Tennessee Valley Authority: Information on Lease-Leaseback and Other Financing Arrangements
Published: 2003-06-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Concern about the implications of the Tennessee Valley Authority's (TVA) debt on its future competitiveness prompted Representative Richard Baker to ask GAO to determine TVA's planned and actual use of nontraditional financing arrangements (which, to date, has consisted primarily of lease-leaseback arrangements), who is at risk under TVA's lease-leaseback arrangements, and whether TVA's accounting for the lease-leaseback arrangements complies with applicable standards and requirements.
section_title: What GAO Found
paragraphs: TVA has traditionally financed its operations with cash generated from operations, the issuance of bonds and notes, and in the past, appropriations. However, in fiscal year 2000, it began to use alternative forms of financing (primarily lease-leaseback arrangements) and is considering expanding their use. The lease-leaseback arrangements involve the refinancing of 24 combustion turbine power generators that are used during periods of peak demand for power. The lease-leaseback arrangements accounted for about $945 million of the $992 million raised by alternative financing arrangements as of May 31, 2003. After the power generators were constructed, TVA leased them to private investors for 50 years and simultaneously leased them back for 20 years. Under these lease-leaseback arrangements, TVA received cash from the private investors, which was obtained by issuing debt in the public market and through the investors' own equity. TVA is responsible for making lease payments for 20 years, at the end of which it has the option to purchase the private investors' interest in the assets. TVA retains legal title to the assets under the arrangements but relinquishes sufficient interest in the assets so that the equity investors are entitled to certain tax benefits. The equity investors pass on some of these benefits to TVA in the form of more favorable financing rates. As a result, TVA is able to lower costs over the first 20 years of the arrangement. However, to retain use of the assets after the 20-year period, TVA would have to purchase the equity investors' remaining interest in the assets at the assets' fair market value at that time. Depending on the fair market value, TVA is at risk of incurring higher overall costs than under traditional debt financing. In large part, the determination as to who will be the net beneficiary of these arrangements and the implications to the federal treasury will hinge on the future value of the assets. TVA's lease-leaseback arrangements have been accounted for and reported in compliance with applicable standards and requirements for financial reporting, budgetary reporting, and debt cap compliance. TVA's lease-leaseback arrangements are treated as liabilities in its financial statements and classified as debt in the President's Budget. However, they are not counted against the debt cap in the TVA Act. While the lease-leaseback arrangements are not considered debt for purposes of financial reporting and debt cap compliance, they have substantially the same economic impact on TVA's financial condition and future competitiveness as traditional debt financing.

section_title: Letter
paragraphs: This report responds to your June 13, 2002, request that we review the  Tennessee Valley Authority’s (TVA) use of lease-leaseback financing  arrangements.  When the Congress gave TVA the authority to self-finance  in 1959 by amending the Tennessee Valley Authority Act of 1933 (TVA Act),  it established a limit on TVA’s ability to incur debt through the issuance of  bonds and notes (debt cap).  The debt cap currently stands at $30 billion.
Recently, you and other members of the Congress have expressed concern  about the potential impact of TVA’s debt on its future competitiveness.  TVA  officials have also indicated that TVA’s financial condition and competitive  prospects could be improved by reducing debt and the corresponding  financing costs.  In the 5-year period from October 1, 1997, through  September 30, 2002, TVA reduced its outstanding debt from $27.4 billion to  $25.3 billion, or about $2.1 billion.  At the same time, TVA entered into  “alternative financing” arrangements (primarily lease-leaseback  arrangements) to refinance new power plants that result in long-term  obligations similar to debt, but which are not counted toward this debt  limit or reported as debt on its financial statements.  While not reported as  debt, these alternative financing arrangements are included as “other  liabilities” on TVA’s balance sheet.
Your concern about the future implications of TVA’s debt and other  financing obligations prompted you to ask us to review TVA’s use of lease- leaseback financing arrangements.  Specifically, you asked us to determine  (1) what lease-leaseback financing arrangements have been used by TVA to  date and the extent to which these and other alternative financing  arrangements are being considered for future use, (2) who has legal  ownership of the assets financed through lease-leaseback arrangements  and who is at financial risk if the projects do not work out as planned, and  (3) whether TVA is properly accounting for the lease-leaseback  arrangements for the purposes of financial reporting, budgetary reporting,  and debt cap compliance.
subsections: section_title: Background
paragraphs: TVA is a multipurpose, independent, wholly-owned federal corporation  established by the TVA Act.  The act established TVA to improve the quality  of life in the Tennessee River Valley by improving navigation, promoting  regional agricultural and economic development, and controlling the  floodwaters of the Tennessee River.  To those ends, TVA erected dams and  hydropower facilities on the Tennessee River and its tributaries.  To meet  the subsequent need for more electric power, TVA expanded beyond  hydropower, adding coal-fired power plants and nuclear generating units to  its power system.
From its inception in 1933 through fiscal year 1959, TVA received  appropriations to finance its internal cash and capital requirements.   However, in 1959, the Congress amended the TVA Act to authorize the use  of debt financing.  Under this legislation, the Congress ended the  appropriations that had financed the TVA power program and required that  TVA’s power program be “self financing” through revenues from electricity  sales.  For its capital needs in excess of funds generated from operations,  TVA was authorized to borrow by issuing bonds and notes.  TVA’s authority  to issue bonds and notes is set by the Congress and is currently $30 billion.   However, the Congress did continue to appropriate money for certain  nonpower programs (e.g., flood control and navigation) through fiscal year  1999.  Since fiscal year 1999, the Congress has not appropriated money to  pay for nonpower programs, and power revenues have been used to pay for  them.
