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2.6 Lease reassessment, modification, and remeasurement
Publication date: 31 Mar 2023
us Utilities guide
Amendments to the terms of a power purchase agreement or changes in the assumptions made at the commencement date of the lease may (1) require a reassessment to determine whether the agreement continues to be or contain a lease, (2) trigger lease modification accounting, or (3) require remeasurement of the lease. LG 5 provides general guidance on accounting for modifications (including terminations) of a lease contract as well as accounting for lease remeasurements for reassessment events that are not modifications. This section addresses certain considerations unique to utilities and power companies.
2.6.1 Reassessment of whether an agreement is or contains a lease
The determination of whether a contract is, or contains a lease, is performed at the inception of the contract. Once it is determined that a contract is or contains a lease, that conclusion is not reassessed unless the legal arrangement is modified.
Excerpt from 842-10-15-6
An entity shall reassess whether a contract is or contains a lease only if the terms and conditions of the contract are changed.
The ASC 842 Glossary defines a lease modification.
Definition from ASC 842 Glossary
Lease Modification: A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).
The following questions address common changes that may occur during the term of a power purchase agreement and whether those changes require a reassessment of whether the arrangement is a lease.
Question UP 2-23
Is reassessment of a contract required if a price modification occurs as a result of a regulatory or other change imposed by a party external to the contract?
Is reassessment of a contract required if a price modification occurs as a result of a regulatory or other change imposed by a party external to the contract?
PwC response
It depends. At times, contractual terms in a power purchase agreement may change due to an action of a regulator or other third party. For example, the pricing in a contract may be linked to a formula established or approved by a regulator (qualifying facilities contracts are often based on the utility’s avoided cost of production). A change in the formula by the regulator, whether through its own action or in response to a request from one or more parties to the contract, would represent a change to the contract terms, triggering a reassessment. Although this change may not be directly executed between the counterparties, the linkage of pricing to an external factor would represent an “informal” modification.
Note that a change in the pricing formula to be used is different from a change in the pricing as a result of new inputs to an agreed-upon methodology. A contract that specifies annual or other price updates based on a specified formula would not require reassessment unless there were other contractual changes.
In addition, any pricing changes should be assessed to determine whether the changes result in variable payments becoming fixed payments. In these circumstances, the lessee would need to reassess the contract as well as remeasure the lease liability and right-of-use asset as appropriate.
Question UP 2-24
Is reassessment of whether a contract is or contains a lease required if the parties to the contract make operational changes in the contract terms?
Is reassessment of whether a contract is or contains a lease required if the parties to the contract make operational changes in the contract terms?
PwC response
It depends. In some cases, the parties to a power contract may agree to certain modifications as a result of operational needs or due to changes in Federal Energy Regulatory Commission (FERC), North American Electric Reliability Corporation (NERC), or local regulations that impact contract operating protocols.
ASC 842-10-15-6 requires the reassessment of whether a contract is or contains a lease as a result of any change in contractual terms or conditions. We believe, however, that the presumption that a reassessment should be performed may be overcome if the agreed-upon changes have no impact on the contract economics or rights of the parties. This determination may require judgment and should include consideration of factors such as the following:
- The reason for the change
- The level of management involved in approval (executive management or board approval suggests a more substantive change)
- The impact on the contractual cash flows (a significant change in cash flows is indicative of an economic effect that should be assessed)
- The impact on production (a change in the amount or timing of generation also suggests an economic impact)
For example, an agreement by the off-taker to pay for emissions credits required due to new environmental legislation would have an impact on the cash flows under the contract and would require a reassessment. In contrast, operational changes implemented by the applicable regional transmission organization that change the delivery point established in the agreement to another near-by location may not require reassessment.
Factors to consider in determining whether a reassessment is required include evaluating whether the change has an economic impact to the buyer or seller. For example, this may include changes to the off-taker’s costs due to new transmission costs, a different market price for potential resale, or new hedging costs. In many cases, an operational change results in some change to the pricing and consideration under the contract, which would trigger a reassessment.
2.6.2 Accounting for a lease modification
Amendments to the terms of the agreement after the lease commencement date that may trigger lease modification accounting include extensions, renewals, early termination, and changes in the timing of the payments.
A physical change made to the specified plant in a power purchase agreement may trigger a modification to the contract. For example, a lease may be modified when a standalone energy storage system is connected to the specified generation facility after lease commencement and conveyed to the lessee for use. If the supplier grants the lessee the right to use the storage system in exchange for an increase in consideration consistent with the standalone selling price of the use of the storage system, the modification to the contract would be accounted for as a separate new contract related to the storage system. Conversely, if the change in consideration is not commensurate with the standalone selling price of energy storage, the contract is accounted for as a single modified lease.
Depending on the facts and circumstances, a lease modification may be accounted for by either the lessee and lessor as two leases – the original lease and a separate new lease, or as one modified lease. A modification to a lease is accounted for as a separate new contract when it (1) conveys the right to use an additional underlying asset that was not included in the original lease to the lessee, and (2) the lease payments increase commensurate with the standalone price for the additional right of use (adjusted for the circumstances of the particular contract).
If a modification meets the criteria to be accounted for as a separate contract, the new contract should be evaluated to determine whether it is or contains a lease. If the new contract is a lease or contains an embedded lease, the new lease should be accounted for as any other new lease.
If a lease modification is not accounted for as a separate contract, the modified contract should be reassessed to determine whether the contract continues to be or contains a lease. If it does, the contract consideration will need to be reallocated and lease classification reassessed (based on assumptions and terms at the modification date). A lessee would also remeasure its lease liability and right of use asset using the discount rate at the date of modification. The lessor’s modification accounting will depend on the classification of the lease before and after the modification. Refer to LG 5.6.2 for details.
Question UP 2-25
What is the impact of regulator or other third-party approval on accounting for a lease modification?
What is the impact of regulator or other third-party approval on accounting for a lease modification?
PwC response
Typically, when a regulated utility is considering entering a significant contract, or substantively modifying a power purchase agreement, approval by its regulator is required. Careful consideration should be made by a reporting entity in these circumstances. Although the parties to the contract may negotiate and sign a modification, the modification may be contingent on regulatory approval. Even if a contract is silent on the matter, the utility’s regulator or the interveners may have the opportunity to review, reject, or require changes to a power purchase agreement or related modifications. Approval by a regulator does not relieve the regulated utility from assessing the impact of the lease modifications; however, the modification date may occur after the modified contract is signed (e.g., the date the regulator approves the contract or modification) if a regulatory approval is required.
2.6.3 Accounting for lease remeasurement
ASC 842 describes other circumstances in which a lessee must reconsider certain assumptions made at the lease commencement date (e.g., whether the exercise of a renewal or purchase option is reasonably certain) and remeasure the lease liability and adjust the related right-of-use asset. In some of those cases, the classification of the lease must also be reassessed.
A lessee is required to remeasure its lease liability and adjust the related right-of-use asset upon the occurrence of the following:
- Lease modifications not accounted for as a separate contract
- A triggering event that changes the certainty of a lessee exercising an option to renew or terminate the lease, or purchase the underlying asset
- A change to the amount probable of being owed by the lessee under a residual value guarantee
- The resolution of a contingency upon which variable lease payments are based such that those payments become fixed
A lessor is not subject to lease remeasurement guidance similar to the remeasurement guidance for a lessee. A lessor should account for the exercise by a lessee of an option to extend or terminate the lease or to purchase the underlying asset as a lease modification unless the exercise of that option by the lessee is consistent with the assumptions that the lessor made in accounting for the lease at the commencement date of the lease.
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.
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