A Lease, or Not a Lease: That Is the Question

The EITF believed the issue was broader than contracts in the energy industry, however, and agreed with the working group's recommendation to expand the scope of the issue. Service contracts in other industries presented issues similar to those involved with energy trading contracts where a supplier built a plant to service a specific customer's needs and, as long as the plant was operational, earned a return on the cost of the plant regardless of whether the customer purchased any of the output. In most cases, both the supplier and the customer accounted for those arrangements as service contracts, not leases.

Paragraph 1 of the FASB Statement No. 13, Accounting for Leases, defines a lease as:

'[A]n agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time. It includes agreements that, although not nominally identified as leases, meet the above definition, such as a 'heat supply contract' for nuclear fuel. This definition does not include agreements that are contracts for services that do not transfer the right to use property, plant, or equipment from one contracting party to the other. On the other hand, agreements 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.' (Emphasis added; footnote reference deleted.)

Although some of the larger accounting firms published guidance on when an arrangement conveyed the 'right to use,' diversity in practice resulted because firms did not have the same views on when an arrangement conveyed the 'right to use' property, plant, or equipment. For example, Arthur Andersen issued guidance in its 'Accounting for Leases' publication that a power purchase agreement conveyed the right to use property, plant, or equipment to the purchaser and should be accounted for as a lease by, the purchaser when: '[T]he terms of the contract (a) allow the purchaser of power the right to use, or control the ability of others to use, a specific generating facility and (b) expose the purchaser to facility-specific risks and rewards.'

Other accountants viewed the phrase 'right to use' more narrowly, looking to the purchaser's ability to operate the facility or, in some cases, obtain all of its output for an extended term.

The model developed in Issue 01-8 for assessing when an arrangement contains a lease partially resolves the diversity over what the FASB intended by the phrase 'right to use.'

The Issue 01-8 Model

The EITF reached a consensus that an arrangement contains a lease when: (a) specific property, plant, or equipment is explicitly or implicitly identified in the arrangement and fulfillment of the arrangement is dependent on that identified asset, and (b) the arrangement conveys the right to use the specified property, plant, or equipment to the purchaser. Determining whether an arrangement contains a lease should be made at the inception of the arrangement.

Identification of Specific Property, Plant, or Equipment: An arrangement for the delivery of goods or services may or may not specify a particular asset that will be used to provide those goods or services. When an arrangement does not specify a particular asset to be used, the purchaser still needs to determine if the arrangement contains a lease of property, plant, or equipment that is implicitly identified. Determining whether property, plant, or equipment has been implicitly identified requires the use of judgment. In deciding whether property, plant, or equipment is identified implicitly in an arrangement, the purchaser would need to determine if the seller controls other assets that could be used to supply the goods or services and, if so, whether it would be economically feasible for the seller to supply the contracted goods or services using those other assets. If the seller only has a single asset capable of producing the goods or providing the services, or it would not be economically feasible to use other assets to produce the goods or supply the services, property, plant, or equipment has been implicitly identified in the arrangement. The seller's control over other assets that could be used to supply the goods or services includes not only assets the seller owns, but also non-owned assets from which the seller has the right to the output or other utility (eg, through a lease of other property, plant, or equipment).

The EITF reached a consensus that specific property, plant, or equipment is not identified (and the arrangement does not contain a lease) if the seller is obligated to deliver goods or services without regard to whether a specified asset is operating and the seller has the ability to deliver those goods or services through means other than control of a specific asset. If, however, the seller is only obligated to either use other property, plant, or equipment to provide goods or services when a specified asset is not operating or refund any payments to the purchaser, the EITF concluded the seller's fulfillment of an arrangement is dependent on the specified asset.

Right to Use: An arrangement conveys the right to use specified property, plant, or equipment when any of the following conditions are present:

• 
  
• The purchaser has the right to operate or control the operation of the property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the asset. The right to control the operation of the property, plant, or equipment is present in an arrangement if the purchaser has the unconditional right to hire and fire the operator or has the ability to set or approve operating policies and procedures.
  
• The purchaser has the right to control physical access to the property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the asset.
  
• Facts and circumstances indicate it is remote that parties not related to the purchaser will take more than a minor amount of the output or other utility of the asset during the term of the arrangement and the purchaser will pay either a fixed price or a price that includes a fixed component, regardless of the output received.
  
  

The third condition above makes it clear that control over the output of specific property, plant, or equipment is sufficient for an arrangement to be a lease, even when the purchaser does not have physical or operational control over the asset.

