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Staff Paper Prepared for the President's Commission to Study Capital
June 18, 1998
BUDGET TREATMENT OF LEASES AND PURCHASES
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 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.
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
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
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.
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
This would not make capital budgeting better than it is now.
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).
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
Private sector GAAP would be less useful as precedent in defending the
rule, although there is recognition that the present dividing lines are
3. Capitalize all leases for determining BA. -- The present value
of future lease payments for all leases would be recorded as BA up front.
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
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
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.
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.
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
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.
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
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.