Solar Development May be Hampered by Proposed New Accounting Rules

David Feldman's picture

The move for more transparency and the recognition of true risk in financial transactions may be catching up to the solar industry.  The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are responsible for establishing financial accounting standards; together, they have issued a joint exposure draft (ED) of new rules for leasing transactions.  If passed, these guidelines would significantly alter the way solar financing transactions are reported on financial balance sheets and could reduce the benefits of certain types of financing structures. Two of the most popular financing arrangements in the solar industry, sale leasebacks and power purchase agreements (PPAs), would be hit the hardest by these changes.     

Proposed Changes

The largest change the ED proposes is bringing all lease transactions onto balance sheets.  Currently, there is a difference between an operating lease and a capital lease.  In an operating lease, the lessee has the right to use an asset and not assume the responsibility of ownership.  Because of this lack of responsibility, the lessee does not have to put the asset on its balance sheet.  The proposed rules would make all companies entering leases record these transactions as assets and liabilities.  Therefore, both parties in a sale leaseback would have the solar system recorded on their balance sheets.

Another significant proposed change redefines what constitutes a lease transaction; in particular, the difference between a lease and a service contract.  This is important because PPAs are currently treated as service contracts.  One PPA provider interviewed for this article wrote, “We’ve had significant guidance from our auditor and been in training sessions with other big 4 audit firms on the convergence {ED}.  They all confirm a normal commercial PPA with the vast majority of energy fed to the host {or presumably all} …would be classified as leases.”  PPAs, treated as leases, would be reported on a company’s balance sheet, removing one of its major incentives for hosts: buying the electricity and outsourcing the hassle of owning a solar system.

An additional proposed change includes requiring more estimations as to the size of the asset and liability, estimations that often increase the dollar amount.  Currently, the contract’s minimum requirements are used for sizing these numbers.  For example, if a lease is written to be for 10 years, with two additional 5-year options, then the lease is recorded as being 10 years long.  However, the new rules would make companies estimate 1) whether they will extend the lease and for how long, 2) how much contingent rental payments will be accrued, 3) what the residual value of the asset will be, and 4) their discount rate.  Therefore, a company would now have to determine whether it plans on extending the lease, what they expect contingent payments to be for the life of the lease, what the value of the asset will be at the end of the lease, and what the proper discount rate is for the transaction.  These decisions and their reasoning must be recorded in companies’ financial statements, which should shed more light on a company’s thought process and expectation for these transactions.  However, it will also increase the recorded liability for the lease on a balance sheet and will force more judgment in calculating what those numbers will be. 

Possible Impacts

The proposed changes to the accounting practices for leases have the potential to affect many parts of a business.  One financial firm’s client report states “disclosure requirements have potential to provide investors with insight into a lessee’s lease contract that is not currently available…including the total cash lease payments paid during the reporting period.”  However, because there are greater reporting requirements, there is likely to be an increase in accounting costs over the life of the lease, making lease transactions more expensive. 

Deloitte suggests that there may also be an increase in state and local taxes that are partially based on financial statements.  Federal tax practices will remain unchanged; therefore, there will be no additional federal taxes incurred.  However, there is the potential for more confusion or errors because the tax books will be different from the accounting books.  Accountants will have to be diligent recording these numbers and understanding that accounting for these transactions on a balance sheet will be different than on a tax return.

The outcome of common metrics that analysts use to evaluate a company will be changed due to more assets and liabilities on a company’s balance sheet.  Although the financial structures of these transactions remain unchanged, companies may be perceived as having higher leverage because of the change in common metric values.  This has the potential to make debt more expensive for companies who perform lease transactions.  Some common examples of metrics that will change according to KPMG are:

  • •    Debt/equity ratio will be higher due to an increase in total debt on the balance sheet (potentially breaking pre-existing debt covenants).
  • •    Return on equity will be lower due to a decrease in net income from higher amortization and interest expense.
  • •    EBITDA for lessees will be higher due to lease payments being treated as an interest expense rather than a rent expense.

