The new leasing standard, from the Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC) 842, Leases, changes the accounting for leases. It requires lessees to record on their balance sheet a right-of-use asset and a lease liability for all leases not deemed to be short-term leases—leases with lease term of 12 months or less at commencement date.

Depending on the classification of the lease under ASC 842, the impact to the statement of operations and cash flow is likely to change. Consequently, the adoption of ASC 842 could potentially have a significant impact to an organization’s financial statements, including key financial ratios and other financial metrics.

Find information on the following lease accounting considerations below:

• ASC 842 effective date
• Practical expedients
• Overarching consideration for all sectors
• Oil and gas
• Renewable energy
• Utilities

ASC 842 Effective Date

The effective date for adoption of ASC 842 for entities that aren’t public business entities, or weren’t required to adopt or didn’t early adopt, is for annual periods beginning after December 15, 2021, and for all interim periods within fiscal years beginning after December 15, 2022.

The following types of leases aren’t in the scope of ASC 842:

• Leases of intangible assets
• Leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources, which includes the intangible right to explore for those natural resources and use the land in which those natural resources are contained—that is, unless those rights of use include more than the right to explore for natural resources, where equipment used to explore for the natural resources is within the scope of ASC 842
• Leases of biological assets, including timber
• Leases of inventory, including assets held for sale in the ordinary course of business, assets in the process of production for sale, and assets to be currently consumed in the production of goods or services to be available for sale
• Leases of assets under construction

Practical Expedients

ASC 842 allows for lessees to elect practical expedients to reduce the burden of implementation. The practical expedients, which must be consistently applied, are as follows:

There are three practical expedients that must be elected as a package:

• Entities don’t need to reassess whether any expired or existing contracts are or contain leases.
• Entities don’t need to reassess lease classifications for any expired or existing leases.
• Entities don’t need to reassess initial direct costs for any existing leases.

Applying Hindsight

An entity also may elect to use hindsight in determining the lease term—that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset—and in assessing impairment of the entity’s right-of-use assets. This practical expedient may be elected separately or in conjunction with the other allowed practical expedients.

An entity may elect to not assess whether existing or expired land easements that weren’t previously accounted for as leases under Topic 840 are or contain a lease under ASC 842. This practical expedient may be elected separately or in conjunction with the other allowed practical expedients.

Policy Elections by Asset Class

A lessee can make a policy election by asset class to combine lease and non-lease components and treat them as one lease component for accounting purposes.

The application of these practical expedients within each sector is further discussed below.

Overarching Consideration for all Sectors

The lease term is a consideration that could be applied to entities within the oil and gas, renewable energy, and utilities sectors.

Lease term

Lease term begins at the commencement date—the date the underlying asset is made available for use—and is based on the noncancelable portion of the lease, plus all of the following:

• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
• Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
• Periods covered by an option to extend or not terminate the lease in which the exercise of the option is controlled by the lessor

Hindsight Practical Expedient

Entities have an option to elect a practical expedient to use hindsight when determining the lease term upon adopting ASC 842. If elected, the hindsight practical expedient must be applied consistently to all of an entity’s leases. This hindsight practical expedient was intended to alleviate the burden of assessing the facts and circumstances to determine the remaining lease term of existing leases when the comparative adoption method was the only option available.

With the establishment of the effective date method through the release of Accounting Standards Update (ASU) 2018-11, the decision to elect the hindsight practical expedient becomes even more challenging depending on which method of adoption an entity selects.

Under the comparative method of adoption, the period to use hindsight would be from the date of the earliest period presented, January 1, 2021, to the effective date, January 1, 2022, versus one day, January 1, 2022 for example, under the effective date method for a calendar year entity.

If hindsight is elected, entities will need to consider all facts and circumstances through the effective date, including management’s determination of what is considered reasonably certain when considering contract renewals and contract modifications.

Public company filings indicate that election of the hindsight practical expedient has been limited, likely due to the prevalent use of the effective date method. However, as discussed in the FASB ASC 842, Leases, the benefits of applying hindsight for those entities using the effective date transition method could be significant.

By electing hindsight, entities may avoid having to remeasure a lease in the year of adoption if remeasurement events are anticipated to occur in the year of adoption and to carry forward lease classification.

A robust assessment will need to be done in order to determine the most appropriate adoption method and election of practical expedients, because these selections will likely have a significant impact on the lease terms as well as to an entity’s financial statements and related disclosures.

Oil and Gas

Within the oil and gas sector, the questions to consider are:

Even if there is an identified asset, an entity will need to assess if the supplier to the contract has substantive substitution rights because this can impact the assessment of control.

Substantive substitution rights are present if the supplier:

• Has the practical ability to substitute alternative assets throughout the period of use
• Would benefit economically from exercising its substitution rights

A supplier’s obligation to perform routine maintenance, perform normal warranty repairs, or perform routine upgrades doesn’t imply there are substantive substitution rights.

If a lessee can’t determine if substitution rights are substantive, the lessee should presume they aren’t. The analysis of whether the supplier has substantive substitution right should be done at inception of the contract and not contemplate future events that aren’t likely to occur.