Under the TVA Act, as amended, TVA is not subject to most of the  regulatory and oversight requirements that commercial electric utilities  must satisfy.  The act vests all authority to run and operate TVA in its three- member board of directors.  Legislation also limits competition between  TVA and other utilities.  The TVA Act was amended in 1959 to establish  what is commonly referred to as the TVA “fence,” which prohibits TVA,  with some exceptions, from entering into contracts to sell power outside  the service area that TVA and its distributors were serving on July 1, 1957.   In addition, the Energy Policy Act of 1992 (EPAct) provides TVA with  certain protections from competition, called the “anti-cherry picking”  provisions.  Under EPAct, TVA is exempt from having to allow other  utilities to use its transmission lines to transmit (“wheel”) power to customers within TVA’s service area.  This legislative framework generally  insulates TVA from direct wholesale competition.  As a result, TVA remains  in a position similar to that of a regulated utility monopoly.
The electric utility industry in the United States is undergoing major  changes, the outcomes of which will affect consumers.  The federal  government and nearly half the states have undertaken efforts to introduce  competition in the wholesale and retail electricity markets, respectively.   Federal actions have already resulted in the introduction and expansion of  regional wholesale electricity markets.  Some states have also introduced  competition into retail markets, though these efforts remain in an early  stage of development.  Most states have either not yet begun to introduce  planned restructuring or are not currently considering the introduction of  retail competition.  Because of the ongoing restructuring efforts in the  electric utility industry, TVA management and many industry experts  expect that in the future TVA will likely lose its legislative protections from  competition.
We have issued reports indicating that TVA’s high debt and related interest  expense could place it at a competitive disadvantage if it lost its legislative  protections from competition.  In July 1997, TVA issued a 10-year business  plan with steps it believed were necessary to better position itself for an era  of increasing competition.  Two key strategic objectives of the plan were to  (1) reduce the cost of power primarily by reducing debt and the  corresponding financing costs and (2) increase financial flexibility by  reducing fixed costs.  To help meet these objectives, the plan called for TVA  to reduce its interest expense by reducing its debt by about one-half of its  1997 level, to about $13.2 billion.  To increase its financial flexibility and  generate cash that could be used to reduce debt, TVA increased its  electricity rates beginning in 1998 and planned to reduce certain expenses  and limit capital expenditures.  TVA’s plan to reduce debt while it is still  legislatively protected from competition was intended to help it achieve its  ultimate goal of being in a position to continue to offer competitively priced  power.
However, TVA has fallen behind in meeting the debt reduction goal in the  original 10-year plan and consequently has revised this goal downward.   Over the first 5 years of the 10-year plan (through September 30, 2002), TVA  reduced its debt by about $2.1 billion.  By reducing debt, and refinancing  some debt at lower interest rates, TVA has reduced its annual interest  expense from about $2.0 billion in fiscal year 1997 (35 percent of total  expenses) to about $1.4 billion in fiscal year 2002 (22 percent of total  expenses).  TVA now expects to reduce its debt by about $3.3 billion by  2007 rather than the planned $14.2 billion, which represents about   $11 billion less debt reduction than planned in 1997.  The revised debt  reduction goal is due to several factors, including increased capital  expenditures for new generating capacity and environmental controls.   TVA’s ability to reduce debt in the near term will be significantly affected by  its recent decision to restart the Browns Ferry Nuclear Plant Unit 1.
section_title: Objectives, Scope, and Methodology
paragraphs: To determine what lease-leaseback financing arrangements have been used  by TVA to date and the extent to which these and other alternative  financing arrangements are being considered for future use, we reviewed  several documents, including TVA’s audited financial statements, a TVA  Inspector General (IG) report on TVA’s use of lease-leaseback  arrangements, a Congressional Budget Office (CBO) report on leases and  lease-leasebacks, and the fiscal year 2003 and 2004 President’s Budgets.  We  also interviewed officials from TVA, private electricity industry officials  familiar with lease financing, and officials from OMB and CBO.
To determine who has legal ownership of the assets financed through such  arrangements and who is at financial risk if the projects do not work out as  planned, we obtained and reviewed copies of the lease-leaseback  arrangements entered into in fiscal years 2000 and 2002, and December  2002, which covered 20 power generating units.  We limited our detailed  analysis to the fiscal year 2002 lease-leaseback arrangement because,  based on our limited review of the fiscal year 2000 and December 2002  lease-leaseback arrangements, we found them to be structured similarly to  the fiscal year 2002 arrangement. In addition, according to TVA officials,  the fiscal year 2000 and 2003 arrangements are structured similarly to the  fiscal year 2002 arrangement.   Our detailed analysis included a review of  TVA’s and the private equity investor’s cash flows under various alternatives  included in the fiscal year 2002 lease-leaseback arrangement to determine  who is at risk.  We also interviewed officials from TVA’s Office of IG, Chief  Financial Officer Organization, and Office of General Counsel; OMB; and  CBO.
To determine whether TVA is properly accounting for the lease-leaseback  arrangements for financial reporting purposes, we reviewed authoritative  accounting literature related to accounting for leases.  We also reviewed  TVA’s accounting journal entries for the fiscal year 2000 and 2002  arrangements.  In addition, we interviewed officials from TVA’s Chief  Financial Officer Organization, Office of General Counsel, IG Office, and  external financial auditor.  To determine whether TVA’s lease-leaseback  arrangements are being treated properly for budgetary reporting purposes,  we reviewed various budget-related documents, including the fiscal year  2003 and 2004 President’s Budgets and OMB guidance for the classification  of leases.  We also discussed the budgetary treatment of the lease- leaseback arrangements with TVA and OMB officials.  To determine  whether TVA’s lease-leaseback arrangements are properly treated for the  purposes of debt cap compliance, we reviewed the TVA Act and the  legislative history related to the act, and interviewed officials from TVA’s  Office of General Counsel.  Additional information on our scope and  methodology is contained in appendix I.
