Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), was issued by the Financial Accounting Standards Board (FASB) in February 2016; it went into effect for public business entities and employee benefit plans and not-for-profit conduit bond obligors that file or furnish financial statements with the SEC for fiscal years beginning after December 15, 2018.
The FASB recently issued ASU 2019-10 which defers the effective date for nonpublic entities to fiscal years beginning after December 15, 2020. For more information, please see our alert.
Accounting Standards Codification (ASC) Topic 842 now requires lessees to record assets and liabilities on the balance sheet for almost all leases, including operating leases that are greater than 12 months. This could significantly change your balance sheet and impact your debt covenants.
Below are some frequently asked questions about ASC Topic 842 and how it affects renewable energy companies—particularly solar farms.
What items meet the definition of a lease?
Under the new lease guidance, a contract will generally contain a lease when there is an identified asset and the lessee has the right to control that identified asset.
A potential starting point is to check if you’re aware of all your leases under the FASB’s amended guidance. Assess your company’s contracts and identify if there are identified assets and determine which party has the right to control the asset. If the supplier or lessor doesn’t have substantive substitution rights, and if the customer or the lessee has say over how the asset is used, then the contract may contain a lease and should be further evaluated.
The scope of ASC Topic 842 encompasses all arrangements that meets the definition of a lease including embedded leases. An easement typically allows another party or entity other than the owner to use or access property for a designated purpose; one such asset could be a specific section of land.
To reduce the cost of adopting the ASC Topic 842 for certain land easements, the FASB provided an optional transition practical expedient as part of ASU 2018-01. If elected, the optional transition practical expedient wouldn’t require you to reevaluate your accounting for existing land easements that aren’t currently accounted for as a lease under legacy GAAP.
However, new or modified land easements still need to be evaluated under ASC Topic 842. Keep in mind that it may be difficult to determine if an easement falls under the definition of a lease. If you’re obtaining or providing the right to use, access, or cross land for a project, then consider what type of easement has been granted:
- Perpetual. These don’t have time limitations and are outside of the scope of ASC Topic 842.
- Term-based. These have time limitations and could meet the definition of a lease under ASC Topic 842.
Even if a term-based easement is long-term in nature, it can fall within the definition of a lease.
What’s most challenging when implementing the new lease accounting standard?
One of the more challenging areas of the new Leases standard is identifying terms within other contracts that meet the criteria for lease accounting.
Across all industries, embedded leases have proven to be complex. Consider a standard product supply agreement, for example. This type of contract might not seem like it contains a lease, but it may include an embedded lease if the purchaser has control over the majority of the services output.
As a result, renewable energy companies should carefully examine all service contracts to assess if there’s a lease component.
Renewable Energy Project Developers
Look at the details of each individual contract to determine if it contains an embedded lease. For example, the contracts for a solar farm may or may not qualify for lease accounting.
A case study from the ASC Topic 842 implementation guidance (Example 9, paragraphs 842-10-55-108 through 55-123) provides examples that feature a solar farm.
Per these examples, indicators that generally result in a power purchase agreement qualifying as a lease include the following:
- The solar farm is an identified asset as it is explicitly specified in the contact and the supplier doesn’t have the right to substitute the specified solar farm.
- The customer has the right to substantially obtain all of the economic benefits from the use of the solar farm over the contract term.
- The customer has the right to direct the use of the solar farm as the customer designed the solar farm before it was constructed.
However, even if the contract contains an identified asset, the following indicators will still generally result in a power purchase agreement not qualifying as a lease:
- The supplier is the only party that can make decisions about how the solar farm is operated and maintained.
- The customer doesn’t have the right to direct the use of the solar farm as the customer doesn’t operate the solar farm and the customer had no involvement in the design of the solar farm.
In short, embedded leases are complex and challenging to assess.
Does lease accounting affect your balance sheet?
The primary issue is the adoption of the standard could increase your liabilities on the balance sheet that impact certain loan covenants depending on how they are written. Operating lease liabilities aren’t technically considered debt under general accepted accounting principles (GAAP), but those that haven’t historically been recognized on the balance sheet will now likely be recognized.
Companies should carefully review their debt covenants, particularly any leverage ratio requirements, to determine if the new liabilities will factor into existing debt covenants.
Tax credits create some interesting questions for financial reporting. The investment and production tax credits are prominent for renewable energy companies. Lease accounting doesn’t create this credit, but if you have an investment tax credit—which most solar companies do—you have to reduce your fair value for the amount of investment tax credit retained by the lessor. This could impact the classification of the lease on your balance sheet, which has a bit of a domino effect.
When should I begin implementation efforts?
The FASB received feedback from stakeholders in regard to challenges being encountered while implementing ASC Topic 842, and how these challenges are magnified for nonpublic entities.
When the FASB deferred the effective date for the new lease standard for nonpublic entities, they indicated it’s taken more time for organizations to implement ASC Topic 842 than expected, one reason being due to the identification of embedded leases.
Even with the deferral, you should continue planning for the new lease standard. The implementation of ASC Topic 842 will be challenging, time consuming, and resource-driven–much more so than many organizations anticipate.
What are your next steps?
- Give yourself time to begin implementation efforts.
- Try to have a solid understanding of how ASC Topic 842 defines a lease.
- Remember that a term-based easement could meet the definition of a lease.
- Look at your service contracts to see if they contain an embedded lease.
- Evaluate any existing debt covenants you may have.
We’re Here to Help
For more details on lease accounting, see our Lease Accounting Guide. To understand your specific implementation efforts, contact your Moss Adams professional.