Re-assessing Whether an Arrangement Is a Lease

As noted above, determining whether an arrangement contains a lease should be made at the arrangement's inception. If subsequent to inception there is either (a) a change in the terms of the arrangement (other than a renewal or extension), (b) an agreement between the parties to extend the term, (c) the exercise of a renewal option that was not reasonably assured of being exercised at the inception of the arrangement, (d) a change in the conclusion that the fulfillment of the contract is dependent on specific property, plant, or equipment, or (e) a substantial change in the physical characteristics of specified property, plant, or equipment, the parties should reassess whether the arrangement contains a lease. See the table below, 'Accounting for Changes in Original Assessment,' which describes the accounting by both parties to the arrangement if the original conclusion that an arrangement contained (or did not contain) a lease changes.

If the purchaser exercises an option to renew the arrangement (or the parties agree to an extension) before the original agreement has expired and the terms of the original agreement are not changed, the accounting for the remaining term of the original agreement would not change. The parties would only consider if the arrangement covered by the renewal or extension contains a lease.

In determining whether additions to (or removals from) property, plant, or equipment should give rise to a reassessment, the EITF indicated that adding or removing a physically distinct unit of property, plant, or equipment does not substantially change the physical characteristics of specified property, plant, or equipment if the purchaser's right to the output of a distinct unit of the property, plant, or equipment is not changed. For example, at inception, Purchaser is entitled to 150 MW of electricity to be produced by a generating facility having a single turbine capable of generating 150 MW. Purchaser determines that the arrangement meets the third condition in the Issue 01-8 model and accounts for the arrangement as a lease. Subsequently, Seller increases the capacity of the generating facility to 300 MW by adding a second turbine to the facility. Purchaser continues to be entitled to 150 MW of electricity after the expansion. If the second turbine is not operating, Purchaser's right to its 150 MW is not affected. As such, the addition does not result in a change to Purchaser's original conclusion.

Multiple Element Arrangements

The EITF reached a consensus that an arrangement containing a lease and other elements, such as a right to services by the seller, should be accounted for separately. Payments by the purchaser (lessee) should be separated between the lease and non-lease elements on a relative fair value basis. Then, for purposes of determining the classification of the lease, the portion of the payment attributed to the lease element should be allocated to executory costs, if any, plus a profit thereon, with the remainder attributed to the lease in accordance with paragraph 7d of Statement 13.

Divided Over Undivided Interests

One issue on which neither the EITF nor its working group could reach agreement relates to whether an undivided interest in property, plant, or equipment could be the subject of a lease when the interest was not physically distinguishable. For example, Customer A and Customer B agree to purchase 80% and 20%, respectively, of the output from a generating facility with a single turbine that Utility will construct and operate. Customer A and Customer B agree to make fixed monthly payments to Utility to reserve the capacity for a period that approximates the useful life of the plant, and will make a variable payment tied to the cost of any electricity purchased. The issue considered by the EITF and its working group was whether Customer A, Customer B, and Utility should account for the arrangement as a lease, even though the asset subject to each agreement (the undivided interest) was not physically distinguishable from the larger asset. At its June 2002 meeting, the EITF tentatively concluded that an undivided interest in property, plant, or equipment could be the subject of a lease; however, that tentative conclusion was subsequently withdrawn. The Task Force ultimately agreed not to address that issue as part of determining when an arrangement contains a lease.

Although a literal reading of the third condition in the Issue 01-8 model discussed above could lead one to conclude that an undivided interest in an asset, such as the one illustrated above, could not be the subject of a lease, that reading would not be consistent with the EITF's decision to not address that issue.

Given the EITF's decision not to resolve whether undivided interests could be the subject of a lease, diversity in practice will continue when deciding whether a purchaser's right to the output from an undivided interest in property, plant, or equipment should be accounted for as a lease under Statement 13. Diversity in the accounting by participants to an arrangement will also likely continue. For example, in the hypothetical above, if the generating facility was owned by Leaseco (instead of Utility), Leaseco may conclude the arrangement is a lease that would be classified as a direct financing lease under paragraph 7 of Statement 13, while Customer A and Customer B conclude the arrangement is not a lease because it involves undivided interests.

