Staff Paper Prepared for the President's Commission to Study Capital Budgeting

June 18, 1998

Should the budget treatment of leases be changed to reduce bias in deciding whether to lease or buy a capital asset and in deciding on the term of the lease?


The Government may acquire the use of buildings and some equipment (such as naval vessels) by either purchasing or leasing them. Purchasing an asset is almost invariably cheaper than a lease-purchase or other long-term lease when the Government has a long-term need for a given asset in a fixed location, because the Treasury can borrow at a lower interest rate than any private developer or manufacturer. Leases may have an advantage when the Government needs an asset for less than its useful life. Some needs are strictly short-term; and short-term leases (generally termed operating leases) allow flexibility, which is especially important when Federal employment is shrinking or being consolidated. Leases may also have an advantage when the Government finds it beneficial to transfer the risk of technological change. Technological improvement often makes information technology obsolete in a short time, and short-term leases can transfer technological risk to private providers, who may be better able to manage it.

Congress and OMB agreed on a scoring rule in the Budget Enforcement Act of 1990 (BEA) to make the budget treatment of long-term leases (generally termed capital leases or lease-purchases) more similar to the budget treatment of asset purchases. Previously, the budget authority (BA) in the first year of the lease was typically for the annual rental plus the cost of termination for convenience, except that for GSA real estate the additional BA was approximately for the annual rental alone. In contrast, the BA for outright purchases was scored in full in the first year. When budget decisions were made, leases appeared cheaper than outright purchases because only a small part of the total BA and outlays was scored up-front, compared with the full cost of an outright purchase.

The BEA scoring rule requires agencies to include BA for the full cost of lease-purchases and other capital leases up-front in the budget in the first year of the transaction. This encourages agencies to select the financing method with the lowest overall costs, regardless of the year in which cash disbursements occur, and to compare the total benefits of the project with its total cost. The scoring rule was inspired by private sector GAAP. It distinguishes between what FASB calls "capital leases" and operating leases, and it scores them differently.

Classification of leases. -- The criteria for determining which leases are lease-purchases or capital leases, and which leases are operating leases, primarily employ FASB's four criteria (with some modification). Leases are lease-purchases or other capital leases if any one of the following conditions is met: the lease transfers ownership by the end of the lease term or shortly afterwards; the lease contains a bargain purchase option; the lease term equals 75 percent or more of the estimated economic life of the asset; or the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the asset.

Scoring lease-purchases and other capital leases. -- The scoring rule made a three-fold division of what FASB calls "capital leases": lease-purchases without substantial private risk, lease-purchases with substantial private risk, and capital leases. These leases are treated analogously to purchases -- to a partial extent.

Scoring operating leases. -- Outlays are recorded when disbursements are made. The BA required each year depends on the nature of the contract and the operations of the agency. If the contract includes a cancellation clause, BA in the first year must be for the annual rental plus the cost of termination; BA in each subsequent year must be for that year's rental. If the contract does not include a cancellation clause, BA in the first year must cover the payments expected to arise under the full term of the contract. If funds are self-insuring under existing authority, however, as in the case of the General Services Administration (GSA), only the amount of BA needed to cover each year's annual lease payment is required.

The scoring rule in application. -- The scoring rule has reduced much of the previous bias in favor of lease-purchases and capital leases, but it is not fully neutral. BA is not required up front for operating leases, even those that are for long periods of time. Outlays for capital leases and lease-purchases with substantial private risk are spread over the term of the lease rather than being recorded up front, despite the Government's long-term commitment. The budget treatment often depends on arbitrary dividing lines. There is an incentive to structure leases to meet the criteria for operating leases. There is also an incentive to use a succession of operating leases even when an agency intends to use given space over a long time, which is more costly than lease-purchases or other capital leases.

Some of these problems parallel the difficulties with the present financial accounting standards. They have been criticized for using arbitrary dividing lines, encouraging manipulation, and not recognizing material assets and liabilities on the balance sheet.

The scoring rule is politically very contentious. Congressional hearings are held almost every year in which some members of Congress criticize the scoring rule as being too restrictive to meet capital needs adequately and as encouraging agencies to enter into uneconomical operating leases. The criticism is mainly with regard to GSA real estate.

Required economic analysis of lease-purchase and other capital lease decisions. -- OMB Circular A-94 requires all lease-purchases and other capital leases to be justified as preferable to direct Government purchase and ownership and requires a separate analysis for major acquisitions. This analysis compares the present value of the life-cycle cost of leasing with the full cost of buying or constructing an identical asset. This guidance, originally issued in the 1980s, has been used widely within the Defense Department and has encouraged economical decisions. However, it has not been a full substitute for budgetary incentives.

Other references. -- The use of lease-purchase to acquire the Ronald Reagan Building and International Trade Center is one of the separate papers on capital budgeting for specific program areas or projects.


The first option is to endorse the present scoring rule. The second, third, and fourth would make the scoring of leases more like the scoring of purchases. The fifth option would address the incentive for the General Services Administration (GSA) to use more costly operating leases for long-term needs.

1. Endorse the present scoring rules. --Continue to use private sector GAAP (with some modification) to differentiate types of leases, and include BA for the full cost of lease-purchases and other capital leases up-front in the first year of the transaction.


Cons: 2. Revise the dividing line to classify more leases as capital leases. -- Classify leases as capital leases if the lease term exceeds 60 percent of the estimated economic life of the asset (instead of 75 percent) or if the present value of the minimum lease payments equals or exceeds 75 percent of the fair value of the asset (instead of 90 percent).


Cons: 3. Capitalize all leases for determining BA. -- The present value of future lease payments for all leases would be recorded as BA up front.


Cons: 4. Capitalize all leases for determining both BA and outlays. -- The same as option 3 but applied to outlays as well as BA. The present value of future lease payments for all leases would be recorded (a) as BA up front and (b) as outlays over the construction period or, if the asset already existed, when the contract was signed.


Cons: 5. Establish separate treatment for GSA real estate investment. Exempt General Services Administration (GSA) buildings from the BEA scoring rules for lease-purchases by not including the full cost in up-front BA. (The full cost would be displayed in the prospectus and supplemental budget documents.) Allow GSA to borrow from Treasury to finance the acquisition of Federal buildings through lease-purchases. The amount of GSA debt outstanding would be limited by a requirement that the annual debt service not exceed 25 percent of the annual capital investment resources of the Federal Buildings Fund (its rental income less cost of real property operating and rental of space). The Federal Buildings Fund charges agencies the commercial equivalent rent for occupying space controlled by GSA.

Under this proposal, the proposed project must meet the following criteria: be in a region or urban area with a long-term stable Federal presence; be in a region or urban area with a low own-to-lease ratio; and have several leases expiring in the near future. Proposed projects would be submitted to OMB and Congress for approval, as is done currently.



President's Commission to Study Capital Budgeting