Accounting for Leases - Part 3

This is the third part in our series on how to account for lease costs. We are primarily focusing on capital leases because that is where disputes congregate. If a lease must be capitalized, there are many other factors that affect the propriety of lease costs charged to Government contracts. If the lease is not a capital lease, that is, it is an operating lease, the lease payments, so long as they are reasonable, are simply period expenses. Today we pick up two more considerations, useful lives and lease renewals/extensions.

Useful lives

Capitalized leases are amortized in a manner consistent with the lessee's (i.e. the contractor's) normal depreciation policy for owned assets. So, if the contractor uses straight-line depreciation on its own assets, it must use straight-line on capital lease assets. The useful life determination gets a bit trickier. These assets must be amortized over a useful life as follows:

• If the leased property reverts to the lessee at the end of the lease or if the lessee is able to purchase the property at a bargain purchase price, then the asset life will be that normally used by the contractor for similar assets.
• If the property is leased for a term which is 75 percent or more of the economic life of the asset, then the asset should be amortized over the life of the lease to the value of the lessee, if any, at the end of the lease. This could be shorter or longer than the contractor's normal useful life practices.

Capital lease renewals, extensions, and terminations

Here are some miscellaneous provisions from FAS-13 (now ASC 840) when leases are renewed, extended, or terminated.

If a capital lease is renewed or extended and the renewal is also classified as a capital lease, the carrying value of the asset may require adjustment. When the capitalized value under the revised lease and the present balance of the obligation differ, the asset and liability account is adjusted upward or downward to reflect the difference.

If a capital lease is renewed or extended and the renewal is classified as an operating lease, the existing lease shall continue to be accounted for as a capital lease to the end of the original term, and the renewal or extension period shall be accounted for as an operating lease.

A termination of a capital lease shall be accounted for by removing the asset and obligation with gain or loss recognized for the difference.

The exercise of a lease renewal option contained in a current lease other than those already included in the lease term, is classified as a new agreement and not a renewal or extension.