Effective Date and Transition

The consensus on Issue 01-8 is effective for arrangements with a date of inception (as defined in paragraph 5b of Statement 13, as amended) on or after the beginning of an entity's first reporting period after May 28, 2003 (July 1, 2003 for calendar year public companies or January 1, 2004 for calendar year private companies). In addition, the consensus applies to modifications of existing arrangements and arrangements acquired in business combinations initiated on or after the beginning of an entity's first reporting period after May 28, 2003.

If an arrangement involves an asset to be constructed and that arrangement is either modified or acquired as part of a business combination on or after the effective date described in the previous paragraph, the guidance in EITF Issue 97-10, 'The Effect of Lessee Involvement in Asset Construction,' would not apply even if the modified (acquired) arrangement was determined to be a lease provided the parties were committed (as used in Issue 97-10) to the arrangement before May 28, 2003 and construction has commenced by December 31, 2003.

Half Empty or Half Full?

Despite the EITF's decision not to address undivided interests, the guidance in Issue 01-8 will prove to be helpful in identifying disguised lease agreements and should improve the transparency of financial reporting by requiring a purchaser (lessee) to provide the disclosures required by Statement 13 and, in some cases, recognize an asset and an obligation for those leased assets on its balance sheet.

Jeffrey Ellis was a member of the Issue 01-8 working group and is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he consults with engagement teams on a wide range of technical accounting issues.

Accounting for Changes in Original Assessment

At its May 15, 2003 meeting, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) came to a consensus on Issue No. 01-8, 'When an Arrangement Contains a Lease,' ending almost two years of deliberations on the issue. As the name implies, the purpose of Issue 01-8 is to provide guidance to accountants to assist them in identifying when an arrangement, including one containing multiple elements, is a lease. Determining when an arrangement is (or includes) a lease can be a difficult and judgmental process. Although the guidance in Issue 01-8 will prove helpful to accountants in determining whether a certain population of transactions contains a lease, it will not remove the difficulty or judgment involved in determining whether a lease exists for a large number of structured transactions.

Background

Issue 01-8 was added to the EITF's agenda in July 2000, primarily as a result of diversity in practice related to determining when an energy-related contract (such as a power purchase agreement that gave the purchaser the right, but not the obligation, to purchase a specified quantity or percentage of the output of a generating facility in exchange for a fixed monthly capacity payment) was a lease, a derivative, or another executory contract subject to the guidance in EITF Issue 98-10, 'Accounting for Contracts Involved in Energy Trading and Risk Management Activities.' (Although added to the agenda in 2000, the issue was not discussed by the EITF until January 2002. Prior to that, the issue had been referred to a working group charged with making recommendations to the EITF. The working group, which included representatives from public accounting, industry and the FASB and Securities and Exchange Commission staffs, commenced its discussions in August 2001.) Contracts within the scope of Issue 98-10 could be reported at fair value, with changes in fair value recognized in earnings, while leases could not. Therefore, it was important for energy traders, who believed fair value accounting provided more relevant information to users of financial statements, to be able to conclude that a contract was not a lease. Energy traders generally argued that a contract was not a lease because a trader did not control (was not operating) the property that was producing (or transporting) the energy, was not taking all of the productive capacity of the property, and was not exposed to the normal risks and rewards of owning the asset. Rather, the energy trader was exposed to the risk of changes in commodity prices if the asset from which delivery was expected was not operating.

The EITF believed the issue was broader than contracts in the energy industry, however, and agreed with the working group's recommendation to expand the scope of the issue. Service contracts in other industries presented issues similar to those involved with energy trading contracts where a supplier built a plant to service a specific customer's needs and, as long as the plant was operational, earned a return on the cost of the plant regardless of whether the customer purchased any of the output. In most cases, both the supplier and the customer accounted for those arrangements as service contracts, not leases.

Paragraph 1 of the FASB Statement No. 13, Accounting for Leases, defines a lease as:

'[A]n agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time. It includes agreements that, although not nominally identified as leases, meet the above definition, such as a 'heat supply contract' for nuclear fuel. This definition does not include agreements that are contracts for services that do not transfer the right to use property, plant, or equipment from one contracting party to the other. On the other hand, agreements 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.' (Emphasis added; footnote reference deleted.)

Although some of the larger accounting firms published guidance on when an arrangement conveyed the 'right to use,' diversity in practice resulted because firms did not have the same views on when an arrangement conveyed the 'right to use' property, plant, or equipment. For example, Arthur Andersen issued guidance in its 'Accounting for Leases' publication that a power purchase agreement conveyed the right to use property, plant, or equipment to the purchaser and should be accounted for as a lease by, the purchaser when: '[T]he terms of the contract (a) allow the purchaser of power the right to use, or control the ability of others to use, a specific generating facility and (b) expose the purchaser to facility-specific risks and rewards.'

