Expand
Once a reporting entity determines that a contract contains a lease and it identifies and allocates the consideration between the lease and nonlease components, it needs to assess the appropriate lease classification.

2.5.1 Lease commencement date

Under ASC 842, lease classification and initial measurement of right-of-use assets and lease liabilities are determined at the lease commencement date based on the terms of the contract. In many arrangements, the commencement date will be different from the lease inception date. The lease commencement date is defined in the ASC 842 Glossary.

Definition from ASC 842 Glossary

Commencement Date of the Lease (Commencement Date): The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.

Prior to the lease commencement date, the lessor has not yet performed under the arrangement. Determining when a lessor has made the underlying asset available for a lessee’s use is the key to correctly determining the commencement date. Determining the lease commencement date may be straightforward and will often coincide with the date stated in the contract in power purchase agreements that involve an existing power plant or generating facility. The assessment, however, may be more challenging when the agreement involves an asset that has yet to be constructed. The commencement date specified in a power purchase agreement or the date when lease payments begin are not always strong indicators of when a lessee has obtained control of a generating facility. Regulatory approvals required for the lessee to use the asset should also be considered in determining the commencement date. The following example illustrates the determination of the lease commencement date for a plant under construction.
EXAMPLE UP 2-11
Determination of the lease commencement date
Ivy Power Producers (IPP) is commencing construction of the Camelia Generating Station, a 750 MW natural gas fired power plant. On January 1, 20X2, IPP signs a 30-year power purchase tolling agreement with Rosemary Electric & Gas Company (REG). 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, 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 no involvement in construction of the facility.
IPP and REG evaluated the agreement and determined it contains a lease. REG receives regulatory approval on June 1, 20X4. The commercial operation date occurs as planned on January 1, 20X5, at which point REG can begin supplying fuel to the plant.
What is the lease commencement date?
Analysis
The lease commencement date is January 1, 20X5, the date when the plant is available for REG’s use. Although regulatory approval occurs before this date, REG does not have the ability to use the plant before construction is complete and commercial operation is achieved.
If REG was involved in construction, it may obtain control of the plant prior to the lease commencement date. In that scenario, REG would be required to reflect its control over the plant prior to construction completion and would account for the agreement as a sale and leaseback. See UP 2.5.3 for additional details on accounting for leases when a plant is under construction.

2.5.2 Considerations in lease classification

Lease classification is determined separately for each lease component. Under ASC 842, a lessee should recognize virtually all leases on its balance sheet as a right-of-use asset and lease liability. Lease classification, however, will impact the amount and timing of the recognition of lease income and expense for lessors and lessees, respectively.
Lease classification is governed by the five criteria stated in ASC 842-10-25-2.

ASC 842-10-25-2

A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  3. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
  4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

If one or more of the ASC 842-10-25-2 criteria are met, the lessee and lessor will classify the lease as a finance lease and sales-type lease, respectively. If none of the ASC 842-10-25-2 criteria are met, a lessor would classify the lease as a direct financing lease if (1) the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset and (2) it is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee. All other leases should be classified as operating leases by both the lessee and lessor.
Refer to LG 3.3 for details on the lease classification criteria discussed above. Additionally, see LG 3.2 for an overview of lease accounting by lessees and lessors for each type of lease. This section focuses on key considerations for power and utility companies in assessing the lease classification of a power purchase agreement that is or contains a lease.
Question UP 2-15
Can a power plant lease be classified as a sales-type lease (by the lessor) and a finance lease (by the lessee) if title does not transfer to the lessee?
PwC response
Yes. Under ASC 840, there were specific rules that applied to the classification of leased assets of real estate and integral equipment such that in order to achieve sales-type lease classification, title must automatically transfer to the lessee by the end of the lease term.
This condition has been removed from the guidance in ASC 842. As such, if other criteria in ASC 842-10-25-2 are met, a lease of a power plant may be classified as a sales-type lease even if title does not transfer. Power purchase agreements are often for a major part of the economic life of the facility. Therefore, if these arrangements are or contain leases, they may meet the criteria to be classified as sales-type leases (by the lessor) and finance leases (by the lessee). Because land is evaluated as a separate component (as discussed in UP 2.4), this could result in the power plant being classified differently than the lease of the underlying land.
Question UP 2-16
When determining the classification of a lease, should tax credits received by a lessor be considered in determining the fair value of a power plant?
PwC response
No. The owners of renewable energy plants often obtain government incentives that may include grants, investment tax credits, or production tax credits. Tax credits are typically associated with ownership, not the use, of the underlying asset. The lease payments criterion in ASC 842-10-25-2(d) requires a lessee and lessor to compare the present value of lease payments to the fair value of the underlying asset. Therefore, tax credits retained by a lessor should be excluded from the determination of fair value used in assessing the lease payments criterion.

