This is the second part of a series we began a couple of weeks ago. To read Part 1, Click here. As we mentioned back on July 2nd, there are two kinds of leases; operating leases and capital leases. Leases that meet any one of four tests (transfer bargain purchase economic life, or fair market) are classified as capital leases. Capital leases are capitalized and depreciated over the assets' useful lives. FAR 31.205-11(h) requires contractors to account for leases in accordance with FAS-13 (now referred to as ASC 840).
Now just because a contractor properly classifies a lease, it does not follow that the Government, the contract audit groups, will like the results. There is a bit more to the capitalization and depreciation equation as we will explain today and throughout the rest of this series.
The first thing to think about is the value to capitalize. In a typical lease, you know the monthly lease cost and the number of months. FAS-13 (ASC 840) requires that the present value of lease payments be capitalized. To determine present value, you need an interest rate. And that rate makes a difference. Consider a piece of equipment with the sum of lease payments over five years totaling $50 thousand. The present value assuming a 5 percent rate is $39 thousand. The present value assuming a 4 percent rate is $41 thousand. What rate should be used?
FAS-13 (now ASC 840) has the answer. Capital leases should be recorded as assets and liabilities at the lower of the present value of the minimum lease payments at the beginning of the lease term or the fair value of the leased property at the inception date. The discount rate used in determining present value is the lower of the lessee's incremental borrowing rate (the rate the lessee would have incurred to borrow the funds necessary to purchase the asset) or the implicit (lessor's) rate in the lease, if the implicit rate can be determined. The minimum lease payments are allocated between a reduction of the liability and interest expense to produce a constant periodic interest rate on the remaining balance.
A lessee may use its secured borrowing rate in calculating the present value of minimum lease payments if the rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.
Now here's where auditors get a bit testy. Many contractors don't have an incremental borrowing rate or a secured borrowing rate. Moreover, the lessor does not have or specify an "implicit" rate in the lease agreement. So what interest rate should be used? The Government likes to come up with a higher rate. That lowers the present value (less depreciation) and increases the interest portion of the lease payments which are unallowable under Government contracts. Contractors on the other hand, strive for a lower rate for just the opposite reason.
Ultimately, both sides have to come to some reasonable agreement. Contractors can best serve their interests if they have thought this through beforehand and have established a defensible method of determining the applicable discount rate.