Subject: Re: Multi year service contract
From: [email-masked]
To: [email-masked]
Cc: [email-masked], [email-masked], [email-masked], [email-masked], [email-masked]
Date: Thu, 27 Jan 2000 08:35:00 -0800 (PST)

Bummer.  Never hurts to ask.  I'll cycle on this and get back to you with 
follow up if any.  Thanks for your help on this.  DF 

   

	From:  Bob Chandler                           01/27/2000 01:49 PM

To: Drew Fossum/ET&S/Enron@ENRON, Tim Kissner/ET&S/Enron@ENRON
cc: George Fastuca/ET&S/Enron@Enron 

Subject: Multi year service contract

Per your request to ask AA where the chokepoint might be on renegotiating the 
electricity contract at Cunningham to backload the payments and expense the 
payments as made; the response is attached below.

First, it was difficult to point them in exactly the right direction without 
tipping them off as to exactly what you had in mind.

However, they thought I might be talking about the TW compressor monetization 
project...and even though I denied it...that is what they were thinking when 
they did the research.   To make a long story short, they indicate that 
straight line amortization of the total contract payments is the way it 
should be booked unless there are circumstances to the contrary that would 
indicate a different allocation over time.  

I don't believe we'll be able to get any good feedback from them on the 
chokepoint issue.  It boils down to how blatantly you want to skew the 
payments and whether they or FERC compliance auditors ever stumble across it 
in an audit.  If Accounting is not aware of such a contract with skewed 
payments, then we would not be in a position to accrue expense on an 
appropriate straight line basis over the life of the contract.  

As to the issue of whether or not ENA should be a party to the transaction, I 
did not seek AA advice on this issue, but I do believe that use of ENA as the 
counterparty would double the chances for having the issue brought up in an 
AA audit, since the issue could also surface in conjunction with AA's audit 
of ENA.
---------------------- Forwarded by Bob Chandler/ET&S/Enron on 01/27/2000 
01:22 PM ---------------------------

Heather Mueck
01/25/2000 07:23 PM
To: Bob Chandler/ET&S/Enron@ENRON
cc:  

Subject: Multi year service contract

Bob -

I left you a brief message on this, so I thought I'd send you a copy of the 
guidance I was referring to.  In a nut shell, there is no pain threshold for 
front end or back end loading the payments under a contract.  Generally, we 
believe you would need to straight line the expense but I can't say for 
certain without the details.

The below is from AA Interpretations and Examples "Accounting for Leases, 
Interpretations of FASB Statements 13, 27, 28, and 98" - I've bolded the 
applicable section.  Call me if you have any additional questions. 

AA Interpretations and Examples\05. Leases
       Accounting for Leases, Interpretations of FASB Statements 13, 27, 28 
and 98

1-12. Facility Management Arrangements
In a typical facilities management arrangement, the vendor purchases from a 
company ("customer") its existing data processing equipment and hires all or 
some of the customer's data processing personnel. The vendor is then engaged 
to provide information technology services to the customer for an extended 
period of time (typically 5 to 10 years).

Company's Obligation Under the Service Contract
Obligations under executory agreements that are contingent upon services to 
be rendered in the future are not liabilities and should not be recorded 
except to the extent losses are inherent in such commitments. No liability 
should be recognized for a customer's future obligation under an information 
technology services contract unless it becomes probable that the customer 
will incur a penalty or loss from termination of the contract.

An issue arises as to whether the sale of existing data processing equipment 
or facilities to a vendor that uses the purchased property to provide 
information technology services to the seller is, in substance, a sale and 
leaseback transaction that should be accounted for separately under SFAS Nos. 
13, 28 and 98. An information technology services contract typically can be 
distinguished from a lease for the following reasons:

The vendor is responsible for the financing and operation of the data 
processing equipment and facilities.
Data processing personnel are employees of the vendor.
The vendor is not required to use the equipment purchased from the customer 
to provide service to that customer and may use the equipment to serve other 
customers.
The vendor provides guarantees regarding performance and retains risks 
related to the operating costs.
The vendor is not entitled to payment unless the required services are 
provided to the customer in accordance with specified standards.

As a result, generally we believe the sale of data processing equipment or 
facilities pursuant to a facilities management arrangement should not be 
unbundled and accounted for separately as a sale and leaseback transaction. 
However, because of the customer's continuing involvement with the equipment 
of facilities sold, we believe any gain or loss on the sale should be 
recognized in a manner consistent with the guidance prescribed in paragraph 
33  of SFAS No. 13 for sale-leaseback transactions.

Some outsourcing arrangements may involve dedicated equipment (so called, 
"exclusive use equipment") that is physically located on the company's 
premises and cannot be used by the vendor to service other customers. For 
example, a significant amount of the equipment may consist of terminals or 
work-stations operated by the company's personnel, such as point-of-sale 
registers in a department store or design terminals in an architectural firm, 
and the vendor may have only limited ability to replace or remove that 
dedicated equipment because of contractual provisions or practical 
considerations. In these situations, the customer effectively contracts to 
use the terminals or workstations for a specified period * a lease. Such 
dedicated equipment should be unbundled from the information technology 
services contract and accounted for separately as a sale and leaseback 
transaction. In unbundling the equipment from the information technology 
services contract, the portion of the fee paid to the vendor applicable to 
the equipment lease should be estimated using whatever means are appropriate 
in the circumstances and the lease accounted for separately according to its 
classification (capital or operating)

If significant, the customer should consider disclosing its commitment under 
the outsourcing arrangement. The disclosures required for any portion of the 
arrangement determined by the customer to be a lease are set forth in 
paragraph 16  of SFAS No. 13.