The timing of expense recognition would also change dramatically under the proposed ED.  KPMG estimates that expenses would be front-loaded because lease payments would be recognized the same way as interest expense (more interest in the beginning of a loan than the end of a loan) rather than the straight-line expense recognition currently associated with most operating leases.  The net effect of this is that the expense recognized in the early years is higher than it would have been otherwise and lower in later years.  This has an effect on net income and the perception of whether a lease is economical in the earlier years.

If PPAs are treated as leases, this could complicate or burden current contract holders and deter potential customers from entering new contracts.  As the lessee, a client/host would have to account for the solar system on their balance sheet, adding costs and complexity.  This would negate two of the PPA’s most important value propositions by diminishing cost savings and no longer having these transactions “off balance sheet.” 

Solar developers may also face obstacles because they often have two distinct arrangements: one with their investors and one with the end users. Developers often finance systems though a sale leaseback with financiers and use a PPA with their client/hosts.  By acting both as a lessor in the PPA and a lessee in the sale leaseback structure, the system would be on their balance sheet twice.  The Solar Energy Industries Association (SEIA) feels that this would create less transparency of the financial position of a company and a potential perception that transactions have been made to appear more expensive than they actually are.

Finally, if PPAs are treated as leases this may prevent non-taxing paying entities from being able to do third-party financing.  Current federal law prohibits the use of the investment tax credit (ITC) when the solar system is leased and a party to that lease is not allowed to claim the benefit, such as a government entity.  If PPAs are treated as leases, then PPA providers who work with entities that do not pay taxes would no longer be allowed to receive an ITC.  Although the Treasury Department has given guidance that 1603 grants do not follow this rule, if the 1603 grant program is not extended beyond 2011, it will no longer be economically viable for government entities to enter into PPAs. Additionally, executed PPAs with government entities may face repercussions. 

Timeline

The ED was issued on August 17, 2010, and comments to the proposed accounting standards update were due December 15, 2010.  There may be one more round for comment in 2011, and the changes are likely to be enacted sometime between 2013 and 2015.  Many in the solar industry fear the potential dampening effect this may have on the industry, and SEIA, a U.S. solar trade association, prepared a formal response to the most recent ED asking that many of the proposed changes be reconsidered. 

Conclusion

FASB/IASB are still receiving feedback from industry, and although changes will most definitely be made, the nature of them will most likely be different from the current proposal.  Transparency and uniformity in accounting practices are important in order to understand the true health of a company.  It appears that the days of off-balance sheet financing through operating leases may come to an end soon.  Although this will add some additional costs to transactions, the solar industry should be able to absorb this change.  However, if PPAs do become reclassified as leases, this may alter the financing landscape of the solar industry, stifling innovations in project financing that have erupted recently in the solar market.  Many more solar assets may be purchased through direct purchase: If a company is seen as having all the liability of ownership, they may just want to own it.

Pennsylvania Electicity's picture

Looking For Fair Accountancy

I hope this will take into fair accountancy but I know that might and might not dwell to others. Great article...
David Feldman's picture

Local government treatment

Hi Steve, Thanks for your posting. The proposal was a joint draft between FASB and IASB, so it would only affect entities that follow these guidelines. However, you bring up a good point; if GASB defers its leasing practices to FASB issuances then this would affect those entities following GASB, such as local governments. GASB has recently made clarifications which differ on certain accounting practices from FASB, however I do not know how GASB may treat these proposed rules if adopted.

A few clarifications

David, Excellent article. A few clarifications. Expense recognition is higher in the early years because interest (not principal) charges are higher. There's a corresponding problem on the lessor's side. Under current accounting rules, the lessor takes the residual into income over the lease term. Under the proposed rules, the residual would not be recognized as income until realized. Thus the lessor's yield would be lower in the early years, higher in the later. Also, the impact on tax-exempt entities is likely to be negative, but not for the reason you mentioned. Lease tax accounting does not look to financial reporting. It has its own set of rules. If tax exempts must account for PPAs as leases for financial reporting, however, PPAs may become subject to debt incurrance limitations. In Colorado, for example, municipalites could find themselves TABOR-restricted from entering into PPAs.
Steve_Nielsen's picture

Good post, thanks Do you know

Good post, thanks Do you know if this proposed change will impact how local governments book PPA vs Sale Leaseback deals? Or will that fall under GASB...