ESG Initiatives & Lease Accounting Teams

2 min read
May 18, 2023
CoStar Real Estate Manager Blog

ESG Initiatives & Lease Accounting Teams

Accounting and financial reporting of new projects draw increased scrutiny from the SEC.

Environmental, social, and governance (ESG) matters are quickly becoming a focal topic in mainstream and social media. Many accounting teams also see ESG becoming top-of-mind for investors, credit rating agencies, lenders, regulators, policymakers, and other interested parties.

What does it mean?

Corporate ESG initiatives are now getting more support and funding. However, they’re creating new and evolving types of transactions that may affect lease accounting under ASC 842.

Energy service agreements (ESAs) are one such transaction that reflects the trend of incorporating ESG objectives into ongoing operations. These transactions may also require specific accounting considerations.

ESAs are often marketed as an “off-balance sheet financing solution” that will allow companies to capture the benefits of new efficient equipment without incurring upfront capital expenditures. In a typical ESA, a company will engage a vendor to help the company reduce its energy costs and, in return, will share a portion of its cost savings with the vendor. In addition to performing various services in connection with the ESA, the vendor will often replace all, or a portion, of a company’s existing energy infrastructure (e.g., HVAC systems, boilers, light bulbs) with new environmentally sustainable equipment and retain title to the equipment located at the company’s location. Payments to the vendor are generally based on the company’s actual cost savings—for example, as a percentage of the actual savings.

How will it impact lease accounting?

From an ASC 842 standpoint, the most significant consideration is whether ESAs include embedded leases and, if so, the amount of the related lease asset and liability to be recorded. In many instances, ESAs will be deemed to include a lease because the company (lessee) controls when the asset is used and to what extent.

Because in many ESAs, the company only pays the vendor to the extent there are energy cost savings, the amount actually paid may appear entirely variable. Therefore, no lease liability or asset would be recorded. However, suppose some or all the payments are basically unavoidable. In that case, they may be viewed as in-substance fixed payments and should be considered in the lease asset and liability measurement.

The SEC, FASB and other regulators are signaling that ESG reporting will soon be front and center. Companies will need to track and report carbon costs and savings with financial-grade precision. Leases have the potential to be reported as indirect carbon costs both upstream and downstream of a company’s core operations.

It will be important for accounting and financial reporting teams to stay abreast of ESG information and engage with other corporate policymakers to shape an ecosystem of ESG transactions for the future.