According to DoD, the proper classification of a lease according to FAS-13 (now ASC 840) does not automatically result in acceptable contract costs. For capital leases, auditors are instructed to consider the acceptability of the amortization period and that requires a definition of "Lease Terms".
According to FAS, the lease term is the fixed noncnacellable term of the lease plus
- all periods covered by bargain renewal options
- all periods for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured,
- all periods covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt related to the leased property is expected to be in effect
- all periods covered by ordinary renewal options preceeding the date as of which a barghain purchase option is exersiable, and
- all periods representing renewals or extensions of the lease at the leessor's option.
However, in no case shall the lease term extend beyond the date a bargain purchase option becomes exercisable.
So, one can see why it is necessary to carefully read and fully understand all the terms of the lease agreement. Some lease agreements are very complex and verbose documents. In fact, many contractors that enter into leases have never read the fine print - kind of like buying a house and signing documents at closing without fully understanding what they say or mean.
When a capital lease is to be amortized over the lease term, renewal periods will be included if they meet the criteria specified above. From an auditor perspective, this would be an important audit consideration when the renewal is assured through substantial penalties for nonrenewal or a guarantee by the lessee of the lessor's debt. Failure to review the lease term for renewal clauses could significantly distory the amortization charges to current contracts.
There is far more to FAS-13 (now ASC 840) than can be explained in brief blog posts. If you have leases, it would be very beneficial to have someone in your company knowledgeable of the fundamental requirements. Failure to properly classify a lease will definitely lead to questioned costs, and possibly penalties.