By Leslie Knowlton and Henry Phillips, with Deloitte & Touche L.L.P. in Houston and Wilton, Connecticut

Power contracts and tolling agreements may be characterized as “leases” of the power plant with potentially adverse accounting treatment for the parties involved.

The emerging issues task force of the Financial Accounting Standards Board, or “FASB,” has a working group focusing on when this should occur. The group has discussed a framework whereby a person taking the output from a power project under contract may be treated as if he leased the power plant in cases where the person has effective control over the use of the power plant or the substantive risks and rewards of ownership.

This same framework may lead to an unhappy conclusion in sale-leasebacks of power plants that the lessee retains too much control or too many ownership attributes in the power plant to take the power plant — and related debt — off its balance sheet.

Background

The emerging issues task force called in 1998 for energy and energy-related contracts — including capacity contracts, requirements contracts and transportation contracts — that meet outlined trading criteria to be carried at fair value, meaning that they must be “marked to market” at the end of each quarter.  Marking to market means that the parties to the contract must show it on their books at the current market value of the contract.  Each quarter, they figure out what the contract is worth and record a gain or loss since the past quarter. This can lead to volatility in earnings. The emerging issues task force consensus that requires this treatment is EITF Issue No. 98-10.

FASB issued a separate directive in 1998 — called FAS 133 — that generally requires mark-to-market accounting for any energy contracts that are considered “derivatives” beginning in 2001.

However, EITF Issue No. 98-10 and FAS 133 generally do not apply to contracts that accountants consider a lease of the underlying power plant.  Lease transactions must be accounted for in accordance with FAS 13 using historical cost accrual accounting rather than fair value mark-to-market accounting, meaning that revenues and expenses appear on a company’s books only as they legally accrue.

A lease, as defined in FAS 13, is “an agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time [emphasis added].” FAS 13 also states, in part:

[A]greements that do transfer the right to use property, plant, or equipment meet the definition of a lease for purposes of this Statement even though substantial services by the contractor (lessor) may be called for in connection with the operation or maintenance of such assets.

The difficulty of determining when a contract meets the definition of a lease and the lack of interpretative guidance have led to diversity in practice.  As a result, the emerging issues task force formed a working group to focus on when arrangements should be treated as leases, even though they may be labeled something else.

Working Group Discussions

The working group is debating three different views that have been presented to the emerging issues task force for comment. The factors mentioned as possible indications of a lease in the discussion below are based on one or more of these views.  However, because of the substantive differences in the evaluation of contract provisions under each proposal, these items may be given more or less significance by the proponents of the different views.

Although the working group has not yet presented its final recommendation, the members have tentatively agreed that the evaluation of whether an arrangement conveys the right to use the underlying land or depreciable assets — one of the factors that FAS 13 said makes a contract a lease — should be based on the substance of the arrangement regardless of how the contract is labeled.

The focus of the working group’s tentative conclusions centers around whether the arrangement conveys the right to control the use or the risks and rewards of ownership of the underlying asset to the purchaser. The working group members also agreed that the subject of the lease must be specified in the contract at some point, although the identification of the property in the arrangement need not be explicit.

Tolling Agreements

Tolling agreements provide the toller the right, but not the obligation, to call on the owner of the power plant to convert his natural gas or another fuel into electricity at a predefined heat conversion rate.  In exchange, the toller pays a fee just as a farmer would pay a mill to grind his wheat into flour.

With deregulation, power companies are becoming more exposed to the risks that typically accompany a free market, but have historically shown a preference for predictable margins.  A tolling arrangement reduces the power company’s exposure to commodity price risk.  Meanwhile, the toller — which may be a trading company or a gas supplier — may use the tolling agreement as a means to capitalize on arbitrage opportunities between the fuel and electricity prices inherent in the market.

When does such an agreement go from being just an agreement to receive fuel and sell electricity for a fixed price to becoming a lease?

The toller may be viewed as having the right to control the use of the facility when certain activities and decisions related to running the power plant are transferred to the toller in the tolling agreement.  Some of the activities and decisions considered by the working group include:

• the right to occupy and control access to the power plant,
• dispatch rights, meaning the right to decide whether to use the power plant to generate power or to buy the power in the market,
• the right to make significant operating decisions, and
• the right to direct the maintenance and other operating practices.

A presumption may exist that the toller has the ability to control the use of or access to the power plant when the toller has effectively contracted for the entire output.  A right of first refusal for the toller to take any excess power generated by the power plant or terms precluding the sale of power to anyone other than the toller could lead to a similar conclusion.

The fee the toller pays to have his fuel converted into electricity usually consists of both a capacity payment and an energy payment. These payments look a lot like what the buyer of electricity pays under a standard power purchase agreement, except that there is no reimbursement through the energy payment for the cost of fuel.  That’s because the toller provides the fuel.

The capacity payment may be viewed as exposing the toller to facility-based risks and rewards, which could cause the contract to be considered a lease.  One of the views expressed by the working group presumes that these fixed payments demonstrate that the seller has not retained the significant costs associated with operating the power plant.  This is especially the case where the purchaser is required to continue making capacity payments to the power plant owner even when the power delivered is less than the contracted amount.

