification. This section focuses on key considerations for classification of a lease by both the lessee and the lessor.

2.5.1 Lease characteristics affecting classification

Prior to determining lease classification, there are certain key characteristics of a lease arrangement that need to be considered by both the lessee and lessor. The key inputs into the classification analysis are:
•  Lease inception
The lease inception date is the date that should be used when evaluating information (e.g., discount rate for purposes of calculating the present value of minimum lease payments, the fair value of the property) necessary to determine lease classification.
•  Integral equipment
Power purchase agreements often involve a lease of integral equipment. Whether a lease involves integral equipment will impact lease classification for the lessor and potentially for the lessee.
•  Construction of assets to be leased (often referred to as build-to-suit arrangements)
These arrangements involve the tailoring and construction of a facility to meet the off-taker’s needs. A lessee that has involvement during the construction period may be deemed to be the owner of the facility during construction. In such cases, the lessee would need to capitalize the asset, including amounts funded by the lessor. Once construction is completed, the arrangement would be evaluated as a sale-leaseback transaction.
Each of these characteristics is further discussed in this section.

2.5.1.1 Lease inception

Identifying the lease inception date is important because it is on that date the lease classification is determined. The lease inception date is also the date on which the value of the lease asset and obligation are calculated. Lease inception is defined in ASC 840.

Definition from ASC 840-10-20

Lease Inception: The date of the lease agreement or commitment, if earlier. For purposes of this definition, a commitment shall be in writing, signed by the parties in interest to the transaction, and shall specifically set forth the principal provisions of the transaction. If any of the principal provisions are yet to be negotiated, such a preliminary agreement or commitment does not qualify for purposes of this definition.

Determining the lease inception date may be straightforward and will often coincide with the signing of the lease. However, many power purchase agreements that contain a lease have provisions requiring regulatory or other approvals or may involve contingencies because the referenced plant has not yet achieved commercial operation. These factors can make it difficult to determine the lease inception date.
In determining the lease inception date, it is necessary to consider whether there are any significant uncertainties surrounding operational, pricing, or other specific provisions that are likely to cause the parties to modify the agreement, and whether cancellation of the contract is permitted without further obligation. For example, if the contract is subject to approval by the regulator, which may result in changes to pricing or other significant terms, and the parties can choose to cancel the contract without further obligation, the lease inception date will not occur until all terms are finalized and the necessary approvals are received.
In addition, penalty payments (e.g., liquidating damages) or events of default triggered by a failure to achieve the commercial operation date (COD) should be considered in evaluating the date at which all of the principal provisions are negotiated.
Application example—lease inception date
Simplified Example 2-13 provides an illustration of determining the lease inception date.
EXAMPLE 2-13
Determination of the lease inception date
Ivy Power Producers is commencing construction of the Camellia Generating Station, a 575 MW natural gas-fired power plant. On January 1, 20X2, IPP signs a 30-year power purchase agreement with Rosemary Electric & Gas Company. The contract specifies a commercial operation date of January 1, 20X5, at which time payments under the contract will commence. All key provisions (e.g., operating protocols, pricing, and timing) are specified in the agreement, including a stipulation that if REG’s regulator does not approve the contract for recovery in rates, it may be cancelled by either party without penalty. REG has evaluated the arrangement and concluded that it contains a lease.
Analysis
The regulatory approval process is not perfunctory and could result in a requirement for the parties to renegotiate the terms. This approval is a significant contingency that would need to be resolved before establishing a lease inception date. As a result, the lease inception date is not established until approval is obtained. If regulatory approval occurs on June 1, 20X3, for example, the lease inception date would be that date. This is the date the parties would use for performing all necessary evaluations and calculations to determine lease classification.

2.5.1.2 Integral equipment

Whether the leased asset is equipment or real estate (including integral equipment) can affect lease classification for the lessor. Depending on the type of facility, a lease arising out of a power purchase agreement often involves integral equipment. Integral equipment is defined in the Codification.

Definition from Master Glossary

Integral Equipment: Integral equipment is any physical structure or equipment attached to the real estate that cannot be removed and used separately without incurring significant cost.