We conducted our work from July 2002 through May 2003 in accordance  with generally accepted government auditing standards.  We requested  written comments from the chairman of TVA or his designated  representative on a draft of this report.  TVA’s chairman provided written  comments, which are reproduced in appendix III.  We also received written  and oral comments of a technical nature, which we incorporated as  appropriate.
section_title: TVA’s Current and Contemplated Use of Alternative Financing Arrangements
paragraphs: In fiscal year 2000, TVA began entering into alternative financing  arrangements (primarily lease-leaseback arrangements) to fund certain  capital requirements.  These  arrangements increase TVA’s long-term risk  and obligations.  However, in our opinion it is unclear whether the current  law requires that the lease-leaseback arrangements be counted toward the  $30 billion debt cap in the TVA Act.  TVA has used lease-leaseback  financing arrangements to refinance 24 combustion turbine power  generators that are used during periods of peak demand for power.   Through May 31, 2003, these arrangements had raised about $945 million,  and a customer power discount prepayment program had raised about   $47 million.  In addition, TVA is considering using a combination of  alternative financing options to fund future capital projects, including the  restart of Browns Ferry Nuclear Unit 1.
Lease-leasebacks are financing arrangements under which an owner of  property raises capital by leasing the property to another party and then  simultaneously leasing the property back to retain use of it.  TVA entered  into lease-leaseback financing arrangements in fiscal years 2000, 2002, and  2003 that involved a total of 24 combustion turbine power generators that  had been previously constructed.  TVA officials told us they decided to use  this type of financing primarily because it lowered their financing costs.   According to industry officials, lease financing (i.e., sale-leaseback and  lease-leaseback arrangements) are commonly used in the utility industry  and have been in existence since the late 1980s.
In addition to the lease-leaseback arrangements, on October 8, 2002, TVA  began its Discounted Energy Units program.  This power discount program  allows TVA’s power distributors to prepay a portion of the price of firm  power they plan to purchase from TVA in the future.  In return, the  distributors receive a discount on a specific quantity of the future power  they purchase from TVA.  The quantity of power varies based on an implied  interest rate associated with TVA’s estimated cost of borrowing for a given  period.  As of March 24, 2003, 34 distributors had signed up to prepay about  $47 million for the future delivery of power.   This program is expected to  run annually through fiscal year 2007.
TVA hired a consultant to assist it in exploring other alternative financing  options, and to solicit and evaluate proposals to finance the restart of  Browns Ferry Nuclear Plant Unit 1, which TVA officials estimate will cost  about $1.8 billion.  TVA expects to receive a final report by June 30, 2003,  after which TVA’s management plans to recommend specific actions to its  board.  In addition to its traditional debt financing and the newer  alternative financing options discussed above, TVA and its consultant are  considering     a second power discount program that would allow TVA’s largest  customer to prepay for approximately one-half of its power needs for a  15-year period in return for a discount on this power over the course of  the agreement;  entering into lease-leaseback arrangements for its currently operating  Browns Ferry nuclear units and common plant, and the assets that will  be acquired to meet the requirements of the Clean Air Act; and   entering into joint ventures with private sector investors.
Table 1 summarizes TVA’s use and consideration of alternative forms of  financing.
section_title: TVA Retains Legal Ownership of Assets, but Both TVA and the Private Equity Investors Are at Financial Risk
paragraphs: The lease-leaseback financing arrangements allow TVA to retain legal title  to the assets while transferring sufficient property interest in the assets to  the private equity investors so that they may claim tax deductions that can  be used to offset the taxable income from the lease payments and any  potential gain on the sale of the assets.  Our analysis of the fiscal year  2002 lease-leaseback arrangement  shows that the net economic benefits of  the transactions to TVA, the private investor, and the federal treasury will  depend on the future value of the assets.  The future value of the assets  largely determines whether TVA’s financing costs are higher or lower than  under traditional debt financing, whether and the extent to which the  private equity investor earns a return on its investment, and whether the  tax implications to the federal treasury are positive or negative.
subsections: section_title: Key Aspects of TVA’s Lease- Leaseback Arrangements
paragraphs: As described previously, TVA used lease-leaseback arrangements to  refinance 24 combustion turbine power generators in fiscal years 2000,  2002, and 2003.  Prior to entering into the lease-leaseback arrangements,  TVA initially financed the construction of the assets, which have an  expected useful life of 40 years, with a combination of cash generated from  operations and borrowings, as necessary, to manage its daily cash flow  needs.  After the assets were constructed, TVA entered into the lease- leaseback arrangements.  Under these arrangements, TVA agreed to lease  the assets to the private equity investors for a 50-year period and  immediately received the full amount, approximately $945 million, due  under the 50-year leases.  The equity investors agreed to lease the assets  back to TVA for a period of 20 years.  Over the 20-year leaseback period,  TVA is required to make semiannual lease payments.
In order to raise the approximately $945 million in lease payments made to  TVA, the equity investors relied on a combination of their own equity and  the issuance of debt in the public market.  To help issue the debt, TVA hired  a financial services company, which established trusts to sell certificates to  the public.  TVA’s lease payments are used to pay the debt certificates  issued to the public.  Although TVA was not a direct party to the  certificates, TVA’s lease payments are being used as security for and to  directly service the debt.  TVA’s obligation to make lease payments is  unconditional throughout the term of the certificates.  TVA’s legal  obligation to make lease payments takes priority over its obligation to pay  principal and interest on its senior debt obligations, and TVA’s lease  obligation was cited by Standard & Poor’s as substantiation for assigning a  triple-A rating to the trust certificates.  On a present value basis, over the  20-year leaseback period for the fiscal year 2002 arrangement, TVA’s lease  payments will total approximately $294 million, of which approximately  $277 million will be distributed to the certificate holders.  The excess   $17 million will be distributed to the equity investor.
