CAS 404 Does Not Apply to Capital Leases

In a decision handed down last August, the ASBCA (Armed Services Board of Contract Appeals) ruled that CAS (Cost Accounting Standards) 404, Capitalization of Tangible Assets, does not apply to leases since leases are intangible assets, not tangible assets (see ASBCA No 60131).
 
Pursuant to Generally Accepted Accounting Principles (GAAP), contractors are required to characterize leases as either operating leases or capital leases for financial accounting purposes. There are a series of tests proscribed by FASB (Financial Accounting Standards Board) No. 13 to determine the proper treatment.

Exelis, a Government contractor subject to CAS accumulated and reported a building lease as an operating lease. The Government determined that the building lease should have been treated as a capital lease. Under an operating lease, a contractor can claim lease costs. Under a capital lease, a contractor must capitalize the fair market value of the lease and depreciate the imputed cost over the useful life of the building. In Exelis' case, the Government demanded $3.8 million (which included interest) representing the increased cost to the Government for Exelis' mischaracterization of the type of lease. Exelis appealed the contracting officer's decision.

Exelis asserted that CAS 404, by its terms applies only to "tangible capital assets" and does not apply to a lease because a lease is an intangible asset. The Government argued that, properly interpreted, CAS 404 applies to Exelis' lease.

In its decision, the ASBCA stated the following (paraphrased). By its terms, CAS 404 applies to "Tangible Assets". The CAS defines "tangible capital assets" as assets that have physical substance, more than minimal value, and are expected to be held by an enterprise for continued use or possession beyond the current accounting period for the services it yields. A lease on the other hand is an "intangible" rather than a tangible asset because the lease itself is a legal right to use and occupy the building and does not have physical substance. This concept is consistent with accounting standards. The building has physical substance but Exelis did not acquire the building. It has an intangible right to use and occupy the building.

Incidentally, the Government didn't lose the case yet. It will continue as a FAR based appeal rather than a CAS based appeal. Final decisions based on CAS, when applicable, if often preferred over FAR since CAS carries an interest provision calculated from the time the noncompliance occurred.