Wednesday, March 22, 2017

Is a Lease Really an Intangible Asset?

Cost Accounting Standard (CAS) 404 establishes criteria for determining the acquisition costs of tangible assets which are to be capitalized. It requires contractors to capitalize the acquisition costs of tangible assets in accordance with a written policy that is reasonable and consistently applied. We have detailed the essential requirements of CAS 404 in a previous post that can be read here.

Recently, there was a decision handed down by the ASBCA (Armed Services Board of Contract Appeals) involving CAS 404 and whether the standard applied to Capital Leases. The case involved Exelis, Inc.'s failure to properly classify a building lease. Exelis recorded the lease as an "operating lease" rather than a "capital lease". Under an operating lease, a contractor simply records the rental payments as an expense (FAR 31.205-36) Under a capital lease, the present value of the lease expenses capitalized and depreciated over the life of the lease (FAR 31.205-11).

The Government took exception to Exelis' accounting for lease payments and cited the contractor for non-compliance with CAS 404. The Government calculated the impact at just over $3 million. Exelis appealed to the ASBCA who ruled that CAS 404 did not apply to capital leases as capital leases are not tangible assets but rather intangible assets. The Government appealed the ASBCA decision but lost the appeal as well. We will not go into the details of those decisions because we have covered those details in previous posts. See here and here for our coverage of the initial decision and the appeal, respectively.

Normally capitalization and depreciation issues are non-controversial. Depreciation is an allowable expense so disagreements usual hinge on useful lives. Contractors want shorter lives, the Government wants longer useful lives. The imipact is just the time value of money. However, since most contractors also claim Facilites Capital Cost of Money (FCCM) on the net book value of assets, the impact on the time value of money is a wash. The higher the book value (acquisition cost less depreciation), the more FCCM a contractor recoups.

So what is the big deal with the Exelis depreciation case? The big deal lies in Exelis' contract mix. Of the $3 million cost impact calculated by the Governement, $2.6 million applies to fixed priced contracts and the remaining $400 thousand applies to flexibly priced contracts. The Government is going to recover the $400 thousand through the settlement of indirect costs process (FAR 52.216-7). However, there is no simple contractual mechanism to recover the $2.6 million by which fixed priced contracts were overstated because Exelis applied the wrong accounting methodology to lease payments. To recover those increase costs, the Government would need to resort to TINA (Truth in Negotiation Act) and there is serious concern as to whether the Government could prevail in a TINA case.

The ASBCA decision continues to baffle us. According to the ASBCA, "...CAS 404 applies to 'Tangible Assets". The CAS defines "tangible capital asset(s)" as "asset(s) that  (have) physical substance. Thus, the plain language of the CAS provides that CAS 404 applies to tangible assets which are assets with physical substance. A lease is an intangible rather than an intangible asset because the lease itself is a legal right to use and occupy the building and does not have 'physical substance'".

Is a lease really an intangible asset as the ASBCA states? For financial reporting purposes, leases are considered liabilities. We have yet to see a case where leases are reported on financial statements as intangible assets. Would the ASBCA also say that a mortgage represents an intangible asset because there is no physical substance to the piece of paper?

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