Is a Lease Really an Intangible Asset?

Cost Accounting Standard (CAS) 404 establishes criteria for determining the acquisition costs of tangible assets which are to be capitalized. It requires contractors to capitalize the acquisition costs of tangible assets in accordance with a written policy that is reasonable and consistently applied. We have detailed the essential requirements of CAS 404 in a previous post that can be read here.

Recently, there was a decision handed down by the ASBCA (Armed Services Board of Contract Appeals) involving CAS 404 and whether the standard applied to Capital Leases. The case involved Exelis, Inc.'s failure to properly classify a building lease. Exelis recorded the lease as an "operating lease" rather than a "capital lease". Under an operating lease, a contractor simply records the rental payments as an expense (FAR 31.205-36) Under a capital lease, the present value of the lease expenses capitalized and depreciated over the life of the lease (FAR 31.205-11).

The Government took exception to Exelis' accounting for lease payments and cited the contractor for non-compliance with CAS 404. The Government calculated the impact at just over $3 million. Exelis appealed to the ASBCA who ruled that CAS 404 did not apply to capital leases as capital leases are not tangible assets but rather intangible assets. The Government appealed the ASBCA decision but lost the appeal as well. We will not go into the details of those decisions because we have covered those details in previous posts. See here and here for our coverage of the initial decision and the appeal, respectively.

Normally capitalization and depreciation issues are non-controversial. Depreciation is an allowable expense so disagreements usual hinge on useful lives. Contractors want shorter lives, the Government wants longer useful lives. The imipact is just the time value of money. However, since most contractors also claim Facilites Capital Cost of Money (FCCM) on the net book value of assets, the impact on the time value of money is a wash. The higher the book value (acquisition cost less depreciation), the more FCCM a contractor recoups.

So what is the big deal with the Exelis depreciation case? The big deal lies in Exelis' contract mix. Of the $3 million cost impact calculated by the Governement, $2.6 million applies to fixed priced contracts and the remaining $400 thousand applies to flexibly priced contracts. The Government is going to recover the $400 thousand through the settlement of indirect costs process (FAR 52.216-7). However, there is no simple contractual mechanism to recover the $2.6 million by which fixed priced contracts were overstated because Exelis applied the wrong accounting methodology to lease payments. To recover those increase costs, the Government would need to resort to TINA (Truth in Negotiation Act) and there is serious concern as to whether the Government could prevail in a TINA case.

The ASBCA decision continues to baffle us. According to the ASBCA, "...CAS 404 applies to 'Tangible Assets". The CAS defines "tangible capital asset(s)" as "asset(s) that  (have) physical substance. Thus, the plain language of the CAS provides that CAS 404 applies to tangible assets which are assets with physical substance. A lease is an intangible rather than an intangible asset because the lease itself is a legal right to use and occupy the building and does not have 'physical substance'".

Is a lease really an intangible asset as the ASBCA states? For financial reporting purposes, leases are considered liabilities. We have yet to see a case where leases are reported on financial statements as intangible assets. Would the ASBCA also say that a mortgage represents an intangible asset because there is no physical substance to the piece of paper?

Going to Court? Give it Your Best the First Time Around

Last November we highlighted an ASBCA (Armed Services Board of Contract Appeals) ruling from August 29, 2016 that CAS 404, Capitalization of Tangible Assets) does not apply to capital leases. This ruling caught us by surprise as almost everyone in Government contracting circles believed otherwise and acted on that premise in determining allowable costs (depreciation) on Government contracts. Read it here.

The Defense Contract Management Agency (DCMA) who defended the case before the Board also thought the Board was wrong and moved for a reconsideration of the Board's opinion alleging that the Board had made a "legal error". The Board denied DCMA's motion and wrote some strong wording concerning DCMA's approach to handling the original case and the motion for reconsideration. The Board wrote:

A motion for reconsideration is not the place to present arguments previously made and rejected. Where litigants have once battled for the court's decision, they should neither be required, nor without good reason permitted, to battle for it again. Motions for reconsideration do not afford litigants the opportunity to take a second bite at the apple' or to advance arguments that properly should have been presented in an earlier proceeding.

Moreover, we note that DCMA's argument regarding the interpretation of CAS 404 comprised just five and-a-half pages of its twelve-page brief in opposition to Exelis' motion to dismiss. Now DCMA has submitted a 34 page brief devoted solely to this issue. Put simply, the rulings of a board are not mere first drafts, subject to revision and reconsideration at a litigant's pleasure. The proper time for DCMA to have made these arguments was in response to Exelis' motion to dismiss, and not in a motion for reconsideration.

Notwithstanding the denial for reconsideration, the Board considered DCMA's additional arguments and found none of them to be persuasive. Those arguments were:

1. the Board misinterpreted the text of CAS 404
2. the Board incorrectly held that GAAP (Generally Accepted Accounting Principles) play no role in the interpretation of CAS 404 and
3. that the Board improperly applied the standard of review by assuming the Exelis' lease of an office building was not a capital lease.

