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9.5 Accounting by the single power plant entity
Publication date: 22 Nov 2023
us Utilities guide
Figure UP 9-4 summarizes considerations with respect to the accounting for amounts received from investors in the entity’s stand-alone financial statements.
Figure UP 9-4
Accounting models for funds received from investors
Accounting models for funds received from investors
Model |
Accounting considerations |
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Legal-form equity generally is accounted for as an equity interest; however, there are certain characteristics that could lead to a liability conclusion.
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Factors that may lead to a liability conclusion in the case of legal-form equity include: (1) unconditional obligation to repay investment; (2) no residual/ownership interests in the entity.
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The sale of future revenue guidance (ASC 470-10-25-1 and 25-2) may apply when transactions are structured such that the return is based on a specified percentage (up to 100%) of identified revenue or income.
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In general, a single power plant entity accounts for financing received as part of equity or as a liability; however, these transactions may also be structured as a sale of future revenue. Regardless of the model applied, the entity should also determine how to allocate income to the investors (see UP 9.6).
9.5.1 Accounting for interests issued by the single power plant entity
ASC 480 provides guidance on how to account for certain issued financial instruments that are not derivatives. Share capital is generally accounted for as equity; however, legal-form equity that encompasses certain characteristics of debt may meet the definition of a liability in ASC 480. For example, securities issued with an unconditional obligation to repay the investment (such as a mandatorily redeemable instrument) would be accounted for as a liability under ASC 480. Reporting entities need to evaluate the terms of issued equity instruments to determine whether liability or equity (or derivative) accounting applies.
Following are considerations in evaluating the classification of instruments commonly issued by single power plant entities. It should be read in conjunction with the FG 5 and FG 7, which includes information on the evaluation of instruments that have characteristics of both liabilities and equity, including the classification of instruments as temporary equity.
9.5.1.1 Considerations for classifying instruments as liabilities
ASC 480 does not provide a specific definition of what constitutes a “liability” as opposed to “equity.” Instead, the guidance provides that certain specified financial instruments should be classified as liabilities. ASC 480-10-25 requires that issuers classify any of the following three types of freestanding financial instruments as liabilities:
- Mandatorily redeemable financial instruments
- Obligations to repurchase the issuer’s equity shares by transferring assets (applies to financial instruments other than outstanding shares)
- Certain obligations to issue a variable number of shares
A key factor is that the financial instrument must be “freestanding” to potentially require liability classification. Equity investments that are embedded in another instrument are not subject to this guidance.
Mandatorily redeemable financial instruments are more common in single power plant entity structures than obligations to repurchase issuer equity shares or obligations to issue a variable number of shares.
Freestanding financial instruments
In determining whether an instrument is subject to the guidance of ASC 480, a reporting entity needs to first assess whether the instrument meets the definition of a financial instrument and, if so, whether it is freestanding.
Partial definition from ASC 480-10-20
Financial Instrument: Cash, evidence of an ownership interest in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either: (1) To deliver cash or another financial instrument to a second entity; (2) To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either: (1) To receive cash or another financial instrument from the first entity; (2) To exchange other financial instruments on potentially unfavorable terms with the first entity.
Definition from ASC 480-10-20
Freestanding Financial Instrument: A financial instrument that meets either of the following conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
In applying this guidance, reporting entities should assess whether the contractual agreement meets the definition of a financial instrument. Legal-form equity issued by a single power plant entity is a financial instrument because the shares provide evidence of an ownership interest in the entity.
If an agreement meets the definition of a financial instrument, the reporting entity should then assess if it is freestanding using the definition of freestanding in ASC 480-10-20 and the examples in ASC 480-10-55. In evaluating whether an investment in a single power plant entity is freestanding, one important consideration is whether other products or services are included in the investment agreement. For example, an investment commitment in an engineering, procurement, and construction contract or a management service agreement may not be a freestanding financial instrument if the contractor is unable to legally and separately exercise the investment (e.g., sell the instrument) after the completion of the EPC services.