Other accountants viewed the phrase 'right to use' more narrowly, looking to the purchaser's ability to operate the facility or, in some cases, obtain all of its output for an extended term.

The model developed in Issue 01-8 for assessing when an arrangement contains a lease partially resolves the diversity over what the FASB intended by the phrase 'right to use.'

The Issue 01-8 Model

The EITF reached a consensus that an arrangement contains a lease when: (a) specific property, plant, or equipment is explicitly or implicitly identified in the arrangement and fulfillment of the arrangement is dependent on that identified asset, and (b) the arrangement conveys the right to use the specified property, plant, or equipment to the purchaser. Determining whether an arrangement contains a lease should be made at the inception of the arrangement.

Identification of Specific Property, Plant, or Equipment: An arrangement for the delivery of goods or services may or may not specify a particular asset that will be used to provide those goods or services. When an arrangement does not specify a particular asset to be used, the purchaser still needs to determine if the arrangement contains a lease of property, plant, or equipment that is implicitly identified. Determining whether property, plant, or equipment has been implicitly identified requires the use of judgment. In deciding whether property, plant, or equipment is identified implicitly in an arrangement, the purchaser would need to determine if the seller controls other assets that could be used to supply the goods or services and, if so, whether it would be economically feasible for the seller to supply the contracted goods or services using those other assets. If the seller only has a single asset capable of producing the goods or providing the services, or it would not be economically feasible to use other assets to produce the goods or supply the services, property, plant, or equipment has been implicitly identified in the arrangement. The seller's control over other assets that could be used to supply the goods or services includes not only assets the seller owns, but also non-owned assets from which the seller has the right to the output or other utility (eg, through a lease of other property, plant, or equipment).

The EITF reached a consensus that specific property, plant, or equipment is not identified (and the arrangement does not contain a lease) if the seller is obligated to deliver goods or services without regard to whether a specified asset is operating and the seller has the ability to deliver those goods or services through means other than control of a specific asset. If, however, the seller is only obligated to either use other property, plant, or equipment to provide goods or services when a specified asset is not operating or refund any payments to the purchaser, the EITF concluded the seller's fulfillment of an arrangement is dependent on the specified asset.

Right to Use: An arrangement conveys the right to use specified property, plant, or equipment when any of the following conditions are present:

• 
  
• The purchaser has the right to operate or control the operation of the property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the asset. The right to control the operation of the property, plant, or equipment is present in an arrangement if the purchaser has the unconditional right to hire and fire the operator or has the ability to set or approve operating policies and procedures.
  
• The purchaser has the right to control physical access to the property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the asset.
  
• Facts and circumstances indicate it is remote that parties not related to the purchaser will take more than a minor amount of the output or other utility of the asset during the term of the arrangement and the purchaser will pay either a fixed price or a price that includes a fixed component, regardless of the output received.
  
  

The third condition above makes it clear that control over the output of specific property, plant, or equipment is sufficient for an arrangement to be a lease, even when the purchaser does not have physical or operational control over the asset.

Re-assessing Whether an Arrangement Is a Lease

As noted above, determining whether an arrangement contains a lease should be made at the arrangement's inception. If subsequent to inception there is either (a) a change in the terms of the arrangement (other than a renewal or extension), (b) an agreement between the parties to extend the term, (c) the exercise of a renewal option that was not reasonably assured of being exercised at the inception of the arrangement, (d) a change in the conclusion that the fulfillment of the contract is dependent on specific property, plant, or equipment, or (e) a substantial change in the physical characteristics of specified property, plant, or equipment, the parties should reassess whether the arrangement contains a lease. See the table below, 'Accounting for Changes in Original Assessment,' which describes the accounting by both parties to the arrangement if the original conclusion that an arrangement contained (or did not contain) a lease changes.

If the purchaser exercises an option to renew the arrangement (or the parties agree to an extension) before the original agreement has expired and the terms of the original agreement are not changed, the accounting for the remaining term of the original agreement would not change. The parties would only consider if the arrangement covered by the renewal or extension contains a lease.

