On February 25, 2016, the Financial Accounting Standards Board (FASB) issued changes to its lease accounting standards, superseding Accounting Standards Codification (ASC) 840, Leases, with ASC 842. It is effective for public business entities for annual periods beginning after December 15, 2018. For all other entities, ASC 842 will be effective for annual periods beginning after December 15, 2019. Early adoption is permitted for all entities.
Since the FASB’s issuance of ASC 842, and with subsequent amendments to the new lease standard, the government contracting community has experienced bouts of anxiety over fears that once fully-allowable rent expense will become partially-unallowable interest expense.
With this Insight, we aim to put these fears to rest. First, a change in generally accepted accounting principles (GAAP) cannot magically transform allowable costs into unallowable costs. Only the statutory and regulatory promulgation process can do that. Second, from our perspective, rent expense associated with operating leases will largely remain unchanged going forward: a generally allowable cost with no associated expense recognized for imputed interest.
What’s changing under ASC 842?
Under ASC 840, leases were classified as either “operating” or “capital.” Companies generally recognized operating lease expense on a straight-line basis over the lease term, with no balance sheet recognition. The expense related to operating leases, for government contract cost accounting purposes, has been (and will continue to be) generally allowable in accordance with FAR 31.205-36, Rental Costs.
Capital leases, however, differed from operating leases in that they were capitalized similar to an asset purchase when the lease’s economic substance met certain criteria. Accordingly, the capitalized value of the lease was depreciated with two expense elements: depreciation expense and an imputed interest expense. The depreciation portion of the expense was generally allowable in accordance with FAR 31.205-11, Depreciation. Contractors often treated the imputed interest expense element of a capital lease as an unallowable cost, although we believe this treatment is debatable (albeit likely not worth debating).
Under ASC 842, capital leases will be generally classified as “finance” leases. Any leases that are not finance leases are considered operating leases. Although the new standard provides a more principles-based approach for determining if a lease is classified as finance or operating, it will substantially result in the same classifications as those under ASC 840. Additionally, under ASC 842, contracts that previously were not considered leases may have lease-like elements that result in imbedded leases that fall under the purview of ASC 842.
One of the most significant changes that alarmed government contractors relates to ASC 842’s requirement to capitalize operating leases as a “right to use” asset. At inception of the lease, the lessee will capitalize a right to use asset and establish a lease liability, discounted to the present value of future lease payments, less any lease incentive received from the lessor. Each period, the lessee will pay the lessor in accordance with the lease terms, record fixed/straight-line rent expense (which may differ from cash paid if the lease payments are variable), re-measure the lease liability based on the present value of the outstanding lease payments, and adjust the right-of-use asset for any changes due to discount/interest. For more information on nuances and journal entries, refer to Baker Tilly’s Insight on the matter.
So, is there an “interest” element to the new “operating lease” classification?
Not really – at least not how the term “interest” is represented in FAR 31.205-20, Interest and Other Financial Costs. The time-value of money, called a “discount rate,” is a factor in determining a lessee’s lease liability. But this time-value element isn’t characterized or recognized by the lessee as interest expense for financial reporting. Operating lease expense will still be recognized, generally, on a straight-line basis as “rent expense” in a manner substantially similar to ASC 840.
Because any theoretical “interest” is an imputed discount adjustment to the lease liability and right to use asset, no interest is either paid to the lessor or recognized as such as an expense. Accordingly, rent expense allowability remains unaffected under ASC 842.
We’re all good, then?
For now, yes. We cannot know when (or if) the FAR or DAR councils will take up this change in GAAP lease accounting. At a minimum, FAR 31.205-11 and 31.205-36, which explicitly reference ASC 840’s definitions of capital and operating leases, should be updated and harmonized to reference ASC 842. These necessary minor changes will not adversely impact the allowablity of rent expense associated with operating leases. We believe the Government is unlikely to alter the current allowability paradigm – but if it does, such a change must survive the rulemaking process.
Regardless of what the Government might eventually do with the FAR cost principles concerning ASC 842, contractors should invest their energy into making proper lease classifications and using terms precisely (i.e., don’t use the term “interest” colloquially) when adopting the new GAAP requirements. Doing so is the best means to preserve the allowability of rent expense and reduce controversy as government auditors, too, acclimate to the new lease GAAP.
For more information on this topic, or to learn how Baker Tilly can help, contact our team.
And check out Baker Tilly’s Tax and Assurance Group’s Leases Essential Guidebook for more on the nuts of bolts of the financial accounting.