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?

Description:

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.

• Budget authority: The present value of future lease payments for lease-purchases and capital leases is recorded as BA up front; imputed interest is recorded as BA annually.

• Outlays: Outlays are generally recorded as cash is disbursed over the term of the lease rather than up front as they would be for a purchase. The only exception is for "lease-purchases without substantial private risk," in which case the present value of future lease payments is allocated as outlays over the construction period; financing is recorded as imputed agency debt; and imputed interest on this debt is recorded as outlays.

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.

Options:

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.

Pros:

• Private sector GAAP is a widely accepted guideline to distinguish between capital and operating leases.

• Private sector GAAP recognizes "that a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee." (SFAS 13, para. 60).

• Endorsement would provide support for maintaining the present scoring rules, which are often severely criticized as restricting leases too much.

• The present scoring rule provides an incentive to satisfy long-term needs with leases that can just meet the criteria to be classified as operating leases. These leases may be more costly than lease-purchases and other capital leases.

• This would not make capital budgeting better than it is now.

Pros:

• Tightens the definition of an operating lease in order to encourage using leases only to meet short-term needs, not long-term requirements.

• The effect of bias on the lease-buy decision is mainly a problem at the margin, where long-term leases are classified as operating leases. Purchasing an asset is not a real alternative for most short-term leases.

• Private sector GAAP would still provide some precedent, especially if the Commission recommended this modification.

• The conceptual improvement would be only partial. Some bias would remain in choosing between leases and purchases, and nothing would be done about the bias between operating leases and expenditures for other purposes than acquiring asset services.

• Agencies would still have an incentive to enter into a succession of ostensible short-term leases, which would be more costly than longer-term leases.

• The dividing line would still be arbitrary and would provide an incentive for manipulation.

• Private sector GAAP would be less useful as precedent in defending the rule, although there is recognition that the present dividing lines are arbitrary.

Pros:

• BA would be recorded equivalently for all leases and purchases. When a lease was for a fraction of an asset's life, the amount recorded would be a corresponding fraction of the asset's value.

• BA for all leases would measure the cost of the Government's multi-year commitment.

• The budget treatment of BA would not depend on arbitrary dividing lines used to classify leases in different ways.

• Elimination of arbitrary dividing lines for calculating BA would reduce manipulation.

• Agencies would have an incentive to enter into a succession of ostensible one-year leases, which would be the most costly means of acquiring asset services for long-term needs.

• Leases would still be favored over purchases, because outlays would be recorded over the term of the lease instead of up front.

• Annual leases essentially do not exist in the private sector, and the Government scoring rule would be criticized for not allowing normal operating leases.

• It would no longer be possible to point to private sector GAAP as precedent for the treatment of leases. The accounting standard setters -- including, two years ago, the chairman, vice chairman, and director of research of FASB -- have expressed some interest in capitalizing all leases, but if this change is made it will probably take many years.

Pros:

• The same as option 3, but would apply to outlays as well as BA.

• The same as option 3, except that lease-purchases and other capital leases would no longer be favored over purchases with respect to scoring outlays; and the incentive for one-year leases would be stronger.

• It would be difficult for agency accounting systems to record imputed outlays, the debt to finance these outlays, and the interest and amortization of this debt.

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.

Pros:

• Lease-purchases, although more costly than outright purchases, are cheaper than operating leases when the Government has a long-term need for a given space. The current scoring rule biases decisions to acquire space for long-term needs in favor of long-term operating leases.

• Allows GSA to obtain ownership of the facilities at the end of the lease term.

• A cap based on the annual income of the Federal Buildings Fund can be used as a control mechanism to limit the amount of lease-purchases. Other agencies do not ordinarily have such a mechanism available (e.g., the Navy does not earn income from the use of its vessels).

• GSA lease-purchases would appear cheaper in the budget than direct construction or purchase, because only the annual cost of the lease payment would be included in BA and outlays when the Government decided on the project.

• GSA lease-purchases would appear cheap in the budget compared to other types of spending in the budget, because only the annual cost of the lease payment would be included in BA and outlays when the Government decided on the project.

• If GSA were exempted from the scoring rules, other agencies would also want to be exempted.