See FG 5.3 for further information on factors to consider when evaluating whether an instrument is freestanding.
9.5.1.2 Applying the guidance in ASC 480
If a single power plant entity determines that it has issued a freestanding financial instrument, it should evaluate the instrument under the criteria in ASC 480 to determine if liability classification is required. In general, legal-form equity in a single power plant entity structure is classified as a liability if the terms of the agreement require the shares to be redeemed through repayment of the investor’s capital contribution at a specified date (or dates). These arrangements typically do not include obligations to repurchase the issuer’s equity shares by transferring assets or obligations to issue a variable number of shares, which would also trigger liability classification.
Mandatorily redeemable financial instruments, as defined in ASC 480, should be classified as liabilities, unless redemption occurs only upon the termination or liquidation of the entity.
Definition from ASC 480-10-20
Mandatorily Redeemable Financial Instrument: Any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.
In assessing whether an instrument is mandatorily redeemable, the entity should consider whether it has an unconditional obligation to make payments to the investor or transfer assets at a specified date (dates) or upon an event that is certain to occur. If the agreement specifies the date or dates on which repayment of the capital contribution (and redemption of the shares) will be made, with no contingencies, this type of arrangement would be classified as a liability by the single power plant entity.
In contrast, if the redemption of shares in an entity is conditional on the occurrence of an event, the shares are not considered mandatorily redeemable until such time that the event occurs or is certain to occur. For example, legal-form equity would not be classified as a liability if repayment of the instrument is required only if the board declares a dividend or distribution.
Question UP 9-6
How does the ability to defer scheduled repayments affect the determination of whether an instrument is mandatorily redeemable?
How does the ability to defer scheduled repayments affect the determination of whether an instrument is mandatorily redeemable?
PwC response
Many power plant entity investment arrangements include provisions that delay or modify scheduled repayments if certain criteria are not met. For example, the investment agreement may require a targeted level of cash flows, sufficient cash reserves, or similar factors before any payments can be made. ASC 480-10-25-6 addresses provisions that may change the timing of cash flows.
In determining if an instrument is mandatorily redeemable, all terms within a redeemable instrument shall be considered. The following items do not affect the classification of a mandatorily redeemable financial instrument as a liability:
- A term extension option
- A provision that defers redemption until a specified liquidity level is reached
- A similar provision that may delay or accelerate the timing of mandatory redemption.
The FASB concluded that these types of provisions may affect the timing of the unconditional redemption obligation but do not remove the redemption requirement. Thus, consistent with this guidance, an instrument may be mandatorily redeemable even if scheduled payments are dependent on sufficient cash flows, liquidity, or other factors (e.g., operating results). An instrument with scheduled payments that may be delayed due to a lack of sufficient funds or similar factors is different from an agreement that includes a priority of distributions or similar provisions but does not include a repayment schedule or any repayment commitments. An expectation that the investment will be repaid is not sufficient to conclude the instrument is mandatorily redeemable; the agreement must specify a requirement for the issuing entity to repay the investment and contain default provisions in the event of nonpayment. In practice, reporting entities may need to consult with legal counsel to determine whether repayments are legally required pursuant to the relevant agreements.
Example 9-1 provides guidance on how single power plant entities should evaluate issued instruments under ASC 480.
EXAMPLE UP 9-1
Investment in a single power plant entity—issuer accounting
Investment in a single power plant entity—issuer accounting
On May 1, 20X3, M&H Holding Company and Desert Sun Tax Company (DST) enter into an investment agreement related to SunFlower Power Company (SFP), which will be building a 100 MW solar facility. Under the terms of the agreement, preferred shares in SFP are issued to DST in exchange for $100 million in cash. DST will receive repayment of its contribution plus a 10% return in accordance with a payment schedule included in the agreement. However, repayments are not made unless operating cash flows are at or above an amount specified in the agreement.