In addition, ASC 360, Property, Plant, and Equipment (ASC 360), provides guidance that integral equipment should be considered real estate for purposes of evaluating sales of real estate. Most power plants meet the definition of integral equipment because they are attached to real estate (land or potentially buildings) and are generally costly to remove due to their size and nature. Further judgment may be needed when considering nontraditional power plant assets, such as rooftop solar panels or fuel cells. In such cases, in assessing whether an asset is integral equipment, a reporting entity should evaluate whether the costs to remove the asset(s) from the land or buildings would be significant.
The evaluation of significant cost includes consideration of the cost of removal and the cost to repair any damage to the asset resulting from its removal. In addition, the cost includes any decrease in value of the asset as a result of the removal. Guidance on determining the decrease in value is provided in ASC 360-20-15-5.

Excerpt from ASC 360-20-15-5

At a minimum, the decrease in the value of the equipment as a result of its removal is the estimated cost to ship and reinstall the equipment at a new site.

ASC 360-20-15-7 provides guidance on determining whether the cost to remove the asset is significant.

ASC 360-20-15-7

When the combined total of both the cost to remove plus the decrease in value (for leasing transactions, the information used to estimate those costs and the decrease in value shall be as of lease inception) exceeds 10 percent of the fair value of the equipment (installed) (for leasing transactions, at lease inception), the equipment is integral equipment.

Any conclusions about whether the leased asset is integral equipment should be revisited by the reporting entity at the date of any future renewal or extension of a lease. Although an asset may not be considered integral equipment at lease inception, it may become integral equipment with the passage of time and would need to be reassessed at a renewal or extension date.
In addition to power plants, the concept of integral equipment also applies to other capital assets, such as transmission towers and natural gas pipelines. Whether a lease contains integral equipment is important for a lessor’s evaluation of lease classification (see UP 2.5.3). Lessees of integral equipment may also be affected if the lease involves land and a building or a sale-leaseback transaction. See ARM 4650.4 for further information.

2.5.1.3 Build-to-suit arrangements

It is common for utilities and power companies to enter into power purchase agreements that contain a lease, prior to construction of the identified plant. In such arrangements, the project owner builds and configures the power plant based on the customer’s specific requirements. Such arrangements are known as “build-to-suit” arrangements. However, all lease arrangements involving construction of the asset subject to lease need to be carefully considered by the lessee. Depending on the facts and circumstances, a reporting entity/lessee could potentially be deemed to be the owner of an asset if it has the option or obligation to lease the asset following its construction. That may be the case if the reporting entity has substantially all the construction period risks.

ASC 840-40-15-5

A lessee shall be considered the owner of an asset during the construction period, and thus subject to this Subtopic, if the lessee has substantially all of the construction period risks—effectively a sale and leaseback of the asset occurs when construction of the asset is complete and the lease term begins (see the implementation guidance beginning in paragraph 840-40-55-2).

There are potentially significant financial statement impacts for the lessee if it is deemed to be the owner during construction of the power plant. Specifically, if the lessee is deemed to be the owner during construction, it should capitalize the construction costs and record a liability (whether construction is financed by the lessor or lessee). The lessee would also record ground lease rentals, assuming it does not own the land on which the power plant is being constructed. Once construction is complete and the lease commences, the arrangement would need to be evaluated as a sale and leaseback of real estate. Derecognition of the real estate would be permitted only when all prohibited continuing involvement has ceased. Given that the criteria for evaluating build-to-suit arrangements are complicated, reporting entities should carefully evaluate all leases involving assets to be constructed.
See ARM 4650.25 for information on evaluating whether the build-to-suit guidance is applicable.

2.5.2 Considerations for lessees

ASC 840-10-25-1 sets out four primary criteria to evaluate for classifying lease arrangements. Additional interpretative guidance also may be applicable when evaluating these criteria. If a lessee determines that any one of the following four criteria is met at lease inception, it will record a capital lease:
•  Ownership of the asset under lease is transferred to the lessee by the end of the lease term.
•  The lease contains a bargain purchase option.
•  The lease term is at least 75 percent of the property’s estimated economic life (the “75 percent test”).
•  The present value of the minimum lease payments at the beginning of the lease term is at least 90 percent or more of the fair value of the leased property (the “90 percent test”).
The 75 percent test and 90 percent test are not evaluated if the commencement of the lease term falls within the last 25 percent of the total estimated economic life of the leased asset.
Evaluating the classification of a lease contained in a power purchase agreement can be challenging. Determining whether ownership of the plant transfers to the purchaser (lessee) by the end of the lease term or whether there is a bargain purchase option is generally straightforward (see ARM 4650.1231 for further information on these tests, including discussion of purchase option pricing and economic penalties). However, power purchase agreements often contain terms that can make evaluating the 75 and 90 percent tests complex, as further discussed in the following sections. See UP 2.5.3 for lessor considerations.