At the end of the 20-year leaseback period, TVA has the option of  purchasing the equity investor’s remaining interest in the assets over the  remaining 30-year period of the 50-year lease.  If, after 20 years, TVA elects  to exercise the purchase option, it would pay the fair market value of the  assets, subject to certain maximum amounts set in the lease-leaseback  arrangements.  Once TVA provides notice that it intends to purchase the  equity investor’s interest in the assets, negotiations between TVA and the  equity investor will commence to determine the fair market value of the  assets.  If they cannot agree on a fair market value within 90 days of TVA’s  notice, the fair market value will be determined by an independent  appraisal procedure.  Table 2 shows the key details of the lease-leaseback  arrangements and the lease proceeds to TVA.
The key events involved in the fiscal year 2002 lease-leaseback  arrangement are shown in figure 1.
Under the lease-leaseback arrangements, TVA retains legal title to the  assets but relinquishes sufficient interest in the assets so that the equity  investors are entitled to certain tax benefits that are not available to TVA.   As we discuss in more detail later, these transactions have implications for  the federal treasury because they result in both tax deductions and income.
Table 3 shows the key advantages and disadvantages for TVA and the equity  investors under the lease-leaseback arrangements.  These advantages and  risks are discussed in more detail in the following sections.
section_title: Risk to TVA under Fiscal Year 2002 Lease-Leaseback Arrangement
paragraphs: Under the fiscal year 2002 lease-leaseback arrangement, TVA will incur  lower financing costs over the 20-year leaseback period, compared to  traditional debt financing.  TVA’s discounted payments over the 20-year  leaseback period would be approximately $28 million less under the fiscal  year 2002 lease-leaseback arrangement than they would have been under  traditional debt financing.  However, TVA would not own all rights to the  assets under the lease-leaseback arrangement, as it would under traditional  debt financing.
In its assessment of the benefits of entering into the fiscal year 2002 lease- leaseback arrangement, TVA did not consider scenarios under which it  would purchase all interest in the assets at the end of the 20-year lease  period or exercise one of the options to terminate the arrangement early.   Our analysis of the arrangement considers the full 50-year lease period,  covering the expected 40-year useful life of the assets, including a possible  decision by TVA to purchase the equity investor’s remaining interest in the  assets at the end of the 20-year leaseback period.  As this analysis suggests,  there is no way of knowing with certainty whether this arrangement will  end up being more advantageous to TVA or more lucrative to the private  investors.
In large part, who will benefit from this arrangement depends on the fair  market value of these generating units at the end of the 20-year leaseback  period.  Depending on the cost to TVA to repurchase the equity investor’s  remaining interest in the asset, it may be at risk of incurring higher costs  under the lease-leaseback arrangement, compared to traditional debt  financing.  For example, if TVA repurchases the equity investor’s interest in  the assets at the amount expected by the equity investor—a lump sum  payment of approximately $115 million at the end of the 20-year lease  (present value of $42 million)—its discounted payments will be  approximately $14 million higher under the lease-leaseback arrangement  than they would have been under traditional debt financing.  If TVA  repurchases the equity investor’s interest in the assets at the maximum  amount set by the terms of the fiscal year 2002 lease-leaseback  arrangement—a lump sum payment of approximately $260 million (present  value of $94 million)—its discounted payments will be approximately   $66 million higher, compared to traditional debt financing.  Although TVA  may elect not to repurchase the equity investor’s remaining interest in the  assets at the end of the 20-year leaseback period, TVA would lose control  over the electricity generated by the plants over the next 30-year period and  may need to purchase power plants or acquire additional electricity to meet  the needs of its customers.
According to TVA’s leasing advisor, one of the primary advantages of the  arrangement is TVA’s prerogative to decide whether to reacquire full  interest in the assets at the end of the 20-year leaseback period, which  enables TVA to assess their value at that time and determine whether it  would be economically advantageous to purchase the remaining interest in  them.  TVA’s leasing advisor highlighted recent market volatility to illustrate  the importance and value of this flexibility to TVA.  Due to a favorable  market for combustion turbines at the time TVA entered into the fiscal year  2002 lease-leaseback arrangement, TVA received $320 million in lease  proceeds for assets that were initially constructed for about $226 million.   However, TVA’s leasing advisor told us that, since TVA refinanced the  assets, the market for combustion turbines has declined, and units similar  to TVA’s have traded for as much as 50 percent less than the amount at  which TVA refinanced its assets.  This market volatility makes it impossible  to know at this time the net impact of the arrangement on the respective  parties.
If the market for these power generating units remains depressed at the  end of the 20-year leaseback period, TVA’s purchase price to reacquire  interest in the assets may fall to a level that would be beneficial to TVA.   TVA would realize lower financing costs under the arrangement if its  purchase price at the end of the 20-year leaseback period were lower than  its savings in financing costs to that point—approximately $28 million  (present value).