Leases with Multiple Components—Lessees

In situations where a contract provides the right to use multiple assets, excluding land, each right is considered a separate lease component if the following criteria is met:

• The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee.
• The right of use is neither highly dependent on, nor highly interrelated with, the other rights to use underlying assets in the contract.

Additionally, certain contracts, such as drilling, processing and gathering, and transportation, may contain a lease and non-lease component. In these scenarios, an entity would need to allocate the contract consideration on a relative standalone price basis to each asset and non-lease component identified in the contract unless the practical expedient is elected.

Practical Expedient

ASC 842 provides a practical expedient which allows a lessee to make an accounting policy election by asset class to combine lease and non-lease components and treat them as one lease component for accounting purposes.

Joint Operating Agreements (JOAs)

Joint ventures are a widely used form of operations that entities employ to share in the activities to explore for and produce oil and gas.

A JOA is the agreement that governs the operations between the working interest owners. The JOA will identify one of the working interest owners as the operator who leads the operational activity of the joint venture. In doing so the operator enters into contracts with outside service providers and contractors.

All other working interest owners are referred to as nonoperators. Assuming these contracts contain a lease, entities that enter into JOAs will need to assess which working interest owner to the JOA controls the identified assets. This is typically analyzed through the lens of who has the enforceable rights with the service provider. The operator often is deemed to have the enforceable rights and therefore would account for a contract as a lease.

However, the other working interest owners that are party to the JOA will need to determine if any sub-leases are in place with the operator. The identification of a sub-lease might change a non-operator’s analysis of who has control of the identified asset.

Right-of-Way and Land Easements

Right-of-way agreements and land easements are very common in the oil and gas industry.

E&P companies enter into land easements in order to be granted access to mineral rights below the ground. Midstream oil and gas companies routinely enter into right-of-way agreements to have access to land in order to build out their pipeline infrastructure.

Right of Way Agreements Under ASC 842

A lease for the rights to use land that is solely to explore for natural resources that are contained within those rights are excluded from ASC 842.

Additionally, a perpetual land or right-of-way easement or land easement contract is outside the scope of ASC 842 because a lease is for the right to use an asset for a period of time. Careful consideration should be given to the terminology in a contract because it might appear to be perpetual when in fact it’s not.

If a right-of-way or land easement is considered to be in the scope of ASC 842, then an entity must determine if the contract allows it to obtain substantially all the economic benefit of the identified asset.

This will be based on many factors, including but not limited to whether the entity can direct the use of the land or restrict access to the land such that it obtains substantially all the economic benefits for the term of the contract.

ASC 842 provides for a practical expedient that allows entities to continue to treat its easement contracts in accordance with legacy generally accepted accounting principles as long as they weren’t accounted for as leases under ASC 840. If the contract was accounted for under ASC 840 or was modified on or after the adoption of ASC 842, entities will need to assess the contract in accordance with ASC 842.

Renewable Energy Considerations

When assessing a lease in the renewable energy sector, there are three main considerations:

• Offtake arrangements
• Land—wind farm or solar
• Service components—energy as a service

Offtake Arrangements

In the renewable entity sector, a purchaser will commonly engage with a developer to buy various forms of power, such as wind, solar, and hydropower from the defined project, commonly referred to as an offtake arrangement.

To determine if the offtake arrangement is a lease or contains a lease, the entity needs to consider some key aspects of the agreement. Similar to oil and gas entities, it will need to be determined if there is an identifiable asset. Secondly, the buyer of energy will need to assess if it controls the asset.

To determine control, the buyer should consider the amount of power it is purchasing compared to the total output of the project and if it was involved with the formation of the project, among other things.

Entities will need to 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.

Case Study

A case study from the ASC Topic 842 implementation guidance 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:

• Solar farm as an identified asset, explicitly specified in the contract, where the supplier doesn’t have the right to substitute the specified solar farm
• Customer has the right to obtain all economic benefits from solar-farm use over the contract term
• Customer has the right to direct the solar farm use if they designed it before construction

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 wasn’t involved with its design.
• The contract allows the supplier to substitute power from another source.

Land—Wind Farm or Solar

The scope of ASC 842 encompasses all arrangements that meet 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 ASC 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 an entity to reevaluate its accounting for existing land easements that aren’t currently accounted for as a lease under legacy GAAP.

New or modified land easements still need to be evaluated under ASC 842, although it may be difficult to determine if an easement falls under the definition of a lease. If an entity is obtaining or providing the right to use, access, or cross land for a project, then consider what type of easement has been granted—perpetual or term-based.

• 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.

Service Components—Energy as a Service

Across all industries, embedded leases have proven to be complex. A standard product supply agreement, for example, may or may not contain a lease depending on the circumstances. 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 because embedded leases are complex and challenging to assess.

Considerations for Utilities—FASB Followers

When assessing a lease in the utilities sector, note the following considerations:

• Power Purchase Agreements
• Pole Attachments
• Easements

These considerations are for those entities that follow the accounting standards issued by the FASB. There are some differences between the FASB and Governmental Accounting Standards Board (GASB) with respect to these issues.

