There are two kinds of leases; capital leases and operating leases. A capital lease is essentially purchasing the asset and therefore, the asset must be capitalized on the balance sheet (and depreciated). An operating lease is what most people typically think of when they hear the term "leasing" - a five year rental agreement on a building, short term leases of equipment, etc. Operating lease payments are expensed in the income statement.
Sometimes it gets a little tricky to classify leases properly, and it makes a difference for Government contractors. Capital leases are covered by FAR 31.205-11(h) (Depreciation), while operating leases are covered by FAR 31.205-36 (Rental Costs). According to FAR 31.205-11(h), contractors must account for leases in accordance with Financial Accounting Standard No. 13 (FAS-13) which is now called ASC 840.
ASC 840 (formerly FAS-13) states that if a lease meets any one of four tests, the lease must be accounted for as a Capital Lease. Those tests include:
- Transfer test. The lease transfers ownership of the property to the lessee by the end of the lease term.
- Bargain purchase test. The lease contains a bargain purchase option. A bargain purchase option is a price that is lower than the fair value of the equipment.
- Economic life test. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, where the lease term begins in the last 25 percent of estimated economic life, this criterion shall not be used to classify the lease.
- Fair market test. The present value, at the beginning of the lease term, of the minimum lease payments equals or exceeds 90 percent of the excess of the fair value of the lease property. The 90 percent test should be considered a lower limit rather than a guideline. However, where the lease term begins in the last 25 percent of the estimated economic life, this criterion shall not be used to classify the lease.
In the coming days, we are going to be discussing in some detail, the mechanics of setting up capital leases and depreciating them under Government contracts. The classification of leases makes a difference in how much a contractor can recover - especially contractors that do not claim FCCM (Facilities Capital Cost of Money). There have been a lot of disputes between the Government and its contractors over the proper treatment of lease costs and we want to help you avoid potential disputes.