Today, as we continue our discussion on capital leases, we will be focusing on audit guidance - the section in DCAA's (Defense Contract Audit Agency's) Contract Audit Manual (CAM) that instructs auditors on what to look out for, the risk areas to be cognizant of, when auditing lease costs. This section can be found in CAM 7-203.
Considerations for ensuring that contractors properly classify their leases.
Auditors are instructed to be alert to instances where, to avoid reporting liabilities on their financial statements, contractors may structure their leases, or include assumptions in testing against the FAS-13 (now ASC 840) criteria, that result in those lease being classified as operating. Based on this guidance, contractors can expect auditors to test the assumptions used for classifying leases as operating vs. capital.
Leases improperly classified as operating leases will fail to recognize the imputed interest component of the lease payment. Therefore, lease payments under leases improperly classified as operating leases may contain an unallowable component associated with the interest.
Mitigating circumstances involving materiality determinations may exist. For example, leases reclassified as capital leases may result in depreciation during the early years of the leases at amounts higher than the lease payments due to use of accelerated depreciation methods and applied cost of money. The total depreciation and cost of money under a capital lease may be greater than the total leasing costs. On the other hand, it may be advantageous to the contractor to treat it as an operating lease for Government contract cost purposes to avoid recognition of the imputed interest component of lease payments. In other words, if the proper classification of leases will cost the Government more money, don't pursue it.
Considerations for Determining Unreasonable Lease Costs
From the Government's perspective, there is a risk whenever the lease term is substantially shorter than the asset's useful life. When this happens, the recovery of a high percentage of the fair market value of the asset over the lease term would be indicative of unreasonable rental costs. In this situation , the auditor is instructed to determine if the lessor considered and provided adequate residual value at the end of the lease term. As defined in FAS-13, the estimated residual value is the estimated fair value of the leased property at the end of the leas term. A reasonable residual value must be considered in computing minimum lease payments in order to attain reasonable lease costs.
Contractors can expect auditors to query them about how they establish useful lives for assets in general and capitalized leases in particular.