Power Purchase Agreements

Most of these types of agreements aren’t accounted for as leases under legacy GAAP. Entities will typically just expense the power purchase costs as incurred each month. There is typically no balance sheet impact, unless a client prepays for the power under an agreement, in which case they’ll amortize the payment over the course of the agreement.

Under the new standard, some of these contracts could end up as leases. Consistent with the analysis above for oil and gas entities, to be considered a lease, an entity must meet the following two criteria:  

• Identifiable asset that an entity is deemed to control
• Entity must determine if it controls the identified asset for a period of time

A contract conveys control of the identified asset if the entity has the right to direct the use of the asset and obtain substantially all the economic benefits of the identified asset from its use.

Entities in the utilities sector will need to evaluate each of these criteria to determine if they have control of the underlying generating asset or facility. This is based on whether they have the right to direct and obtain substantially all of the economic benefits—capacity and other benefits, including renewable energy credits if applicable—from the use of the asset.

In situations where power and utilities entities buy substantially all of the power from a generating asset owned by a third party under a power purchase agreement, there could be instances where this would be viewed as having control and be considered a lease in the future.

A case study from the ASC Topic 842, Leases, implementation guidance provides examples that feature a power plant.

Per these examples, indicators that generally result in a power purchase agreement qualifying as a lease include the following:

• The power plant is an identified asset, and the customer has the exclusive right to purchase all the power produced for the period of use.
• The customer directs the use of the power plant because it provides instruction to the supplier about quantity and timing of delivery of power.
• The customer has the right to substantially obtain all economic benefits from the use of the power plant over the contract term because the supplier can’t use the power plant for another purpose.

In addition to the above examples, a tolling arrangement in which a customer has a right to control the supply of fuel to the asset could be an indicator of control and should be considered.

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 power plant is operated and maintained.
• The customer didn’t design the power plant.
• The customer doesn’t have the right to direct the use of the power plant as the customer doesn’t operate the power plant
• The customer has no right to change how and for what purpose the power plant is used during the period of use.

Entities will need to review all their contracts and agreements in this area to reevaluate whether they have the power to direct and obtain substantially all benefits from the use of the asset.

Pole Attachments

A common issue for a utility entity is determining the unit of account used for assessing control. Common practice in the industry is that a telecommunications entity will attach equipment to a pole owned by a power and utility entity and in return will pay a fee.

The issue of determining the unit of account is critical because this analysis is the first step in determining which entity has the right to direct the use of the asset and obtain substantially all the economic benefits of the identified asset from its use and ultimately if the agreement contains a lease.

First, the utility entity will need to evaluate the unit of account. Upon determination of the unit of account, then the utility entity must evaluate if it controls the unit of account. Effectively, this depends on whether the portion of the pole that the telecommunications company attaches to is distinct and has a discrete functional use, or whether the larger asset, in this case, the pole is the identified asset.

The objective of the asset owner—a utility entity for example—when the asset was built or purchased is a significant consideration. For example, did the utility entity build the asset with an intention to lease out a space on the pole? That may be the case with a cell tower that has specific hosting locations designed to be leased by third parties. However, it might not be the case for an electric utility’s distribution poles that were not built with the commercial objective of leasing out a portion of the pole.

Once the unit of account is determined, the next step is to determine control and who has the rights to the economic benefits in the context of that unit of account. If the entire pole is determined to be the unit of account, then there’s a likelihood that the utility entity maintains the rights to the economic benefits. If a portion of the pole is determined to be the unit of account, it could be supported that the telecommunications entity has the right to control that portion of the larger asset.

Easements

Many power and utility entities obtain permanent or temporary easements for the purpose of accessing or crossing land to be able to construct and maintain equipment on that land.

These types of agreements have typically never been recorded as leases in the past under ASC 840. Upon adoption of ASC 842, entities will need to evaluate easements because of the new lease definition. Consistent with oil and gas entities, power and utilities entities will need to consider whether the agreement is for a period of time or perpetual and whether the entity is able obtain substantially all the economic benefit of the identified asset.

Generally, permanent easements will not meet this definition given the lack of time constraints, but many temporary easements may meet the new definition and need to be recorded as leases.

Under the new definition, “a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration,” with “for a period of time” being key given that some easements are temporary, and some are permanent. The same considerations oil and gas companies give to assess control, as discussed above, will need to be given by power and utility companies.

Power and utility entities can take advantage of the practical expedient that allows entities to continue to treat right-of-way and land easement contracts in accordance with legacy GAAP as long as they weren’t accounted for as leases under ASC 840.

Similar to oil and gas entities, if the contract was accounted for under ASC 840 or was modified on or after the adoption of ASC 842, the contract will need to be reassessed in accordance with ASC 842.

We’re Here to Help

For guidance on how to account for ASC 842 in your sector, contact your Moss Adams professional. You can also visit our Oil & Gas Practice, Power & Utilities Practice, or our Renewable Energy Practice pages for additional resources.