As we stated in our previous posting, the Government can still pursue the case based on FAR and probably will. It is not unlikely however that DCMA will appeal the Board's rulings to a higher court.

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.

Asset Valuations Resulting from Business Combinations

Yesterday, we wrote about the FAR (Federal Acquisition Regulation) prohibition against expensing goodwill against Government contracts (see FAR 31.205-49). Today we address a related matter - how to value assets resulting from business combinations. Or rather, how to value assets for Government cost accounting purposes, which may or may not be the same as for financial reporting purposes. As you recall, under the purchasing method of accounting for business combinations, assets of the acquired company are recorded at their fair value by the acquiring company. Usually, but not always, this results in a write-up of assets. Assets may have been fully depreciated but there is still economic life to those assets. Land, which is not depreciated, is carried on the books at its acquisition cost when typically, the value increases with time.

FAR 31.205-52 addresses asset valuation from business combinations. FAR distinguishes between tangible and intangible assets and states:

• (a) For tangible capital assets, when the purchase method of accounting for a business combination is used, whether or not the contract or subcontract is subject to CAS, the allowable depreciation and cost of money shall be based on the capitalized asset values measured and assigned in accordance with CAS 404, if allocable, reasonable, and not otherwise unallowable.
• (b) For intangible capital assets, when the purchase method of accounting for a business combination is used, allowable amortization and cost of money shall be limited to the total of the amounts that would have been allowed had the combination not taken place.

To figure out what the foregoing really means, one must refer to CAS 404.50(d). CAS 404 states, concerning capitalized values of tangible capital assets acquired in a business combination:

• (1) All the tangible capital assets of the acquired company that during the most recent cost accounting period prior to a business combination generated either depreciation expense or cost of money charges that were allocated to Federal government contracts or subcontracts negotiated on the basis of cost, shall be capitalized by the buyer at the net book value(s) of the asset(s) as reported by the seller at the time of the transaction.
• (2) All the tangible capital asset(s) of the acquired company that during the most recent cost accounting period prior to a business combination did not generate either depreciation expense or cost of money charges that were allocated to Federal government contracts or subcontracts negotiated on the basis of cost, shall be assigned a portion of the cost of the acquired company not to exceed their fair value(s) at the date of acquisition. When the fair value of identifiable acquired assets less liabilities assumed exceeds the purchase price of the acquired company ... the value otherwise assignable to tangible capital assets shall be reduced by a proportionate part of the excess.

So, to simplify things, Government contractors cannot write-up the value of tangible capital assets that have already been charged to the Government through depreciation - the Government doesn't want to buy the assets twice.

Intangible capital assets other than goodwill (e.g. intellectual property such as patents and trademarks) bear no such distinction. Amortization is limited to the amount that would have been allowed had the combination not taken place. It doesn't matter whether the Government was previously charged for the amortization. There can be no write-up of values.

Applications - CAS 404 - Capitalization of Tangible Assets

Over the years, we've covered all of the CAS (Cost Accounting Standards) Standards to some extent. Usually, the postings have been high-level summaries of the fundamental requirements of the particular standard. We have produced an index of those summaries here. These CAS summaries continue to be some of our most popular postings. Sometimes, we receive comments - questions really - on how to apply these requirements to specific fact situations  Today begins a periodic series on applying CAS standards to real-life situations. These postings should be read in concert with the overview series and we will be adding these to our CAS index as we go.

Today we begin with CAS 404, Capitalization of Tangible Assets. The overview of the standard can be found here. Essentially, this standard allows contractors to establish minimum capitalization policies for purchased assets. These minimums cannot exceed a useful life of two years or a value of $5 thousand, although they may be lower. The Standard also requires contractors to establish minimum dollar amounts for the capitalization of original complements of low cost equipment and for betterments and improvements. While it doesn't establish specific minimum thresholds, the aggregate represents a material investment.

Here are some examples of how this Standard should be implemented.

A contractor that has a policy of capitalizing tangible assets which have a service life of more than one year and a cost of more than $6 thousand, would be in noncompliance. The contractor would have to modify its policy to conform to the $5 thousand minimum established by CAS 404.

A contractor that has a policy of capitalizing assets with a service life of more than one year and a cost of $250 would have to capitalize an asset with an 18 month service life and a cost of $300. Note, the Standard requires that capitalization be based on the contractor's written policy and capitalization policies may be less than the 2 year/$5,000 thresholds above which purchased assets must be capitalized.

A contractor has an established policy of capitalizing tangible assets which have a service life of two years and a cost of $500. The contractor acquires an asset with a useful life of 18 months and a cost of $5 thousand. This asset does not need to be capitalized because the service life is less than that required by CAS and required by its capitalization policy.