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?

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.