Lease accounting may also apply when there are no market-based liquidated damages provided for in the tolling arrangement.  A typical market-based liquidated damage clause would require the power plant owner to buy replacement power in the market during periods when the power plant is out of service or compensate the toller for the cost of buying such replacement power. Thus, the power plant owner could provide the required power from any source.  However, most tolling contracts do not include market-based liquidated damages.  Instead, tolling arrangements usually require a reduction in the capacity payment made by the purchaser in the event of the seller’s nonperformance.  Some members of the working group believe that the lack of market-based liquidated damages signifies that the contract is specific to the power plant and exposes the toller to facility-based risks and rewards.

Even when market-based liquidated damages are provided for in the tolling agreement, other factors may be a problem.  For example, the seller must be able to meet its obligations under the contract in all reasonably possible scenarios.  An arrangement with a highly-leveraged special-purpose entity could indicate that it is not reasonable to expect that the entity would have the financial resources to meet its liquidated damage penalties.  In addition, further analysis would be needed to determine whether a market-based liquidated damage clause that includes a cap on the damage amount effectively removes the plant specificity aspect of the agreement.

Power Purchase Agreements

Power purchase agreements are similar to forward contracts and call options. They obligate the holder to purchase power at a predetermined price.  Like tolling agreements, companies that do not own physical assets may enter into a power purchase agreement to take advantage of an arbitrage opportunity.  Generators view these agreements as risk management products to mitigate exposure to commodity price risk.

Many of the considerations involved in evaluating a tolling arrangement also apply to power purchase agreements.  However, power purchase agreements often provide for financial settlement when the purchaser does not want to take physical delivery of the power.  In this regard, it could be argued that the agreement does not transfer the risks and rewards of ownership of the power plant to the purchaser.

The purchaser will often enter into other energy contracts to manage the commodity price risk of the agreement.  If the power purchase agreement is accounted for as a lease of the power plant and the other energy contracts managing the exposure are marked to market, then significant fluctuations in the purchaser’s earnings can result even though the economic position has not changed.  For example, assume a company enters into a power purchase agreement and subsequently enters into forward sales agreements to manage the exposure of its purchases.  The forward sales perfectly offset the purchases at inception. Thus, the company has no economic exposure to changing market prices.  In the following year, the market price for power declines.  If each of the contracts were marked to market, the losses from the power purchase agreement would be offset by the gains on the forward sales agreements in the company’s financial statements for the year of the market decline.  However, if the power purchase agreement were treated as a lease, then only the mark-to-market gains from the forward sales agreements would be reflected in the company’s financial statements with no offset for the other side of the transaction.

Sale-Leasebacks of Power Plants

A sale-leaseback is a common financing method for power plants.  If certain conditions are met, then the seller-lessee records the sale and is permitted to remove the power plant and related debt from its balance sheet.  Sale-leaseback accounting is only permissible if, among other things, the transaction is a normal leaseback and excludes continuing involvement provisions or conditions.

Under FAS 98,

“[a] normal leaseback ... involves the active use of the property by the seller-lessee ... and excludes other continuing involvement provisions or conditions . . . . The phrase active use of the property by the seller-lessee refers to the use of the property during the lease term in the seller-lessee’s trade or business, provided that subleasing of the leased back property is minor.”

In cases where the output of the power plant that is the subject of a sale-leaseback arrangement is sold under a power contract that itself is considered a lease, it could be argued that the seller-lessee is not actively using the property because the power plant has been “subleased.” Alternatively, the lessee may be viewed as having too great a continuing involvement in the power plant to be able to take the plant off its books.  Failure to meet the criteria for sale-leaseback accounting would prohibit off-balance sheet treatment by the seller-lessee and require the seller-lessee to retain the power plant on its balance sheet and recognize a liability for any cash received in connection with the transaction.

Impact of Lease Accounting Treatment

From the perspective of the purchaser:

• If the contract were considered a “capital lease,” then the purchaser would record the lease on its books as a long-term asset and an obligation at an amount equal to the present value of the rent that the lease requires him to pay in the future.  He would be allowed to depreciate the asset and record the embedded interest expense in the rent payments.
• If the contract were considered an “operating lease,” then  the rent required by the lease would simply be expensed, straight-line, over the term of the lease.

From the perspective of the power plant owner:

• If the contract calls for the power plant owner to transfer  title to the purchaser at any time during the lease term, then the present value of the lease payments would be reclassified from fixed assets to a long-term lease receivable.  Any remaining balance in fixed assets for the facility would be reclassified to unearned income and amortized into income over the life of the lease.
• Otherwise, for existing power plants, the owner would account for the lease as an “operating lease” as if he had leased his power plant to the person who has contracted for the output. The power plant would remain on the owner’s balance sheet and would continue to be depreciated over its remaining useful life.  The owner would recognize revenue, straight-line, over the lease term.

In either case, accounting for leases requires historical cost, rather than fair value, treatment.  In other words, rent payments are expensed or taken into account as they accrue.  The lease itself is not marked to market.

If the relationship between the parties is not considered a lease, then the types of contracts discussed in this article are usually subject to mark-to-market accounting.  Even if the contract does not meet the trading criteria described in EITF Issue No. 98-10, it will usually be considered a “derivative” under FAS 133.  Proponents of mark-to-market accounting argue that the transparency of the risk exposures within a company’s portfolio is limited by the application of different accounting methods to different positions.

Conclusion

To the extent the emerging issues task force decides to define “lease” broadly, the impact on the financial statements of energy traders and electricity generators could be significant. The ramifications also extend beyond the energy industry and the types of arrangements discussed above.  Until the final guidance is issued, the determination of whether an arrangement should be viewed as a lease remains a subjective one.