Also, in analyzing its potential costs under the lease-leaseback  arrangement, TVA officials told us that they did not consider any of TVA’s  early termination options (see table 4 for a summary of these options)  because they do not expect to use them.  They said the early termination  options were included in the arrangements for TVA’s benefit and provide  additional flexibility in case of unexpected circumstances—for example,  damage to the assets or a change in the law making it illegal for TVA to  lease the assets.  TVA will assess the feasibility of the early buyout options  at the time they become available.  If the assets’ fair market value at the  time of the options is at an amount for which TVA concludes that  purchasing the assets at the buyout price would be advantageous, TVA may  exercise one of its early buyout options.  Due to significant termination  costs, our analysis shows that, if TVA exercises its 2009 early buyout  option, its discounted payments will be approximately $25 million more  under the lease-leaseback arrangement than they would have been under  traditional debt financing.  If TVA exercises its 2017 early buyout option, its  discounted payments will be approximately $54 million higher.  The early  buyout options are intended to provide flexibility to TVA, in the event that  the assets’ fair market value is higher than expected.  For example, if at the  time of the 2017 early buyout option date, the fair market value of the  assets is higher than expected, TVA can purchase the equity investor’s  remaining interest in the assets at a set price established in the lease  arrangement and avoid the possibility of paying additional value for the  assets 4 years later at the end of the 20-year leaseback period.
As shown in table 4, TVA can also terminate the lease-leaseback  arrangement in the case of burdensome events, obsolescence, or loss, in  which case our analysis shows that TVA’s discounted payments will be from  approximately $7 million to $16 million higher under the lease-leaseback  arrangement than they would have been under traditional debt financing.
section_title: Risk to Private Parties under Fiscal Year 2002 Lease-Leaseback Arrangement
paragraphs: As part of the fiscal year 2002 lease-leaseback arrangement, private  investors paid $320 million to TVA; $272 million of this payment was raised  from debt investors, and $48 million was raised from a private equity  investor.  The debt portion of the payment was funded through the issuance  of certificates to the public.  As discussed previously, the principal and  interest owed on the certificates are, in effect, to be satisfied through TVA’s  ongoing lease payments over the 20-year leaseback period.  TVA’s  obligation to make lease payments is unconditional throughout the term of  the certificates.  Based on TVA’s unconditional obligation to make lease  payments, we concluded that the bondholders are at minimal risk of  losing the principal and interest payments they are owed.  The minimal  risk to debt holders is also reflected in the triple-A rating given to the  certificates by Standard & Poor’s.
However, the equity investor may be at risk of realizing a lower return than  expected or a loss under certain scenarios.  As part of the fiscal year 2002  arrangement, the equity investor made a $48 million payment to TVA and, in  return, receives certain benefits, including  (1) cash in the amount by which  TVA’s lease payments exceed the amount of principal and interest owed on  the certificates—about $17 million (on a present value basis) over the 20- year period, (2) the ability to sell the assets, or the power they generate,  after the 20-year leaseback period, and (3) tax benefits that can be used to  offset taxable income.
The equity investor’s expected return is based on TVA electing to buy back  interest in the assets at their fair market value at the end of the 20-year  leaseback period.  If TVA chooses to do so, the equity investor is at risk of  losing money on the arrangement.  The equity investor’s discounted cash  disbursements, under this scenario, would exceed its discounted cash  proceeds by approximately $25 million.  However, the equity investor  would own certain interest in the assets and would be able to sell its  interest to another party or use the assets to raise revenue.
In entering into the arrangement, the equity investor projected an after-tax  rate of return of about 5.3 percent, according to TVA’s leasing advisor.   The equity investor expected that the lease to TVA would go the full term  (20 years), and, at the end of the lease term, the price paid by TVA to  reacquire interest in the assets would be about 36 percent of the fair market  value of the assets at the inception of the lease.  However, if TVA decides to  purchase the equity investor’s interest in the assets and the fair market  value of the assets is lower than anticipated, the equity investor is at risk of  not achieving its projected rate of return or of realizing a loss.  If TVA’s  purchase price at the end of the leaseback period is below 36 percent of the  asset’s fair market value at the inception of the lease, the equity investor is  at risk of not earning its projected rate of return.  If the purchase price is  less than 30 percent, the equity investor is also at risk of losing money on  the arrangement.
In addition, as discussed above, TVA has options to terminate the lease- leaseback arrangement early.  According to our analysis, if TVA exercises  either of its two early buyout options, the equity investor will earn in  excess of its projected rate of return.  However, if TVA terminates the  arrangement early due to burdensome events, obsolescence, or loss, the  equity investor will be at risk of earning a return lower than its projected  after-tax rate of 5.3 percent.  A summary of the risks to the equity investor  and TVA is included in table 5.
In addition, the lease-leaseback arrangements could have implications for  the federal treasury.  For the equity investor, these transactions create tax  deductions that would not be available to TVA as a tax exempt entity, but  also generate income in the form of lease payments.  Whether the  transactions result in a net loss or a net gain to the federal treasury depends  largely on if and when the equity investor’s rights to the assets are sold and  for what amount.  For example, based on our analysis of the fiscal year  2002 lease-leaseback arrangement, if the equity investor sells the assets at  the end of the 20-year leaseback period for an amount that is less than 8  percent of the original cost, the equity investor’s tax deductions would have  exceeded its income and the arrangement would result in a net loss to the  federal treasury.  If, on the other hand, the sales price were to exceed 8  percent of the original cost, the equity investor’s income would have  exceeded its tax deductions and the arrangement would result in a net gain  to the federal treasury.
section_title: Lease-Leaseback Accounting Complies with Applicable Standards and Requirements
paragraphs: TVA’s lease-leaseback arrangements are classified as liabilities in TVA’s  financial statements, as required by GAAP, and are classified as debt for  budgetary reporting purposes, as required by OMB guidance.  In addition,  because in our opinion the relevant statute is unclear as to whether the  arrangements should be counted against TVA’s statutory debt cap, TVA’s  position that they should not be counted against the cap is not  unreasonable.
TVA, with concurrence from its external auditor, appropriately recorded its  lease-leaseback arrangements on its balance sheet as an increase to cash  and as a financing obligation (increase to liabilities) while retaining the  assets on its books at historical cost.  See appendix II for a more detailed  analysis of TVA’s treatment of the fiscal year 2002 lease-leaseback  arrangement.