2.5.2.1 Determining the estimated economic life of a plant

If the lease term is for a major part of the remaining economic life of the underlying asset, the lessee has effectively obtained control of the underlying asset and should classify the lease as a finance lease and the lessor should classify the lease as a sales-type lease. While ASC 842 does not include bright lines in this determination, one approach to applying this indicator is to conclude that 75% or more of the remaining economic life of the underlying asset is a “major part” of the remaining economic life, as discussed in ASC 842-10-55-2(a). Leases that commence at or near the end of the underlying asset’s economic life are exempt from applying this specific lease classification criterion.
Application of the lease term test in practice for a power purchase agreement may be challenging because of the subjective nature of “economic life.” The ASC 842 Glossary provides the following definition of economic life.

Definition from ASC 842 Glossary

Economic Life: Either the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.

When determining the estimated economic life of a power plant, it may be helpful to consider the asset’s useful life. As discussed in PPE 4.2.1, the useful life of a long-lived asset takes into consideration entity-specific assumptions related to the intended use of the asset. Although there could be differences between an asset’s useful life and its economic or physical life, reporting entities have historically used industry standard economic lives for assets such as coal, oil, and natural gas-generating plants based on experience with the actual useful life of the assets. Reporting entities often rely on a combination of historical experience and engineering estimates for renewable facilities such as wind turbines and solar panels given evolving technology.
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 UP 2-17
What are the common economic lives for power plant assets?
PwC response
There is no one-size-fits-all economic 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 economic lives of wind facilities tend to be 25 to 30 years, but the actual life depends on several variables, including wind speed and variability in usage.
When estimating the economic 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 more stress and wear as a result of intermittent use. 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.
LG 3.3.3 provides further guidance on applying the lease term test, including determination of the lease term and additional examples addressing the determination of estimated economic life.

2.5.2.2 Lease payments

One of the classification criteria outlined in ASC 842-10-25-2 is whether the present value of the lease payments is equal to substantially all of the fair value of the underlying asset. Lease payments are determined based on the guidance in ASC 842-10-30-5, which excludes variable lease payments that do not depend on an index or a rate. The identification of variable payments is, therefore, one of the key factors in determining whether the lease payments classification criterion is met. ASC 842 defines variable lease payments in the Master Glossary.

Definition from ASC 842 Glossary

Variable Lease Payments: Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.

Variable lease payments based on performance or use are excluded from the calculation of lease payments for classification and measurement, even if there is a high probability of some payment for usage during the lease term. Accordingly, lease payments would not include payments that vary solely based on the future use or performance, regardless of the probability of occurrence (except in cases where the contract contains a guaranteed minimum payment or penalty that effectively amounts to a floor for payments).
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 generally be variable payments because the lessor cannot require the off-taker to take any amounts (because the lessee determines the level of production).
The evaluation of variable lease payments becomes more complex in assessing must-take arrangements when the lessee is required to take any power produced from the facility as discussed in the following questions.
Question UP 2-18
Does a minimum performance guarantee in a must-take power arrangement that contains a lease result in some level of fixed lease payments?
PwC response
It depends. Variable payments include amounts that are outside the control of both parties to a contract (e.g., future inflation rates) or that vary solely on future use or performance, regardless of the probability of occurrence. Variable payments, however, are considered in substance fixed payments to the extent that they contain unavoidable minimum payment amounts as discussed in ASC 842-10-55-31.