2.5.2.1 The “75 percent test”

The 75 percent test considers the length of the lease as compared with the estimated economic life of the asset.

ASC 840-10-25-1(c)

 Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

In evaluating a lease of a power facility, typically, the key judgment in performing the 75 percent test is the determination of the estimated economic life of the asset, which is discussed in this section. See ARM 4650.1241 for further information in general on performing the 75 percent test.
Estimated economic life of the asset
Application of the 75 percent test in practice for a power purchase agreement may be challenging because of the subjective nature of “estimated economic life.”

Definition from ASC 840-10-20

 Estimated Economic Life: The estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at lease inception, without limitation by the lease term.

The definition indicates that the period of economic use relates only to use for the purpose for which the property was intended at the inception of the lease. Furthermore, it is to be determined without limitation by the lease term. The estimated economic life of a leased asset is determined at the lease inception date based on known conditions. Therefore, a lease’s classification is not reevaluated if the economic life later changes (e.g., due to an impairment resulting from an impending shut down or an updated engineering study). However, any changes in the economic life may change the lease classification conclusion if a lease is later required to be reassessed for a modification.
In general, the intended use of a power plant does not change over the course of its life; therefore, there is limited interpretation on that aspect of the definition. Nonetheless, reporting entities should carefully consider the reasonableness of their estimation of the economic life of the power plant. Historically, reporting entities have used industry standard economic lives for assets such as coal, oil, and natural gas plants based on experience with the actual useful life of the assets. However, there is less historical experience for newer technologies, such as wind turbines and solar panels, which will require greater reliance on engineering estimates.
When determining the estimated economic life of a power plant, the depreciable life should also be considered. Depreciation is the allocation of cost over the estimated useful life of an asset. The useful life and economic life of a power plant are considered similar and therefore depreciable lives, which are based on useful lives, may be a sound basis on which to estimate economic lives for comparable assets. Accordingly, estimated economic lives established for the application of the guidance in ASC 840 generally should be consistent with asset lives established for depreciation purposes. In addition, other factors, such as turbine manufacturer warranties, major maintenance schedules, and asset retirement obligations, should be considered in the analysis to ensure consistent conclusions are being reached.
Question 2-22
What are the common useful lives for power plant assets?
PwC response
There is no one-size-fits-all useful life for power plants. The life will depend on many factors, including the type of plant, the specific technology used, historical and projected plant run profiles, and specific capital expenditure and maintenance programs. For example, there are many coal and natural gas power plants operating in the United States that are greater than 50 years old, while many hydro power plants are 100+ years old. Natural gas-fired plants are typically assumed to have a 30- to 40-year life. Alternatively, renewable and clean energy sources, due to their reliance on more recent technology, tend to have somewhat shorter estimated useful lives. For example, solar facilities may be estimated to last 25 to 30 years; however, they may require replacement earlier depending on the type of system and technology. Similarly, the estimated useful lives of wind facilities tend to be 25 to 30 years, but the actual life depends on a number of variables, including wind speed and variability in usage.
When estimating the useful life of power plants, it is also common practice to consider the “load” at which the plant normally operates. Base load plants, which run continuously, may have longer lives due to less variability in usage. Conversely, peaking plants are required to be ramped up quickly to meet short-term demands, often resulting in shorter lives due to intermittent use causing more stress and wear. However, all facts and circumstances need to be evaluated, including historical and projected market conditions, and there should be close coordination with the reporting entity’s plant engineers and consideration of the depreciable life.

2.5.2.2 The “90 percent test”

The 90 percent test considers the present value of the future minimum lease payments as compared with the fair value of the plant at lease inception.

