(Editor’s Note. We have received several questions recently on whether the monthly payments contractors pay for certain assets can be written off as rental expenses or whether they must be capitalized and treated as ownership assets. In response to these inquires we thought it would be a good idea to address (1) the government accounting distinctions between rental costs and costs of ownership and (2) the financial accounting distinction between operating leases and capital leases. We have used our experience as the basis for this article.)

Under FAR 13.205-36, rental costs are generally allowable, including those costs "under operating leases." The amount of monthly payments for the operating lease would normally be those charged by the leasor and paid by the contractor. Assets not rented or leased are owned by the contractor. Though no specific cost principle addresses treatment of these owned assets, several do address elements of the costs of these assets (e.g. depreciation, cost of money, gains and losses on disposition, maintenance and repair). Expenses related to these assets are normally referred to as "costs of ownership." These costs are normally allowed and typically include depreciation, taxes, facilities, repair and maintenance and cost of money (where interest costs are unallowable).

Operating leases and capital leases are concepts common in the world of financial accounting as opposed to government accounting where generally accepted accounting principles in FASB No. 13 addresses the two types of leases. There are basically two ways to account for a lease: the operating method or the capital method. An operating lease is a regular rental of property. As payments become due, rent expense is charged. The lessee normally does not report anything on its balance sheet. The lessee uses a capital lease if one of the following four conditions are met:

the lessee obtains ownership to the property at the end of the lease term.

a bargain purchase option exists where either the lessee can buy the property at a nominal amount or renew the lease at minimal payments.

the life of the lease is 75% or more of the life of the property.

the discounted value of minimum lease payments at inception of the lease equals or exceeds 90% of the fair market value of the property. Minumum lease payments exclude costs paid by the lessee to reimburse the leasor for its costs of maintenance, insurance and property taxes.

In most cases, operating leases are equivalent to rental costs. The government accounting rules recognize an exception if the leasor of an operating lease is "related" (e.g. officers, owner or owner’s family) to the lessee in which case the allowable costs would be limited to ownership costs. Though many contractors believe a "related" party arrangement should be treated like any other operating lease when the lease costs and terms are similar to those found in the local marketplace, the government disagrees saying given the opportunity to manipulate those costs, they should be limited to costs of ownership.

Though the term "capital lease" infers a lease component, there is the presumption that the asset is owned by the lessee and the proper amount of costs to recognize for government costing purposes are the ownership costs of that asset. Payments under a capital lease may be the same as ownership costs but are usually different in which case the contractor must separately compute the ownership costs and charge only those costs to the government. Hope that clears that up.

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