PwC

1. Accounting For Leases NARUC Staff Subcommittee on Accounting and Finance Spring 2008 Conference Michael (Casey) Herman, Partner Mia DeMontigny, Senior Manager PwC

2. Agenda/Contents Overview Identifying a lease Classification of leases Regulatory accounting Sale-leaseback transactions Lease considerations in construction Standard-setting activities

3. Overview • The application of lease accounting to contracts has become and continues to be more common as a result of EITF 01-8 and related long-term procurement programs • EITF 01-8 model is based on the right to use property, plant and equipment and not the form of the arrangement (i.e., the contract does not need to be called a “lease” to be a lease) • Often, purchase arrangements that would be accounted for as executory contracts prior to the issuance of EITF 01-8 will be accounted for as leases today

4. Accounting for power purchase agreements Is the contract a lease (EITF 01-08)? Is the contract a variable interest(FIN 46R)? Is the entity the primary beneficiary? No Yes Yes No Yes Consolidate Determine if the contract is a capital or operating lease Consider FAS 133 (including embedded derivatives) Disclose Today we will focus on lease determination and issues only

5. Is the contract a lease? Is the contract a lease? What does this mean? • The contract is a lease if: • The contract is dependent on a particular plant (may be explicit or implicit), and • The buyer has the right to control the plant through any of the following: • Ability to operate the plant while obtaining more than a minor amount of the output, or • Ability to control physical access while obtaining more than a minor amount of the output, or • Remote that another purchaser will take more than 10% of output • A contract for more than 90% of the output of a plant will be a lease • A contract for less than 90% of the output could be a lease if it is remote that another purchaser will take any output

6. What type of lease is it (lessee)? What type of lease is it? What does this mean? • The contract is a capital lease if: • The purchaser has a bargain purchase option or title is transferred at the end of the lease • Lease term is more than 75% of the estimated economic life • Present value of minimum lease payments >= 90% of the fair value of the leased property • The contract is an operating lease if: • The property is in the last 25% of its useful life (unless there is a bargain purchase option or title transfer) • If is not a capital lease • A short-term contract (< 5 years) will often be classified as an operating lease • A lease of old equipment (in the last 25% of its economic life) will also generally be classified as an operating lease • A long-term purchase power agreement (> 20 years) will typically be a capital lease • Additional analysis will be required to assess medium term contracts

7. What type of lease is it (lessor)? What type of lease is it? What does this mean? • Consider FIN 43 and EITF 00-11 • The contract is a sales-type lease only if title is transferred at the end of the lease • The contract is a direct financing lease if: • There is no manufacturer’s or dealer’s profit; i.e., fair value of the plant at the inception of the lease = its fair value • Any of the criteria for a capital lease are met and both: • Collectibility of minimum lease payments is predictable • No important uncertainties of costs to be incurred by lessor • The contract is an operating lease if the above criteria are not met • Often, a PPA resulting in a lease of the plant will be an operating lease for the lessor unless title transfers to the lessee at the end of the lease • The analysis should be performed at lease inception • Lease inception is the time that the lease arrangement or written commitment is signed • Classification as direct financing is considered rare: may possibly qualify if lease inception is at or very shortly after the construction of the plant

8. Regulatory accounting • FAS 71 concludes that the regulator cannot affect the classification of a lease liability on the balance sheet – classification is governed by FAS 13 • If lease is capital, but treated as operating for ratemaking purposes, must still reflect the lease asset and lease obligation on the balance sheet • However, the income statement expense recognition should follow recovery pattern (paragraph 42 of FAS 71) • Amortization of leased asset modified so that total of interest on lease obligation + amortization of leased asset = rental expense allowed for ratemaking • Effectively forces the amortization of the leased asset to equal the reduction of the obligation / no change in interest

9. Impact of regulatory treatment • Generally results in smaller amortization expense in early years as compared to a non-regulated entity • Utilities do not usually earn a rate of return on capitalized lease obligations as would be the case for owned assets in rate base • However, capitalized lease assets may have an impact on cost of capital (borrowing rate) due to the lease obligation • Difference between GAAP lease expense and ratemaking lease expense reported as a regulatory asset or liability • By including lease payments as an allowable expense, the regulator sets rates that result in recovery of approximately the combined amount of the capitalized lease asset and interest on the obligation over the lease term • Results in reasonable assurance of an asset (paragraph 9 of FAS 71)

10. Example: lease expense recognition patterns for a utility under FAS 13 and FAS 71 • A utility leases an asset costing $1,000 for a term of ten years, which is also the asset’s useful life • The interest rate implicit in the lease is 12% • Rate recovery occurs as rental payments are made