While GAAP does not require lease-leaseback arrangements to be classified  as debt on the financial statements, it does provide guidance for classifying  them as liabilities.  Although the issuance of debt is an integral part of the  lease-leaseback arrangements, the legal structure of the arrangements  allows them to be recorded as liabilities instead of debt.  We believe this is  a distinction without a meaningful economic difference because, in this  case, debt and liabilities have very similar characteristics.  Since TVA is  required to make semiannual payments for the duration of the 20-year  leaseback period, provided no early buyout or termination options are  exercised, future sacrifices of economic benefits are reasonably assured  and an obligation to render payment clearly exists.  Thus, while the lease- leaseback arrangements are not treated as debt for financial reporting  purposes, they are in essence debt because they have substantially the  same economic impact on TVA as traditional debt financing.  Moreover,  officials at Standard & Poor’s and some state regulators generally view the  lease-leaseback arrangements as debt.
TVA’s lease-leaseback arrangements are treated as debt in the fiscal year  2004 President’s Budget, in accordance with OMB guidance.  TVA originally  treated the fiscal year 2000 lease-leaseback arrangement as an obligation  rather than debt, but OMB questioned this treatment when TVA’s fiscal year  2003 budget submission treated the 2002 lease-leaseback arrangement  similarly.  Based on criteria for classifying leases established in OMB  Circular A-11, OMB officials concluded the lease-leaseback arrangement  was equivalent to the purchase of assets financed by the issuance of agency  debt because (1) TVA retains legal ownership of the assets, (2) the present  value of TVA’s lease payments is very high compared to the fair market  value of the assets, and (3) TVA controls use of the assets.
Under OMB’s current treatment of the lease-leaseback arrangements, the  lump-sum cash proceeds TVA receives from the private parties at the  inception of the lease-leaseback arrangements are treated as borrowing.  In  addition, interest payments made to the private parties are scored as  outlays in the budget as they are made.  All of TVA’s lease-leaseback  arrangements are now treated as debt in the President’s Budget.  While  TVA has disagreed with OMB’s position that the lease-leaseback  arrangements should be treated as debt, it recognizes OMB’s authority to  decide how the arrangements should be presented in the President’s  Budget.
TVA’s decision not to treat the lease-leaseback arrangements as debt for  purposes of its statutory debt cap is not unreasonable.  Section 15d(a) of  the TVA Act authorizes TVA to “issue and sell bonds, notes and other  evidences of indebtedness…in an amount not exceeding $30,000,000,000.”   It is TVA’s position that Section 15d of the TVA Act effectively provided TVA  with two new ways to acquire power system assets.  One way is by selling  bonds (section 15d(a)) and the other way by entering into leases, lease- purchase agreements, and power purchase agreements (section 15d(g)).   The limitation in section 15d(a) applies to bonds, notes, and other  evidences of indebtedness (collectively referred to in the statute as bonds).
In TVA’s opinion, the language, structure, and legislative history of section  15d clearly demonstrate that lease obligations are not bonds for the  purpose of the limitation.  TVA asserts that the descriptive references of the  bonds in section 15d make sense when applied to bonds as the traditional  financial instrument but not to TVA’s obligations under the lease-leaseback  arrangements.  TVA also asserts that the legislative history demonstrates  that the Congress was aware that the limitation of TVA’s authority to issue  bonds did not limit TVA with respect to leases, lease-purchase agreements,  and power purchase agreements.  Therefore, it is TVA’s position that the  section 15d limitation on bonds does not apply to the lease-leaseback  arrangements.
Based on our analysis of the law and its legislative history, we conclude  that the current law does not clearly and unambiguously address whether  the amount of the lease-leaseback arrangements should be counted against  the debt cap.  However, there is support for the view that bonds are treated  as separate means of financing the expansion of facilities from leases and  lease-purchase agreements.  There is also support for the view that,  although bonds are covered by the ceiling in section 15d(a) of the TVA Act,  leases and lease-purchase agreements are not.  Finally, there is support for  the view that lease-leaseback arrangements are sufficiently analogous to  lease and lease-purchase agreements to support the conclusion that they  are not bonds for the purpose of section 15d(a) of the TVA Act.  Therefore,  TVA’s decision that its lease-leaseback arrangements should not be treated  as debt for purposes of the debt cap in section 15d(a) of the TVA Act is not  unreasonable, even though these arrangements have the same impact on  TVA’s financial condition and future competitiveness as traditional debt.
Based on our discussions with OMB officials, they are also of the opinion  that the TVA Act is unclear regarding whether TVA’s lease-leaseback  arrangements should be counted against the $30 billion bond ceiling  established by section 15d of the TVA Act.  As a result, the fiscal year 2004  President’s Budget proposes that legislation be drafted to ensure that lease- leaseback arrangements and other arrangements equivalent to traditional  debt financing are included under TVA’s debt cap.
section_title: Conclusions
paragraphs: TVA has entered into substantial (about $945 million) lease-leaseback  arrangements with private investors and is considering expanding its use of  these and other nontraditional financing arrangements.  While the lease- leaseback arrangements provide TVA with a lower cost of financing over  the first 20 years, they also pose risks.  The savings in financing costs TVA  achieves over the first 20 years will be lowered by (1) costs it will incur if it  purchases the remaining interest in the assets or replaces the assets or   (2) revenue it will forgo due to loss of generation capacity.   The risk that  TVA’s total costs under the lease-leaseback arrangements could be higher  than under traditional bond financing is offset by two advantages:  (1) TVA  has the ability to walk away from the assets at the end of 20 years if they  have become obsolete or their generating capacity is no longer needed and  (2) the TVA Act has been interpreted such that the arrangements do not  count against TVA’s statutory debt cap, thereby allowing TVA to maintain  ready access to capital in the debt market.  However, these arrangements  essentially have the same economic impact on TVA’s financial condition as  traditional debt and therefore could negatively affect TVA’s future  competitiveness.  The federal treasury could experience a net benefit or  loss, depending on whether the private equity investor’s tax deductions  exceed its taxable income, with the ultimate impact depending largely on  the future value of the assets.