Gain or Loss on Sale of Equipment or Facilities
Because of the interdependence of terms, there is no practicable and 
objective way to separate the sale of data processing equipment, software, 
facilities or "know how" from the service contract. For that reason, we 
believe any gain or loss from the sale of data processing equipment, 
software, facilities or "know how" pursuant to a facilities management 
arrangement should be recognized similar to a sale and operating leaseback 
transaction as prescribed in paragraph 33  of SFAS No. 13. That is, gain from 
the sale should be recognized currently only to the extent such gain exceeds 
the present value of the minimum payments due over the term of the service 
contract, discounted using the seller's incremental borrowing rate. Any gain 
not recognized at the inception of the contract should be deferred and 
amortized ratably over the term of the service contract as an adjustment to 
the minimum annual fees expensed in each period. Further, if the fair value 
of the property at the time of the transaction is less than its undepreciated 
cost, a loss should be recognized immediately for the difference between the 
undepreciated cost and fair value, regardless of the amount actually received 
from the vendor for the property transferred.

Expense Recognition
Payment terms may include fixed annual fees that increase or decrease over 
the term of the service contract. These payment terms may be structured in a 
high-to-low pattern (that is, to recognize the favorable price/performance 
curve of data processing equipment/capabilities) or a low-to-high pattern 
(that is, to recognize the estimated effects of inflation on future costs). 
Further, there may be payment escalation provisions in the service contract 
indexed to inflation and/or the volume of transactions processed by the 
vendor. We believe total minimum fees to be paid pursuant to an information 
technology services contract should be charged to expense on a straight-line 
basis over the term of the contract unless the level of service performed by 
the vendor is not uniform over the term of the contract. If the level of 
service is not uniform over the term of the contract, the amount of fees 
attributable to the additional services to be rendered by the vendor should 
be expensed ratably over the time periods the additional services are 
provided by the vendor. The amount of fees attributable to the additional 
services should be based on their relative fair value, as determined at the 
inception of the contract, to the fair value of all services to be provided 
by the vendor over the term of the contract.

The "term" of the information technology services contract includes the fixed 
non-cancelable term of the contract plus all periods, if any, for which 
failure to renew the contract imposes a "penalty" on the customer in such an 
amount that a renewal appears, at the inception of the contract, to be 
reasonably assured. The expression "penalty" should be interpreted broadly to 
include requirements that can be imposed on the customer (a) by the vendor 
(for example, a monetary penalty for not renewing the contract) or (b) by 
factors outside the contract to disburse cash, forego an economic benefit or 
suffer an economic detriment. Factors to consider in determining if an 
economic detriment may be incurred include the uniqueness of the equipment or 
software, the "know how" of the vendor, the availability of comparable 
replacement systems and data processing personnel or vendors, the disruption 
to the company's business or service to its customers if the contract were 
not renewed and the willingness of the customer to bear the cost associated 
with replacing the vendor (either by bringing the functions in-house or by 
engaging another vendor). The term of the contract should also include all 
periods, if any, (a) covered by bargain renewal options, (b) preceding the 
date at which the customer can exercise a bargain purchase option to 
reacquire the equipment, software, facilities or data processing personnel 
(see Interpretation 5(d)-3, "Bargain Purchase Option 'as Encumbered' by Fixed 
Price Renewals "), and (c) during which a loan from the customer to the 
vendor or a guarantee of the vendor's debt, directly or indirectly related to 
the leased property, is expected to be outstanding or in effect.

Future fee increases that depend upon a factor that exists at the inception 
of the agreement, such as the consumer price index or the volume of 
transactions processed by the vendor, should be included in the computation 
of fixed fees to be recognized on a straight-line basis over the term of the 
contract based on the factor at the inception of the agreement. Increases or 
decreases in fees that result from changes occurring subsequent to the 
inception of the agreement should be included in the determination of income 
as they accrue.

Incentives Offered by the Vendor
A facilities management arrangement may include incentives for the customer 
to sign the service contract. For example, an incentive implicit in a 
facility management arrangement may be the vendor's assumption of the 
severance liability for existing data processing personnel not retained by 
the vendor. Other types of incentives include up-front cash payments by the 
vendor, below market financing, excessive rental paid to lease space from the 
customer, equity transactions (purchase or sales/grants) with the customer at 
off-market terms, and so forth.

The fact that the vendor "assumes" a loss or cost does not negate the 
customer's need to immediately recognize the loss or expense. The amount of 
the loss or cost assumed by the vendor should be estimated by the customer 
using whatever means makes sense in the particular facts and circumstances. 
The customer should recognize the loss immediately by a charge to income and 
the offsetting deferred credit (incentive) should be recognized ratably over 
the term of the service contract in proportion to the fixed contractual fees 
expensed in each period. Similarly, incentives that result in the recognition 
of an asset or a deferred charge should be reported on the balance sheet at 
the amount received or fair value, and the offsetting credit (incentive) 
recognized ratably over the term of the service contract.