ASC 842-10-55-31

Lease payments include in substance fixed lease payments. In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following:
  1. Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance)
  2. The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments.

A guaranteed minimum payment that effectively amounts to a floor for payments is considered to be an in substance fixed payment, as it cannot be avoided. The same would apply to penalties for failure by the lessor to achieve a certain production level that establish a minimum payment amount.
Therefore, we generally expect that the amounts up to the guaranteed level of production should be used in the determination of fixed lease payments in a must-take power arrangement.
Question UP 2-19
Does the fuel source impact the assessment of whether production-based payments are fixed or variable?
PwC response
Generally, no. 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, we believe that production-based payments would generally be variable payments unless there is a minimum guarantee of off take or a minimum performance guarantee, as discussed in Question UP 2-18. This would be the case even if there are engineering and other studies to support a specified level of production and if the facility has a history of reliably producing at a certain level.
Question UP 2-20
In a tolling or other arrangement with no minimum performance guarantees, is output that is virtually assured considered a fixed lease payment?
PwC response
No. In a tolling or option contract where the lessee determines the level of production, the lessor has no control of the amount dispatched and thus all amounts are variable. The lessee could choose not to dispatch at any point (assuming that there is no minimum guarantee of off take).
Question UP 2-21
Do default provisions in a power purchase agreement that do not relate to use of the underlying asset impact the calculation of lease payments?
PwC response
No. Power purchase agreements may include default covenants that are unrelated to the lessee’s use of the plant (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 or other provisions. As a result, a question may arise as to whether potential amounts to be paid in the event of non-compliance should be included in the minimum lease payments for purposes of determining lease classification. ASC 842-10-30-5, however, states that “lease payments shall consist of payments related to the use of the underlying asset during the lease term.” Therefore, only penalty payments related to use of the asset would be included in the determination of lease payments.
Question UP 2-22
Should protective rights (i.e., provisions that protect a lessee from making payments when the underlying asset is not available for use) be considered in determining the amount of lease payments?
PwC response
No. As discussed in LG 3.3.4.3, a lease may include protective rights that impact the amount of lease payments due. Protective rights are generally rights that protect a lessee from the requirement to make payments during periods when the underlying asset is not available for use. For example, lease payments due under a power purchase agreement may be substantially reduced during periods of excessive downtime for maintenance or inspection, when a lessor defaults on its obligations, or when weather conditions render the underlying asset unavailable to the lessee. The effect of protective rights should be disregarded when determining lease payments for purposes of classification and measurement.

2.5.2.3 Variable lease payments in sales type and direct financing leases

In July 2021, the FASB issued ASU 2021-05, which requires a lessor to classify a lease with variable payments that do not depend on an index or a rate as an operating lease if classifying it as a sales type or a direct financing lease would result in the recognition of a selling loss at commencement.
Due to the inherent production uncertainty associated with renewable generation (driven by meteorological and geological factors), renewable power purchase agreements may include only variable consideration based on the actual electricity produced by a facility during the period. If the contract is a sales type or direct financing lease, the lessor derecognizes the carrying value of the specified asset and records a net investment in the lease. As discussed in UP 2.4, production-based payments where the fuel source is intermittent are considered to be variable payments. Therefore, when the lease is classified as a sales type or direct financing lease, the variable payments are excluded from the measurement of the net investment in the lease because they do not depend on an index or a rate.
Accordingly, the net investment in the lease could be zero in renewable power purchase arrangements that have no fixed lease payments. The difference between the carrying amount derecognized and the net investment in the lease recognized could result in a “day one loss” recognized at lease commencement. Following lease commencement, the lessor would recognize variable lease payments as income which, in part, represent the recovery of the loss recorded at commencement. Many in the utilities and power industry raised concerns that recording a “day one loss” for these power purchase agreements did not faithfully represent the economics of the transaction.
ASU 2021-05 provided updated operating lease classification criteria intended to address this issue. Under this model, the lessor would not derecognize the specified asset and thus would not record a loss at lease commencement. Instead, the lessor would continue to depreciate the asset in accordance with its normal depreciation policy while recognizing any fixed lease consideration on a straight line basis over the lease term. The variable production based payments would be recognized in income in the period the goods or services are provided.