11. Sale-leaseback transactions: utility plant • Sale of property and a lease of all or part of the property, for all or part of the property’s remaining economic life, back to the seller • Sale-leaseback transactions continue to be seen in the industry • Method to raise capital – e.g. sale later in the plant’s life • Utility/lessee may seek to do a sale-leaseback on a major capital addition to ease “rate shock” to its customers • Buyer/lessor receives tax benefits of the major plant • Seller/lessee objective usually to record a sale and operating lease • Lowers burden on balance sheet • Recognition of profit on sale

12. Sale-leaseback transactions • Sale-leaseback transactions are primarily governed by FAS 98 • Accounted for as follows: • Purchaser-lessor: as a purchase of the asset and classification of the lease in accordance with FAS 13 • Seller-lessee: as a sale (if sale criteria are met), removal of property and related liabilities from the balance sheet, and classification of the lease in accordance with FAS 13 • If sale criteria are not met for real estate, including integral equipment, then as a borrowing or deposit

13. Sale-leaseback transactions: utility plant • There are many considerations when determining whether sale accounting involving real estate (including “integral equipment”) can be accomplished, and it can be very difficult to achieve under FAS 98 • Key issue is usually lack of transfer of risks and rewards, and continuing involvement on the part of the seller-lessee • E.g., nuclear facilities would not qualify if the seller-lessee responsible for decommissioning • Guidance outlining types of continuing involvement can be found in: • FAS 98, paragraphs 11-13 • FAS 66, paragraphs 25-39 and 41-43

14. Sale-leaseback transactions: continuing involvement Examples of provisions prohibiting sale accounting under FAS 98 • Obligation or option to repurchase the property, including contingent puts • Seller-lessee guarantee of the buyer-lessor’s investment or a return on that investment • Requirement at the end of the lease to pay the buyer-lessor for a decline in the fair value of the property below estimated residual value • Seller-lessee providing nonrecourse financing to the buyer-lessor (e.g. accelerated lease payments that are not justified by estimated increases in the cost of using the leased property) • Any provision that allows the seller-lessee to participate in any future profits of the buyer-lessor or appreciation of the leased property

15. Lease considerations in construction • Current resurgence in construction bears consideration of potential issues for lessees • A lessee could be deemed the owner of a construction project in certain instances • Guidance is in EITF 97-10 and issue is whether the lessee has substantially all of the construction period risks – applies specifically, but is not limited to “build-to-suit” real estate • If deemed the owner during construction, effectively a sale-leaseback of the asset occurs when the asset is complete and the lease term begins • Subject to FAS 98 sale-leaseback considerations previously discussed

16. Lease considerations in construction Generally, there are three scenarios that could cause a lessee to be deemed the owner of a construction project: • Construction commences before lease agreement is executed • Lessee exposed to paying 90% or more of the costs of a construction project – the “maximum guarantee test” of EITF 97-10 • Similar to the “90% test” in paragraph 7d of FAS 13 • If lessee could be required, at any point of time during the construction period, to pay 90% or more of total project costs • Test performed only once • Lessee assumes qualitative characteristics of construction project ownership under EITF 97-10

17. Qualitative characteristics of construction ownership EITF 97-10 qualitative considerations demonstrating construction ownership by the lessee • In-substance equity investment in the lessor-owner (e.g. loan that is in-substance an investment) • Direct payments to suppliers for certain costs of the project • Lessee indemnification of the owner-lessor or its lenders for pre-existing environmental risks, and risk of loss is more than remote • Lessee indemnifications or guarantees to any party other than the owner-lessor for costs arising from third-party damage claims • Lessee takes title to the real estate at any time during the construction period or provides certain supplies or other components used in constructing the project • Lessee owns the land and does not lease it OR leases the land and does not sublease it to the owner-lessor before construction commences

18. Leases: standard setting activities • EITF 08-3: Accounting by Lessees for Maintenance Deposits under Lease Agreements • Addresses advance nonrefundable deposits made by the lessee to the lessor that will be reimbursed to the lessee upon completion of maintenance of a leased asset • Tentative decision in March 2008 that lessee should treat the deposit as a receivable; uncollectible amounts would be additional rent expense • Cost of maintenance should be expensed or capitalized (according to the lessee’s accounting policy) when maintenance performed • Will be effective in fiscal periods beginning after December 15, 2008

19. Leases: standard setting activities • EITF 08-2: Revenue Recognition by Lessors on Maintenance Payments in Lease Arrangements • Addresses how revenue should be recognized by lessors that perform maintenance services • No decision yet • Joint project by FASB and IASB on lease accounting • FASB took project on due to concerns that current model does not result in an accurate reflection of the resources and obligations resulting from lease transactions • Project is addressing FAS 13 and IAS 17 and related amendments and interpretations • Significant long-term project

20. © 2008 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, other member firms of PricewaterhouseCoopers International Ltd., each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP. PwC Questions?