While the cost principle is titled “Rental Costs,” it addresses the cost of renting and leasing real and personal property utilized in the performance of US Government procurement contracts and subcontracts. The way I read the cost principle, FAR 31.205-36(b) provides that rental and leasing costs are allowable with the following limitations:
- Rentals or leases between unrelated parties must be reasonable considering the following:
- Comparable rental property;
- Current market conditions;
- The requirements of the agreement between the parties;
- Options other than renting or leasing; and
- Provisions of any additional agreement between the parties.
- Under a sale and leaseback arrangement, the costs are limited to the cost that would have been incurred had the sale and leaseback not been entered, considering any gain or loss.
- Rentals or leases between related parties are limited to the cost of ownership unless the leasing party leases to unrelated parties.
Let’s discuss each of these in a little more depth. We will start with the most straightforward one.
Sale and Leaseback
In most cases, a “sale and leaseback” is simply a financial transaction used by the seller to raise capital. FAR 31.205-27, Organization Costs, makes the cost of raising capital unallowable, and FAR 31.205-20, Interest and Other Financial Cost, makes interest and other financing cost unallowable. So, it is not surprising that the Government places a limitation on these transactions.
Rentals and Leases Between Unrelated Parties
While you would think this is the easiest of the provisions, our friends at DCAA can make anything difficult. DCAA auditors like to request you provide documentation that the agreed-upon rental/lease rate was reasonable several years after you entered into the agreement. DCAA loves to question what they believe is unsupported cost. If you did not create documentation when you entered into the agreement to support that the amount was reasonable, it must be questioned. Often, the auditor may question the entire amount – you would not want an auditor to agree to any amount they believe they could not audit.
One of the great joys that comes with having US Government contracts and subcontracts is the need to document everything—even transactions your financial accountants or auditor would find to be very low risk. Do not let DCAA get one over on you. Create contemporaneous documentation as to why all your rental and lease agreements are reasonable.
Rentals and Leases Between Related Parties
This is the more difficult provision to deal with. To put this into layman’s terms, you do not get to make additional profit on transactions between related parties when the cost will be passed on to your US Government contracts and subcontracts. When you are renting or leasing from a related party, you must ensure that the cost charged to your US Government contracts and subcontracts does not exceed what the cost principle calls “the normal cost of ownership.” Additionally, you must ensure that none of the costs of ownership (e.g., taxes, insurance, etc.) are duplicated. For example, if you are paying the taxes, and the other party considered the tax expense in their monthly rate they are charging you.
Divisions and subsidiaries of the same company clearly trigger this limitation. One of the other requirements triggering this limitation is whether the parties are “under common control.” Two separate companies owned and managed by the same person or group of persons is going to be found to be under common control. So, if the contractor and the company that owns and rents the building to the contractor are under the management of the same person – we have common control. However, if the owner of the contractor happens to own less than 50% of the stock of the company that owns and rents the building, which is managed by a different person – common control comes into question.
DCAA Audit Guidance on Related Party Lease Cost
In DCAA’s Selected Area of Costs Guidebook: FAR 31.205 Cost Principles, Chapter 40 – Leased Costs, Section 40-5.2 – Related Party Operating Leases states: “Leasing costs between divisions, subsidiaries, or organizations under common control for operating leases are generally allowable to the extent that costs do not exceed the normal costs of ownership (excluding interest or other costs unallowable and including the cost of money) (FAR 31.205-36(b)(3)).” The guidance then uses the following several paragraphs to address “common control.”
Remember, the auditor is simply looking for something (i.e., anything) they can show to say there is common control so they can apply the limitation. While the DCAA guidance does reference the Financial Accounting Standards Board Accounting Standard Codification 850-10-20 definition of control, which states: “The possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise.” Most financial auditors consider this definition based on the totality of the evidence. However, remember that these are DCAA auditors we are talking about, and their focus is questioning cost, so all they need is one questionable piece of evidence to throw the rest out. For example, the DCAA guidance states: “A party may have actual control even if such control is not evidenced by the agreement. Therefore, it is imperative to review the events and transactions that actually occurred in making a determination of whether or not control exists. Two of the most important areas to review are (1) the actual decision-making process and (2) the reasonableness of the lease terms.”