ASC 840-10-25-1(d)

Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

Key considerations in performing the 90 percent test when evaluating leases of power plants include the impact (1) of contingent rentals on minimum lease payments and (2) on the fair value of the property at inception of the lease of any power plant-related government incentives received. These concepts are discussed in this section. See ARM 4650.1242 for further information in general in performing the 90 percent test.
Question 2-23
How do default provisions included in a power purchase agreement impact the calculation of minimum lease payments?
PwC response
It depends. Lease arrangements may include default covenants that are unrelated to the lessee’s use of the property (for example, the plant off-taker may be required to maintain certain financial ratios as a condition of the arrangement). The lessee may be required to pay default penalties in the event of noncompliance with these provisions. As a result, a question arises as to whether potential amounts to be paid in the event of noncompliance should be included in the minimum lease payments for purposes of determining lease classification.
The guidance on default covenants is included in ASC 840-10-25-14, which indicates that lease classification is not affected if all of the following conditions exist:
•  The default covenant provision is customary
•  The occurrence of the event of default is objectively determinable
•  There are predefined criteria related only to the lessee to be used to determine whether there is an event of default
•  It is reasonable to assume that default will not occur based on facts and circumstances existing at lease inception
However, if any of these conditions are not met, then the minimum lease payments used for purposes of lease classification should include the maximum amount that the lessee could be required to pay. The evaluation of these conditions requires judgment; see ARM 4650.1242 for further information.
Minimum lease payments—contingent rent
Minimum lease payments represent amounts that the lessee will pay, or could be required to pay, in connection with the leased asset. However, certain payments that are contingent on future use of the asset are not included in minimum lease payments, as described in ASC 840-10-25-4.

Excerpt from ASC 840-10-25-4

Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety.

Contingent rentals are future lease payments that are based on factors, trigger events, or specified targets (e.g., production, sales, or some other variable including changes in the consumer price index) that are outside the control of the lessor. The concept of contingent rentals contemplates that the lessor does not have the ability to effectively control the amount of rentals that it can require the lessee to pay in the future, and, as such, contingent rentals do not represent a present obligation for the lessee to make payments in connection with the leased property. Contingent rentals are defined in ASC 840.

Definition from ASC 840-10-20

Contingent Rentals: The increases or decreases in lease payments that result from changes occurring after lease inception in the factors (other than the passage of time) on which lease payments are based, excluding any escalation of minimum lease payments relating to increases in construction or acquisition cost of the leased property or for increases in some measure of cost or value during the construction or pre-construction period. The term contingent rentals contemplates an uncertainty about future changes in the factors on which lease payments are based.

In some cases, a power purchase agreement is structured such that the off-taker is responsible for dispatch; it will pay a fixed capacity charge and a separate charge for any energy delivered. In those circumstances, unless the contract specifies a minimum amount, all of the payments based on energy would be contingent because the lessor cannot require the off-taker to take any amounts.
The evaluation of contingent rentals becomes more complex in assessing must-take arrangements where the lessee is required to take any power produced from the facility as discussed in Questions 2-24 and 2-25.
Power purchase agreements that contain a lease, but include only contingent payments, generally result in operating lease classification because there are no minimum lease payments required (assuming the other criteria for capital lease classification are not met). When accounting for a power purchase agreement as an operating lease, contingent rental expense should be measured and recognized at the time the payments become probable, as required by ASC 840-10-25-35. If an arrangement meets the criteria for capital lease classification (e.g., because the lease term is greater than 75 percent of the asset’s economic useful life), but all lease payments are contingent, there would be no obligation or related asset to recognize as there are no minimum lease payments. In these circumstances, it may be appropriate to classify the payments made by the lessee as an operating expense. Recording the payments as interest expense may not be appropriate because of a lack of a financing obligation recorded on the balance sheet. Presentation as an operating expense would only be appropriate for capital lease arrangements that have no minimum lease payments. See ARM 4650.1242 for further information on contingent rents.
Question 2-24
Does a minimum performance guarantee in a must-take power arrangement that contains a lease result in some level of minimum lease payments?
PwC response
It depends. In general, if an arrangement requires the off-taker to take all of the output, and provides penalties for failure by the lessor to achieve a certain minimum production level, there is likely some level of minimum lease payments
ASC 840-10-25-5 discusses the definition of minimum lease payments from the perspective of the lessee.

Excerpt from ASC 840-10-25-5

For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
a.  Contingent rentals
b.  Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property.

