We generally think of capital leases as pertaining to hard assets, things your utility can touch, use, make set payments on and return or buy for a discount at the end of the lease term.
If your utility has a Power Purchase Agreement (PPA), the PPA may qualify for capital lease accounting treatment under current lease standards. While these standards will be changing in the future, as discussed later in this whitepaper, proposed lease changes may not alter this basic approach.
Current lease criteria
Currently, a contract triggers recording of a transaction of a capital lease if one of these criteria are met:
- Transfer of ownership – the lease transfers ownership of the property to the lessee by the end of the lease term
- Bargain purchase option – the lease contains a bargain purchase option, i.e., the asset can be purchased for a nominal amount (generally less than fair value) at the end of the lease term
- Lease term – the lease term is equal to 75 percent or more of the estimated economic life of the leased property
- Minimum lease payments – 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
How can this apply to a power purchase agreement?
As stated, certain contracts give rise to the use of hard assets for the defined lease period that allows your organization to be the sole or primary beneficiary of a hard asset, such as the output of a power plant.
The definition from the Accounting Standards Codification (ASC) 840-10-20 states that a lease is “an agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time. Power purchase agreements that are dependent on an identified power plant may contain a lease. Review your PPA for some of these clauses:
- Under ASC 840, a reporting entity should assess whether an arrangement contains a lease based on its substance. This is applicable if the contract explicitly or implicitly identifies specified property, plant and equipment
- Reporting entities should determine whether the contract meets the following criteria:
- It depends on an identifies power plant, i.e., is the plant explicitly identified
- It conveys the purchaser the right to control the use of the power plan, i.e., control dispatch of output
- The purchaser has the right to control physical access to the plant while obtaining or controlling more than a minor amount of the output
- If the ability to purchase replacement power is limited to outage periods, the agreement contains an identified asset
- It is remote that any parties other than the purchaser will take more than a minor amount of the output during the agreement
- The pricing in the contract is neither fixed per unit of output, nor equal to the market price per unit of the output at the time of delivery
To determine if your contract is a lease follows these steps:
Use of regulatory accounting to recognize differences in lease amortization and rate recovery
Your utility’s approach to ratemaking will drive the accounting for lease payments. There are two main possible approaches:
- The full amount of lease payments are recovered through customer rates – cash basis ratemaking
- The lease amortization is recovered through customer rates – utility basis ratemaking
Regulatory accounting under GASB 62 or ASC 980 will recognize the difference between the two methods by recognizing future recoverable costs for the difference between lease payments and amortization. See the article Regulatory Accounting and GASB 62 applications on the Baker Tilly website. This also fits the ASC 980 application.
Potential changes to current lease accounting guidance
There are coming changes in lease accounting under Financial and Governmental Accounting Standards. To keep informed of current developments, use these references:
These potential changes as currently written would not materially alter the approach discussed in this paper.
PPA’s can reflect your utility’s de facto ownership of the power supplier’s assets for the term of the PPA. Using the evaluation criteria in this whitepaper will help determine whether you’ve entered into a straight purchase power agreement or if you have indeed taken control of the supplier’s asset and need to account for the PPA accordingly.
For more information on this topic, or to learn how Baker Tilly energy and utility specialists can help, contact our team.