2.5.3 Accounting for leases when plant is under construction

Utilities and power companies may enter into power purchase agreements that contain a lease prior to construction of the identified plant. In such contracts, the project owner may build and configure the power plant based on the customer’s specific requirements. Such arrangements are known as “build-to-suit” arrangements.
When the off-taker (prospective lessee) enters into a power purchase agreement prior to the completion of construction of an identified plant, it should evaluate whether it controls the plant during the construction period. Generally, the evaluation of whether control of a plant under construction is transferred to the off-taker during the construction period is similar to the evaluation in the revenue recognition standard to determine whether a performance obligation is satisfied over time. ASC 842-40-55-5 lists several examples that demonstrate when a lessee has obtained control during the construction period.

Excerpt from ASC 842-40-55-5

Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:

  1. The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period
  2. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use to the owner-lessor.
  3. The lessee legally owns either:
    1. Both the land and property improvements that are under construction
    2. The non-real-estate asset that is under construction
  4. The lessee controls the land that property improvements will be constructed upon and does not enter into a lease of the land before the beginning of construction that, together with renewable options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.
  5. The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.

If the off-taker is deemed to be the owner during construction, it should account for the plant similar to any other owned asset under construction (i.e., under ASC 360, Property, Plant and Equipment) and should record a liability for any costs paid for by the lessor. The off-taker would recognize ground lease rents, if any, as an expense in accordance with ASC 842-10-55-21.

Excerpt from ASC 842-10-55-21

Therefore, lease costs (or income) associated with ground or building leases that are incurred (earned) during a construction period should be recognized by the lessee (or lessor) in accordance with the guidance in Subtopic 842-20 and 842-30, respectively, That guidance does not address whether a lessee that accounts for the sales or rental of real estate projects under Topic 970 should capitalize rental costs associated with ground and building leases.

In addition, once the off-taker is deemed the owner of the asset under construction, the arrangement is within the scope of the sale and leaseback guidance. Both the off-taker and the project owner should evaluate whether the transaction represents a qualified sale and leaseback or a financing transaction.
If control transfers to the off-taker during construction, the project owner (lessor) should not recognize the plant during the construction period. Instead, it would account for any payments made during the construction period as a collateralized loan to the off-taker in accordance with ASC 310, Receivables.
Refer to LG 6.3.3 for further information on accounting for leases for assets under construction.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

Expand Expand
Resize
Tools
Rcl
Add to favorites
Please ensure
that you select
Print Background (colors and images) when printing.
CONTINUE
PwC image modal

This content is copyright protected. It is for your own use only - do not redistribute. These materials were downloaded from PwC's Viewpoint (viewpoint.pwc.com) under license.

Warning 2

✕

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Viewpoint allows you to save up to 25 favorites.

Consider removing one of your current favorites in order to to add a new one.

Go to favorites

Are you sure you would like to remove this page from your list?

Yes
You are already signed in on another browser or device.
Click Continue if you want to automatically close other logged in sessions and continue. If you want to manually check for other active logged in sessions first, please select Cancel to go back to the previous page.
Need some help? Contact us
signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide
✕

Hello and welcome to Viewpoint

Your go-to resource for timely and relevant accounting, auditing, reporting and business insights. Follow along as we demonstrate how to use the site

Before we start.

Choose your preferred language below.