Contingent rentals include amounts that are outside the control of both parties to a contract (e.g., future inflation rates) or that are solely in the lessee’s control (e.g., lessee has the ability to dispatch a facility). Because of the associated uncertainty, these amounts do not represent amounts that a lessee “is obligated to make or can be required to make.” In contrast, if the operations and dispatch of a facility are controlled by the lessor and the contract requires the lessee to take all of the power produced, and the fuel source is also within the control of the lessor (e.g., a natural gas plant or a coal plant), the lessor effectively controls whether the lessee will be required to make certain payments. Although the payments are based on future production from the facility, the level of production is in the control of the lessor and, thus, these amounts are not consistent with the definition of contingent rentals. Therefore, we generally expect that the amounts up to the guaranteed level of production should be used in the determination of minimum lease payments, except as discussed below with respect to certain renewable facilities.
Some renewable facilities are subject to production variability associated with a fuel source that is outside the control of the parties to the agreement (e.g., wind, solar). As a result, the output levels are inherently uncertain because production is dependent on weather or geological conditions. In such cases, the lessor cannot ultimately control whether the lessee will be required to make certain payments (as the facility’s operation depends on outside factors). Recognizing this inherent uncertainty, we believe that all production-based payments should be treated as contingent if the fuel source is outside the control of the parties to the arrangement. This would apply even if the lessor has provided a minimum production or performance guarantee.
In applying this view, reporting entities should assess the level of assurance and control associated with the fuel source. For example, wind, solar, and hydro facilities are dependent on a fuel that is wholly outside the control of the parties to the contract. In contrast, methane or geothermal facilities may be more similar to fossil fuel plants. Reporting entities should consider their specific facts and circumstances in determining the appropriate accounting. Furthermore, the interpretation of minimum lease payments should be disclosed, if material, and should be applied on a consistent basis (to instances of reasonably similar facts and circumstances).
Question 2-25
In a must-take power purchase agreement, is there always at least some expected amount of output that is “virtually assured” that should be considered a minimum lease payment?
PwC response
It depends. Arguably, if the facility relies on a fuel source that is within the control of one of the parties to the arrangement, there is likely to be some portion of production that is virtually assured. As discussed in our response to Question 2-24, we believe amounts up to any guaranteed level of production should be used in the determination of minimum lease payments. However, in assessing arrangements without minimum performance guarantees, there are different views on whether there is a level of production that is not contingent. Some believe that all amounts are contingent because they are dependent on the future operation of a power facility, even though production is within the control of one of the parties to the arrangement. Even if there are engineering and other studies to support a specified level of production, and if the facility has reliably produced at a certain level in the past, there could be variations in the amount or timing of production (e.g., time of year or time of day).
Others hold a view that the facility would not have been constructed without sufficient support for a minimum level of production. The off-taker would not have entered into the agreement without some expectation that output would be produced. Furthermore, parties involved in financing the entity would not have provided support without an expectation of future cash flows. Therefore, supporters of this view believe that there is always a level of production that is virtually assured; they acknowledge that determining the appropriate level requires judgment.
In assessing arrangements involving facilities dependent on a fuel source within the control of one of the parties to the arrangement, we believe that both views have merit when assessing amounts in excess of the guaranteed minimum. Thus, a reporting entity may conclude in such cases that rents related to production above a contractually guaranteed minimum are either all contingent or that there are minimum lease payments. Minimum lease payments based on production above a contractually guaranteed minimum level should be supported with appropriate evidence. For example, payments under a power purchase agreement for a fossil fuel plant may be contingent on future production. Nonetheless, facts and circumstances may suggest that at least a certain amount of power will be produced based on the usage of the plant (e.g., it is a base load plant), historical experience, and the stability of the technology such that it would be reasonable to estimate a corresponding level of minimum lease payments.
However, in evaluating renewable facilities where the fuel source is outside the control of the parties to the arrangement, there is inherent uncertainty about future production. Therefore, in such cases, we believe that all rentals dependent on production from such plants are contingent. See Question 2-24 for further information.
Question 2-26
In a tolling or other arrangement where the lessee has volumetric optionality and there are no minimum performance penalties, can output that is virtually assured be considered a minimum lease payment?
PwC response
No. As discussed in the excerpt from ASC 840-10-25-5 above, minimum lease payments represent the amount that the lessee is required to pay or could be required to pay in connection with the leased asset. In contrast, contingent rentals include amounts that are outside the effective control of both parties to a contract or that are solely in the lessee’s control. In an arrangement where the lessee determines the level of production, all amounts are contingent as the lessee could choose not to dispatch at any point (assuming that there is no minimum guarantee of off-take). This is consistent with the example in ASC 840-10-55-38, which discusses rentals based on future sales from a retail store.
Note that this conclusion differs from the accounting for a must-take arrangement (discussed in the response to Question 2-25) because of the difference in which party has control of the amount of output from the facility. In a must-take arrangement, the lessor can force the lessee to take all of the output produced and thus payments based on production could be considered minimum lease payments under one of the two views described. In a tolling or option contract, the lessor has no control of the amount dispatched and thus all amounts are contingent.
Impact of government incentives on the fair value of the leased asset at inception
The owners of renewable energy plants often obtain government incentives that may include Section 1603 grants, investment tax credits (ITC), or production tax credits (PTC). Section 1603 grants provide grantees with the choice of applying for and receiving a government grant in lieu of investment tax credits. See UP 16 for further information about Section 1603 grants.
Investment tax credits have an impact on the calculation of the fair value of the lease asset for purposes of the 90 percent test, as discussed in ASC 840-10-25-1(d).