section_title: Matter for Congressional Consideration
paragraphs: The Congress may want to consider amending the TVA Act to clarify  whether the debt cap should include alternative sources of financing (such  as lease-leaseback arrangements) that have the same impact on TVA’s  financial condition and competitive position as traditional debt financing.
section_title: Agency Comments and Our Evaluation
paragraphs: In written comments on a draft of this report, TVA’s Chairman generally  agreed with the report and characterized it as a fair and thorough analysis  on this complex subject.  However, the Chairman expressed concern over  our suggesting that the Congress may want to consider amending the TVA  Act to clarify whether the debt cap should include nontraditional sources  of financing such as lease-leaseback arrangements.  He pointed out that  both TVA and its outside counsel are of the view that the current statute  and legislative history are clear in the authority provided to TVA to issue  debt securities (to which the debt cap applies) and to enter into leasing  arrangements (to which the debt cap does not apply).
As stated in the report, based on our analysis of the law and its legislative  history, we conclude that the current law does not clearly and  unambiguously address whether the amount of the lease-leaseback  arrangements should be counted against the debt cap.  Therefore, we have  made no changes to the report in response to this comment.  TVA’s written  comments are reproduced in appendix III.
TVA also provided us with oral comments of a technical nature, which we  have incorporated into the final report as appropriate.
As arranged with your office, unless you announce the contents of this  report earlier, we will not distribute it until 30 days from its date.  Then we  will send copies of this report to appropriate House and Senate  committees, interested members of the Congress, TVA’s board of directors,  and the Director of the Office of Management and Budget.  We will also  make copies available to others upon request.  In addition, the report will  be available at no charge on GAO’s Web site at http://www.gao.gov.
If you or your staff have any questions on matters discussed in this report,  please contact me at (202) 512-9508 or calboml@gao.gov.  Major  contributors to this report are listed in appendix IV.
section_title: Objectives, Scope, and Methodology
subsections: section_title: Description of Lease- Leaseback Arrangements
paragraphs: To describe the lease-leaseback arrangement(s) used to date, we did the  following:  Interviewed officials from the Tennessee Valley Authority’s (TVA) Office  of Inspector General (IG), TVA’s external auditor, and the Office of  Management and Budget (OMB).
Reviewed TVA’s annual reports and the fiscal year 2003 and 2004  President’s Budgets.
Interviewed representatives of the investor-owned utility members of  TVA Exchange Group, Standard & Poor’s, the Electric Power Supply  Association, and the Edison Electric Institute.
Reviewed a sample of annual reports and financing statements of  electric utilities.
Obtained and reviewed copies of the lease-leaseback arrangements  entered into in fiscal years 2000 and 2002, and December 2002, which  covered 20 of the 24 generating units.
Limited our detailed analysis to the fiscal year 2002 lease-leaseback  arrangement. Based on our limited review of the fiscal year 2000 and  December 2002 lease-leaseback arrangements, we found them to be  structured similarly to the fiscal year 2002 arrangement.   In addition,  TVA officials told us that the fiscal year 2000 and 2003 arrangements are  substantially the same in structure as the fiscal year 2002 arrangement.
section_title: Alternative Financing Options Being Considered by TVA for Future Capital Projects, Including the Restart of Browns Ferry Nuclear Plant Unit 1
paragraphs: To identify proposals under consideration for financing future capital  projects, including the restart of Browns Ferry Nuclear Plant Unit 1, we   interviewed officials from TVA, OMB, and the Congressional Budget  Office (CBO);  reviewed a TVA IG report on TVA’s use of lease-leaseback financing;  reviewed TVA’s proposed 2003 and 2004 federal budgets; and  reviewed recent press reports related to TVA.
section_title: Legal Ownership and Risk If the Lease- Leaseback Arrangements Do Not Work Out as Planned
paragraphs: To determine who has legal ownership of the assets financed by lease- leaseback transactions, and who is at financial risk if the projects do not  work out as planned, we  obtained and reviewed copies of the fiscal years 2000 and 2002, and  December 2002 lease-leaseback arrangements covering 20 of 24 power  generating units;  interviewed officials of TVA’s IG, Chief Financial Officer (CFO)
Organization, and Office of General Counsel (OGC),  OMB, and CBO;   reviewed summary documents prepared by TVA’s OGC and IG that  identify and explain the responsibility of the different parties to the  agreements;  reviewed an economic analysis of the fiscal year 2002 lease-leaseback  arrangement prepared by TVA to compare its borrowing cost under  traditional debt financing with its cost under the lease-leaseback  arrangements;  compared TVA’s cash flow under the fiscal year 2002 arrangement to  traditional debt financing if TVA were to exercise the early buyout and  termination options in the fiscal year 2002 arrangement; and  analyzed the equity investor’s cash flows under the fiscal year 2002  arrangement.
section_title: Classification of Lease- Leaseback Arrangements According to Generally Accepted Accounting Principles, OMB Guidance, and the TVA Act
paragraphs: To determine whether TVA was treating the lease-leaseback arrangements  according to generally accepted accounting principles in its external  financial statements, we  reviewed the accounting journal entries used by TVA to record the fiscal  year 2000 and 2002 lease leaseback transactions covering 16 of 24 power  generating units in TVA’s accounting system;  interviewed officials of TVA’s IG, CFO Organization, and external   reviewed authoritative accounting literature on accounting for leases  including Statement of Financial Accounting Standards (SFAS) 13,  Accounting for Leases, SFAS 66, Accounting for Sales of Real Estate,  and SFAS 98, Accounting for Leases, to evaluate TVA’s accounting  treatment;  obtained and reviewed annual reports for publicly traded utility  companies to identify financial reporting disclosures related to leasing  transactions; and  obtained and reviewed copies of the fiscal years 2000 and 2002, and  December 2002 lease-leaseback arrangements covering 20 of 24 power  generating units.