The income, losses, and tax attributes of SFP are allocated based on a waterfall distribution specified in the investment agreement. In general, income, losses, and tax attributes are allocated to DST until it achieves return of its investment and its priority return; remaining amounts are allocated to M&H. Operating and liquidating cash flows are distributed similarly; however, the agreement includes specific details on the order of payments. The waterfall requires that the unpaid priority amounts from prior periods, if any, are paid first to DST, followed by priority amounts owed to DST in the current period. Any remaining amounts are distributed to M&H.
Should the preferred shares issue to DST be accounted for as equity or as a liability?
Analysis
The preferred shares issued to DST would be accounted for as a liability under ASC 480.
The shares meet the definition of a freestanding financial instrument because they were entered into separate from any other agreement or equity instruments. Furthermore, the share agreement imposes an obligation on SFP to make distributions to DST. The agreement conveys to DST the contractual right to receive cash flows representing the initial payment of $100 million plus a 10% return.
The financial instrument meets the definition of a mandatorily redeemable financial instrument under ASC 480 because SFP has an unconditional obligation to redeem the instrument by transferring assets at a specified time. Although there is some uncertainty about the timing of the repayment to DST (because it is dependent on a specified level of cash flows), SFP is legally required to repay the initial contribution and the 10% priority return pursuant to a repayment schedule. The repayment has priority in distribution and there are no conditional payment provisions (e.g., repayment is not contingent on declaration of a dividend). This scenario is similar to the discussion in ASC 480-10-25-6.
9.5.2 Sale of future revenues
Single power plant entities may at times enter into an arrangement with investors that represents a sale of future revenues, as discussed in ASC 470.
Excerpt from ASC 470-10-25-1
An entity receives cash from an investor and agrees to pay to the investor for a defined period a specified percentage or amount of the revenue or of a measure of income (for example, gross margin, operating income, or pretax income) of a particular product line, business segment, trademark, patent, or contractual right. It is assumed that immediate income recognition is not appropriate due to the facts and circumstances.
For example, a financial investor may provide an initial contribution to a single power plant entity in exchange for the receipt of a certain return over a 10-year period. The financial investor’s motivation in this arrangement is to receive its return in the form of a portion of the tax benefits generated by the power generation facility through tax credits and tax operating losses. If a transaction involves the sale of future revenue, the single power plant entity should account for the amounts received as debt or as deferred income, depending on the specific facts and circumstances.
ASC 470-10-25-2 provides the criteria for determining whether an obligation to provide future payments should be accounted for as debt or deferred income.
While the classification of the proceeds from the investor as debt or deferred income depends on the specific facts and circumstances of the transaction, the presence of any one of the following factors independently creates a rebuttable presumption that classification of the proceeds as debt is appropriate:
- The transaction does not purport to be a sale (that is, the form of the transaction is debt).
- The entity has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
- The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
- The investor’s rate of return is implicitly or explicitly limited by the terms of the transaction.
- Variations in the entity’s revenue or income underlying the transaction have only a trifling impact on the investor’s rate of return.
- The investor has any recourse to the entity relating to the payments due the investor.
If the transaction is essentially a financing arrangement in which the investor is providing financing to the single power plant entity in exchange for a portion of its revenues or income, the entity should account for the amounts received from the investor as debt. Further, the criterion in ASC 470-10-25-2(b) will generally be met in a single power plant entity structure because the power plant entity has significant continuing involvement in the generation of cash flows through the operation of the power plant. If this criterion is met, there is a rebuttable presumption that the arrangement will be accounted for as debt by the single power plant entity.
The classification also impacts the method used to amortize the investment contribution over the life of the agreement. Amounts classified as debt are amortized using the effective interest method, while amounts recorded as deferred income should be amortized based on the units-of-revenue method (as defined in ASC 470-10-20).
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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