Excerpt from ASC 840-10-25-1(d)

The present value at the beginning of the lease term of the minimum lease payments,
. . .equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor.

Therefore, when evaluating lease classification, ASC 840 requires that the fair value of the leased property used as the denominator in calculating the 90 percent test be reduced by investment tax credits retained by the lessor. However, a question arises as to how to consider other forms of tax incentives, in particular Section 1603 government grants, which are similar to ITC.
Question 2-27
Should Section 1603 grants received by the lessor for the plant that is subject to the lease be deducted from the fair value of the plant in performing the 90 percent test?
PwC response
Yes. Section 1603 grants are provided as an alternative to investment tax credits and qualifying parties may elect to receive Section 1603 grants in lieu of ITC on qualifying properties. In such cases, a reporting entity should follow a grant accounting model for either the Section 1603 grant or ITC, unless there is an economic disincentive for taking the grant instead of ITC (see UP 16.3 for further information). Given this conclusion, and the fact that the Section 1603 grant results in an immediate cash payment from the government once approved, we believe that the Section 1603 grant should also be deducted from the fair value of the leased property when performing the 90 percent test, provided the control with respect to the risk of recapture of the grant is retained by the lessor, and the lessor expects to realize the grant.
This guidance is specific to the Section 1603 grants and should not be analogized to for other grants or tax credits, including the production tax credit.

2.5.3 Considerations for lessors

Lessors are required to classify leases as sales-type, direct financing, leveraged, or operating. In addition to the four criteria described in UP 2.5.2, ASC 840-10-25-42 requires two additional criteria to be met for a lease to qualify as a sales-type lease or direct financing lease from the lessor’s perspective:
• Collectibility of minimum lease payments is reasonably predictable (e.g., payment dependent upon receipt of government approval may not be reasonably predictable but typically estimates regarding collectibility for receivables do not indicate this criterion is not met).
• No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.
See ARM 4650.3 for further information about lease classification by lessors, including evaluation of the above two criteria. This section discusses unique issues for lessors in the utility and power industry.

