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?

Going to Court? Give it Your Best the First Time Around

Last November we highlighted an ASBCA (Armed Services Board of Contract Appeals) ruling from August 29, 2016 that CAS 404, Capitalization of Tangible Assets) does not apply to capital leases. This ruling caught us by surprise as almost everyone in Government contracting circles believed otherwise and acted on that premise in determining allowable costs (depreciation) on Government contracts. Read it here.

The Defense Contract Management Agency (DCMA) who defended the case before the Board also thought the Board was wrong and moved for a reconsideration of the Board's opinion alleging that the Board had made a "legal error". The Board denied DCMA's motion and wrote some strong wording concerning DCMA's approach to handling the original case and the motion for reconsideration. The Board wrote:

A motion for reconsideration is not the place to present arguments previously made and rejected. Where litigants have once battled for the court's decision, they should neither be required, nor without good reason permitted, to battle for it again. Motions for reconsideration do not afford litigants the opportunity to take a second bite at the apple' or to advance arguments that properly should have been presented in an earlier proceeding.

Moreover, we note that DCMA's argument regarding the interpretation of CAS 404 comprised just five and-a-half pages of its twelve-page brief in opposition to Exelis' motion to dismiss. Now DCMA has submitted a 34 page brief devoted solely to this issue. Put simply, the rulings of a board are not mere first drafts, subject to revision and reconsideration at a litigant's pleasure. The proper time for DCMA to have made these arguments was in response to Exelis' motion to dismiss, and not in a motion for reconsideration.

Notwithstanding the denial for reconsideration, the Board considered DCMA's additional arguments and found none of them to be persuasive. Those arguments were:

1. the Board misinterpreted the text of CAS 404
2. the Board incorrectly held that GAAP (Generally Accepted Accounting Principles) play no role in the interpretation of CAS 404 and
3. that the Board improperly applied the standard of review by assuming the Exelis' lease of an office building was not a capital lease.

As we stated in our previous posting, the Government can still pursue the case based on FAR and probably will. It is not unlikely however that DCMA will appeal the Board's rulings to a higher court.

Accounting for Leases - Part 5

Today we intend to conclude our discussion on capital leases. So far we've discussed the criteria (or tests) that contractors must apply in order to determine whether a lease should be classified as an operating lease or a capital lease, some of the techniques for applying the tests and some of the warnings and considerations that the Government thinks about anytime it sees lease costs. From the Government's perspective, capital leases are less expensive than operating leases based primarily on the imputed interest that is unallowable on Government contracts. That is why we often see auditors trying to reclassify rental payments to capital lease payments. Today we're going to discuss additional considerations concerning amortization periods.

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.

Accounting for Leases - Part 4

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.

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.

Accounting for Leases - Part 2

This is the second part of a series we began a couple of weeks ago. To read Part 1, Click here. As we mentioned back on July 2nd, there are two kinds of leases; operating leases and capital leases. Leases that meet any one of four tests (transfer bargain purchase economic life, or fair market) are classified as capital leases. Capital leases are capitalized and depreciated over the assets' useful lives. FAR 31.205-11(h) requires contractors to account for leases in accordance with FAS-13 (now referred to as ASC 840).

Now just because a contractor properly classifies a lease, it does not follow that the Government, the contract audit groups, will like the results. There is a bit more to the capitalization and depreciation equation as we will explain today and throughout the rest of this series.

The first thing to think about is the value to capitalize. In a typical lease, you know the monthly lease cost and the number of months. FAS-13 (ASC 840) requires that the present value of lease payments be capitalized. To determine present value, you need an interest rate. And that rate makes a difference. Consider a piece of equipment with the sum of lease payments over five years totaling $50 thousand. The present value assuming a 5 percent rate is $39 thousand. The present value assuming a 4 percent rate is $41 thousand. What rate should be used?

FAS-13 (now ASC 840) has the answer. Capital leases should be recorded as assets and liabilities at the lower of the present value of the minimum lease payments at the beginning of the lease term or the fair value of the leased property at the inception date. The discount rate used in determining present value is the lower of the lessee's incremental borrowing rate (the rate the lessee would have incurred to borrow the funds necessary to purchase the asset) or the implicit (lessor's) rate in the lease, if the implicit rate can be determined. The minimum lease payments are allocated between a reduction of the liability and interest expense to produce a constant periodic interest rate on the remaining balance.

A lessee may use its secured borrowing rate in calculating the present value of minimum lease payments if the rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.

Now here's where auditors get a bit testy. Many contractors don't have an incremental borrowing rate or a secured borrowing rate. Moreover, the lessor does not have or specify an "implicit" rate in the lease agreement. So what interest rate should be used? The Government likes to come up with a higher rate. That lowers the present value (less depreciation) and increases the interest portion of the lease payments which are unallowable under Government contracts. Contractors on the other hand, strive for a lower rate for just the opposite reason.

Ultimately, both sides have to come to some reasonable agreement. Contractors can best serve their interests if they have thought this through beforehand and have established a defensible method of determining the applicable discount rate.

Accounting for Leases

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.