To determine whether the lease-leaseback arrangements are being  classified properly in the federal budget, we   reviewed the fiscal year 2003 and 2004 President’s Budgets;  interviewed officials from TVA, OMB, and CBO; and  reviewed OMB’s Circular A-11 for guidance on how OMB classifies and  scores leases for budgetary reporting purposes.
To determine whether the lease-leaseback arrangements should be counted  toward the limitation on TVA’s authority in the TVA Act to issue bonds and  notes, we   reviewed the fiscal year 2002 lease-leaseback arrangement;  interviewed officials from OMB and TVA’s OGC;  obtained and reviewed a memo prepared by TVA’s OGC summarizing its   reviewed the fiscal year 2004 President’s Budget; and  reviewed and interpreted language included in section 15d of the TVA  Act, and reviewed the legislative history of the act.
section_title: Organizations Contacted
paragraphs: During the course of our work, we contacted the following organizations.
subsections: section_title: Federal Agencies
section_title: Bond Rating Agencies
section_title: Customer Representative or Trade Groups
paragraphs: Entergy Corp.
Duke Energy Corp.
section_title: Other
section_title: Analysis of TVA’s Treatment of the Fiscal Year 2002 Lease-Leaseback Arrangement for Financial Reporting Purposes
subsections: section_title: Authoritative Accounting Standards for Leases
paragraphs: Table 6 lists authoritative accounting standards for leases (which include  the applicable standards for lease-leaseback arrangements) that we  reviewed to determine whether the Tennessee Valley Authority’s (TVA)  treatment of the lease-leaseback arrangements for financial reporting  purposes is in accordance with generally accepted accounting principles  (GAAP).  The Financial Accounting Standards Board (FASB) issues all  Statements of Financial Accounting Standards (SFAS), Financial  Accounting Standards Board Interpretations (FIN), and Financial  Accounting Standards Board Technical Bulletins (FTB).
section_title: Summary of GAAP Accounting for Leases
paragraphs: A lease is an agreement that conveys the right to use property, usually for a  specified period.  Leases typically involve two parties: the owner of the  property (lessor) and the party contracting to use the property (lessee).
A key accounting issue associated with leases is the identification of those  leases that are treated appropriately as sales of the property by lessors and  as purchases of property by lessees (e.g., capital leases).  A capital lease  transfers the benefits and risks inherent in the ownership of the property to  the lessee, who accounts for the lease as an acquisition of an asset and the  incurrence of a liability.  Leases that are not identified as capital leases are  called operating leases and are not treated as sales by lessors and as  purchases by lessees.  If, at its inception, a lease, including lease- leasebacks, meets one or more of four criteria, the lease is classified as a  capital lease per SFAS No. 13, Accounting for Leases, paragraphs 6 and 7.   The four criteria are (1) ownership of the leased property is transferred to  the lessee by the end of the lease term, (2) the lease contains a bargain  purchase option, (3) the lease term is substantially (75 percent or more)  equal to the estimated useful life of the leased property, and (4) at the  inception of the lease, the present value of the minimum lease payments,  with certain adjustments, is 90 percent or more of the fair value of the  leased property.  TVA’s fiscal year 2002 lease-leaseback arrangements meet  criteria 3 and 4 above and therefore were recorded on the balance sheet in  accordance with capital lease accounting criteria.
According to SFAS No. 98, Accounting for Leases, and SFAS No. 66,  Accounting for Sales of Real Estate, the way a capital lease is accounted  for depends on whether you are the lessor or the lessee.  The lessor, TVA in  the 50-year lease, would account for the lease as a sale (sales-type lease) or  financing (direct financing lease), whichever is appropriate.  A lease  involving real estate is not classified by the lessor as a sales-type lease  unless (1) the title to the leased property is transferred and (2) there is not  any form of continuing involvement in the daily operations.  Since TVA did  not transfer legal title of the assets and continues to be involved in the  operation and maintenance of the turbine units and to control the  distribution of power produced by the facilities, TVA accounted for the  lease proceeds of $320 million as a direct financing lease resulting in  financing obligations.
Table 7 below shows the fiscal year 2002 accounting entries for the fiscal  year 2002 lease-leaseback arrangement.
The accounting transactions for TVA’s fiscal year 2002 lease-leaseback  arrangements are presented in its financial statements as follows:    Outstanding lease financing obligations are included in the “Current  liabilities” and “Other liabilities” line items on the Balance Sheet.
The cash proceeds were included in the “Proceeds from combustion  turbine financing” line item on the Cash Flow Statement.
The lease costs are included in the “Operating and maintenance” line  item on the Income Statement.
In addition to the above journal entries, TVA records the normal accounting  entries related to construction, capitalization, depreciation, and operation  of the combustion turbine units consistent with all other generating assets  it owns.  The fiscal year 2002 lease-leaseback transaction assets were  initially constructed at a historical cost of $226.4 million.  TVA depreciates  the assets using the straight-line depreciation method over the 20-year term  of the leaseback agreement.
section_title: Comments from the Tennessee Valley Authority
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the individual named above, Rich Cambosos, Donald Neff,  Chanetta Reed, and Brooke Whittaker made key contributions to this  report.
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