2.5.3.1 Integral equipment

Integral equipment refers to any physical structure or equipment attached to real estate that cannot be removed and used separately without incurring significant cost. Examples of integral equipment include an office building, a manufacturing facility, a power plant, a refinery, and, possibly, the machinery on those sites. Integral equipment is considered “real estate” and is subject to the scope of various real estate-related accounting standards.
ASC 360-20-15 provides that the determination of whether equipment is integral equipment should be based on the significance of the cost to remove the equipment from its existing location (including the cost of repairing damage) plus the decrease in value of the equipment as a result of the removal. The decrease in value cannot be less than the estimated cost to ship and reinstall the equipment at a new site. When the total of the cost to remove and the decrease in value (determined at the time of the transaction) exceeds 10 percent of the fair value of the equipment, the equipment is considered integral.
For utilities and power companies that lease power plants and other similar assets, the consideration of whether the lease involves integral equipment is critical to the analysis of lease classification. Figure 2-9 highlights the impact of these considerations when assessing lease classification.
Figure 2-9
Integral equipment—key considerations for lease classification by the lessor
Lease classification
Considerations
Sales-type
•  Ownership (title) of the leased property automatically transfers to the lessee by the end of the lease
Direct financing
•   Lease does not give rise to manufacturer’s profit; i.e., fair value of the plant must be the same as its cost or carrying amount (if different from cost)
•  Generally only applicable when the property to be leased is acquired by the lessor at or very shortly before the inception of the lease
Leveraged
•  Meets the definition of a direct financing lease, has an additional party involved (a long-term creditor), and meets certain other criteria
Operating
•  Applicable if none of the other classification categories are met
Lessors in the utility and power industry often classify leases of power plants as operating, because the property generally does not transfer title to the lessee at the end of the lease term and the carrying value and fair value of the plant differ at lease inception. As such, the leases do not qualify as sales-type or direct financing leases. Additionally, a power purchase agreement may include a performance guarantee, which may preclude sales-type lease classification as this type of guarantee represents a significant uncertainty associated with costs yet to be incurred by the lessor and, therefore, would not meet both of the required criteria in ASC 840-10-25-42.
ASC 840-10-55-46 discusses this concept as it applies to leveraged leases (one of the conditions for a lease to qualify as a leveraged lease is that it meets the criteria applicable to qualify as a direct financing lease).

Excerpt from ASC 840-10-55-46

Although the carrying amount (cost less accumulated depreciation) of an asset previously placed in service may not be significantly different from its fair value, the two amounts will not likely be the same. Therefore, leveraged lease accounting will not be appropriate, generally, other than when an asset to be leased is acquired by the lessor.

In general, we would not expect the carrying value of a plant to equal its fair value at lease inception unless the plant is acquired at the time of, or very shortly before, lease inception. Therefore, generally we would not expect direct financing lease treatment to be applicable to power plant leases.
Application example—lessor classification of a lease involving integral equipment
Example 2-14 considers the lessor classification criteria for a power plant that is integral equipment.
EXAMPLE 2-14
Lessor classification of a lease involving integral equipment
Ivy Power Producers is commencing construction of the Camellia Generating Station, a 575 MW natural gas-fired generating facility, to sell power under a 10-year power purchase agreement with Rosemary Electric & Gas Company. The facility is being built in contemplation of serving only REG based upon its needs over the course of the agreement. Therefore, all of the output from the facility will be supplied to REG for purposes of serving retail customers. IPP will retain ownership of the facility at the end of the term of the agreement and there are no renewal or bargain purchase options. IPP determines that the agreement contains a lease of integral equipment and is considering how the lease should be classified in its financial statements. For purposes of this example, assume that REG is not the accounting owner during construction (i.e., build-to-suit guidance is not applicable).
Analysis
IPP considers the different potential lease classification alternatives.
•  Sales-type lease
Because the lease involves integral equipment, it is evaluated as real estate for the purpose of classification. Accordingly, the only criteria applicable when determining whether a lease involving real estate is a sales-type lease is whether title transfers to the lessee. In this fact pattern, IPP retains ownership of the facility at the end of the lease term and, therefore, this lease would not qualify as a sales-type lease.
•  Direct financing or leveraged lease
Because the arrangement does not involve the financing by any other party, IPP concludes that an analysis as a leveraged lease is not necessary. In order for the lease to qualify as a direct financing lease, there should be no manufacturer’s or dealer’s profit (or loss) at lease inception (i.e., the cost (or carrying value if different) of the facility and fair value must be the same at lease inception). In addition, the arrangement should meet at least one of the criteria in ASC 840-10-25-1 and both of the criteria in ASC 840-10-25-42. In this fact pattern, the facility will be built to serve REG with developer’s profit built into the price of construction. IPP has incurred costs of development and construction involves some risk such that its cost is not equivalent to fair value at lease inception. As a result, further analysis of ASC 840-10-25-1 and ASC 840-10-25-42 is not considered necessary; the lease will not qualify as a direct financing lease.
•  Operating lease
In this fact pattern, the lease should be classified as an operating lease because it does not qualify as either a sales-type or a direct financing lease. Therefore, IPP would continue to recognize the power plant as a long-term asset in property, plant, and equipment; and recognize depreciation expense and rental income over the life of the agreement.
In assessing this type of arrangement, a reporting entity should consider all facts and circumstances in determining the appropriate accounting.
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