This is where I believe the guidance gets a little murky. Again, it is very likely that DCAA will look at your decision to rent or lease after a substantial amount of time has passed. You need contemporaneous documentation. No matter how good a story you can put together after the fact, the auditors are not likely to buy it.
Additionally, DCAA refers to the reasonableness of the lease terms. They are considering the reasonableness of the amount you agreed to pay, assuming you are paying the related party too much. They are looking through the agreement terms to find anything that would appear to show common control, at least in their view. I especially like this little statement: “While showing that the lease costs are unreasonable will not in itself constitute a determination of common control, it is an important factor in making such a determination. In addition, if the Government is unable to prevail in its common control argument, it nevertheless should prevail in proving that the lease costs were unreasonable at the time of the lease decision under the provisions of FAR 31.205-36(b)(1).”
The Exception to the Rule
FAR 31.205(b)(3) provides that rental or lease cost “from any division, subsidiary, or affiliate of the contractor under common control, that has an established practice of leasing the same or similar property to unaffiliated lessees” is allowable using the considerations of reasonableness for a rental or lease between unrelated parties. Again, in layman’s terms, if one of the related parties is in the business of renting or leasing office space or equipment to other unrelated parties and the contractor agrees to the same terms and payment amounts as those other unrelated party renters or lessees, the amount paid to the related party can be charged to your US Government contracts and subcontracts.
Remember, your DCAA auditors are here to question cost, so they will still expect contemporaneous documentation to support that the terms and amounts are reasonable. In the back of the auditor’s mind, they are sure you set up the leasing company to drive higher costs to your US Government contracts and subcontracts. Sorry, but the truth is that “objectivity” is not the easiest auditing standard requirement for many DCAA auditors.
Key Takeaways
- Develop and maintain contemporaneous documentation to support that the terms and amounts of your rental agreements and leases are reasonable.
- Make sure you have documentation to support the exception related to “under common control” before the Government asks for it.
When you have been so involved in the details, it is sometimes hard to see gaps in your documentation. Have one of our experts review the documentation before you are sitting across the table from a DCAA auditor. The Redstone GCI team assists contractors throughout the U.S. and internationally in understanding the government’s requirements and implementing an adequate accounting system, including the necessary supporting documentation for high-risk transactions/costs. We would be happy to be part of your team.
John is a Director with Redstone Government Consulting, Inc. providing government contract consulting services to our clients primarily related to the DFARS business systems, CAS Disclosure Statements, and DCAA/DCMA compliance preparation, advisory, and defense. Prior to joining Redstone Government Consulting, John served in a number of capacities with DCAA/DCMA for more than 30 years. Upon his retirement, he was based in Texas as an SES-level Corporate Audit Director for DCAA, managing a staff of 300 auditors at one of the largest DOD programs. Professional Experience John began his career in the late 80s working in the Clearwater, FL audit office and over the next three decades he progressed through a number of positions within both DCAA and DCMA with career highlights as DCAA Program Manager at Ft. Belvoir, Chief of Technical Programs Division, Deputy Assistant Director-Policy, Director of the DCMA Cost and Pricing Center, the SES-level Lockheed Martin Corporate Audit Director, and Director of Integrity and Quality Assurance. John’s three decades of experience in performing and leading DCAA auditors and DCMA reviewers provides a wealth of expertise to our clients. John’s role, not only in the performance of audits, but also in the development of audit policy affords him unique insights into the defense of audit findings and the linkage of audit program steps to the underlying regulatory framework. He is an expert in FAR, DFARS, and other agency acquisition regulation, as well as a subject matter expert in the Cost Accounting Standards having reviewed and provided audit feedback on many of the largest and most complex cost accounting practices during his tenure with the DCAA. John’s tenure with DCAA and DCMA came at a critical time during each agency’s history where a number of changes were occurring such as the response to the ICS backlog, development of audit approaches to the DFARS Business Systems and implementation of new audit initiatives as a result of Congressional oversight through the NDAA process. John’s leadership at the DCMA Cost & Pricing center saw oversight of all major DOD pricing actions, leadership of should cost review teams, the Commercial Pricing group and many other areas of strategic value to our clients. His involvement in these and other Agency initiatives is of great value to our clients due to his in depth understanding of DCAA and DCMA’s internal policy directives. Education John holds a Master of Business Administration and a B.A. in Accounting from the University of South Florida. Certifications Certified Information Systems Auditor State of Alabama Certified Public Accountant