In determining whether additions to (or removals from) property, plant, or equipment should give rise to a reassessment, the EITF indicated that adding or removing a physically distinct unit of property, plant, or equipment does not substantially change the physical characteristics of specified property, plant, or equipment if the purchaser's right to the output of a distinct unit of the property, plant, or equipment is not changed. For example, at inception, Purchaser is entitled to 150 MW of electricity to be produced by a generating facility having a single turbine capable of generating 150 MW. Purchaser determines that the arrangement meets the third condition in the Issue 01-8 model and accounts for the arrangement as a lease. Subsequently, Seller increases the capacity of the generating facility to 300 MW by adding a second turbine to the facility. Purchaser continues to be entitled to 150 MW of electricity after the expansion. If the second turbine is not operating, Purchaser's right to its 150 MW is not affected. As such, the addition does not result in a change to Purchaser's original conclusion.

Multiple Element Arrangements

The EITF reached a consensus that an arrangement containing a lease and other elements, such as a right to services by the seller, should be accounted for separately. Payments by the purchaser (lessee) should be separated between the lease and non-lease elements on a relative fair value basis. Then, for purposes of determining the classification of the lease, the portion of the payment attributed to the lease element should be allocated to executory costs, if any, plus a profit thereon, with the remainder attributed to the lease in accordance with paragraph 7d of Statement 13.

Divided Over Undivided Interests

One issue on which neither the EITF nor its working group could reach agreement relates to whether an undivided interest in property, plant, or equipment could be the subject of a lease when the interest was not physically distinguishable. For example, Customer A and Customer B agree to purchase 80% and 20%, respectively, of the output from a generating facility with a single turbine that Utility will construct and operate. Customer A and Customer B agree to make fixed monthly payments to Utility to reserve the capacity for a period that approximates the useful life of the plant, and will make a variable payment tied to the cost of any electricity purchased. The issue considered by the EITF and its working group was whether Customer A, Customer B, and Utility should account for the arrangement as a lease, even though the asset subject to each agreement (the undivided interest) was not physically distinguishable from the larger asset. At its June 2002 meeting, the EITF tentatively concluded that an undivided interest in property, plant, or equipment could be the subject of a lease; however, that tentative conclusion was subsequently withdrawn. The Task Force ultimately agreed not to address that issue as part of determining when an arrangement contains a lease.

Although a literal reading of the third condition in the Issue 01-8 model discussed above could lead one to conclude that an undivided interest in an asset, such as the one illustrated above, could not be the subject of a lease, that reading would not be consistent with the EITF's decision to not address that issue.

Given the EITF's decision not to resolve whether undivided interests could be the subject of a lease, diversity in practice will continue when deciding whether a purchaser's right to the output from an undivided interest in property, plant, or equipment should be accounted for as a lease under Statement 13. Diversity in the accounting by participants to an arrangement will also likely continue. For example, in the hypothetical above, if the generating facility was owned by Leaseco (instead of Utility), Leaseco may conclude the arrangement is a lease that would be classified as a direct financing lease under paragraph 7 of Statement 13, while Customer A and Customer B conclude the arrangement is not a lease because it involves undivided interests.

Effective Date and Transition

The consensus on Issue 01-8 is effective for arrangements with a date of inception (as defined in paragraph 5b of Statement 13, as amended) on or after the beginning of an entity's first reporting period after May 28, 2003 (July 1, 2003 for calendar year public companies or January 1, 2004 for calendar year private companies). In addition, the consensus applies to modifications of existing arrangements and arrangements acquired in business combinations initiated on or after the beginning of an entity's first reporting period after May 28, 2003.

If an arrangement involves an asset to be constructed and that arrangement is either modified or acquired as part of a business combination on or after the effective date described in the previous paragraph, the guidance in EITF Issue 97-10, 'The Effect of Lessee Involvement in Asset Construction,' would not apply even if the modified (acquired) arrangement was determined to be a lease provided the parties were committed (as used in Issue 97-10) to the arrangement before May 28, 2003 and construction has commenced by December 31, 2003.

Half Empty or Half Full?

Despite the EITF's decision not to address undivided interests, the guidance in Issue 01-8 will prove to be helpful in identifying disguised lease agreements and should improve the transparency of financial reporting by requiring a purchaser (lessee) to provide the disclosures required by Statement 13 and, in some cases, recognize an asset and an obligation for those leased assets on its balance sheet.

Jeffrey Ellis was a member of the Issue 01-8 working group and is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he consults with engagement teams on a wide range of technical accounting issues.

Accounting for Changes in Original Assessment