DAB Decision 13
January 27, 1976 University of California at San Diego, Proposed
Recharge Rates for the Computer Center; Audit Control No. 40101-09;
Docket No. 23; Decision No. 13 Bernstein, Bernice L.; Malone, Thomas
Mason, Malcolm S.
DECISION
The leasing of equipment has grown enormously. It has been estimated
that during the 1960's leasing grew at an annual average rate of 15 to
20% and that by the end of 1975 equipment on lease will total $100
billion (Financial Accounting Standards Board (FASB), Proposed Statement
of Financial Accounting Standards, Accounting for Leases, August 26,
1975, Paragraph 43). In its application to grants, this requires the
articulation for this rapidly expanding area of principles of prudent
decision-making and of proper reporting. These are still in process of
articulation and have not yet been fully solved but are evolving through
successive refinements in the direction of a reasonably consistent
approach. This problem is particularly prominent in the field of
computer equipment.
STATEMENT OF THE CASE
An HEW audit determined that grantee's payments for a computer system
acquired from Burroughs Corporation contains unallowable interest
charges in the amount of $1,050,000, Audit Control No. 40101-09, dated
November 13, 1973. One effect of this determination, if sustained,
would be a requirement that grantee's computer recharge rates to
federally supported research agreements be reduced to compensate. See
OMB Circular A-21 J.35.
Grantee and HEW Regional officials exchanged several letters on the
factual and legal issues including copies of opinions of their
respective counsel. The Regional Comptroller sustained the audit
finding. Grantee appealed to the Regional Director, who sustained the
ruling. Grantee appealed to this Board.
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The Agreement in question does not characterize the transaction as a
lease or a sale, but its terms appear on their face to be consistent
with those of a lease with option to purchase. They also appear to be
consistent with those of an installment sale in which title is retained
for security purposes.
Both sides have argued rather fully the characterization of this
transaction under the Uniform Commerical Code as adopted in California.
Neither side has offered any argument as to why a characterization,
intended largely to determine recordation requirements and which set of
creditors (lessor/seller's or lessee/buyer's) will be able to levy on
the property, should be a guide as to whether the payments are
reimbursable as between Government and grantee. The Chief Reporter,
Professor Karl N. Llewellyn, particularly sought to avoid in the Code
the decision of narrow practical problems by the application out of
context of broad general concepts. See Official Comment on Section
2-101 and Section 9-101.
FACT BACKGROUND
The agreement between Burroughs and grantee was several times amended.
For convenience we refer principally to the agreement dated April 25,
1972 and ignore differences between the several versions except as
relevant to the discussion.
The agreement was for 84 months. This is roughly the expected economic
life of the equipment involved. The agreement was terminable however at
the unqualified option of the grantee at the beginning of any fiscal
period. The non-cancelable period (the "lease term" under the proposed
FASB standards) is thus less than a year, very much less than the
economic life of the property. The anticipated residual value of the
property at the end of the noncancellable portion of the agreement would
be substantial. The agreement does not transfer title at the end of the
term, unless grantee affirmatively exercises its option to buy a portion
or all of the equipment at a price fixed in the agreement. The option
coupled with terminability permits acquisition of the property whenever
that is economically advantageous without locking the grantee in to an
acquisition that is not advantageous. This is particularly a valuable
privilege in view of the rapid evolution of computer technology. The
equipment is not special purpose to the University. The option price is
not a bargain option but is a price roughly equivalent to the expected
residual value of the property at the date of exercise, diminishing
progressively from the full initial
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price (over $1,700,000) to a price equivalent to the depreciated value
after seven years ($34,295). Thus, the arrangement, in FASB's
terminology, is an operating lease not a capital lease from lessee' s
point of view (nor a sales-type lease or direct financing lease from
lessor's point of view). In the terminology of Securities and Exchange
Commission Regulations S-X Sec. 3-16 (q), it is not a financing lease.
In the terminology of HEW Grants Administration Manual Chapter 1-770-10)
it is not a "Lease Which Creates a Material Equity in Property" but
a
"Long-Term Lease."
It is agreed that the equipment could have been purchased outright at
the inception of the agreement for $1,758,595. The cost of maintenance
is agreed to be $1,196,105. The sum of scheduled cash payments is
$2,954,700 (after addition of a substitute core memory) which exactly
covers the initial cost price and maintenance.
The agreement also included provision, however, for a right on the part
of Burroughs to computing services equivalent at the grantee's regular
on-campus users rate of $12,500 a month. The auditors added to the cash
payments 84 x $12,500 or $1,050,000, then subtracted the maintenance and
initial price and came out with an excess of $1,050,000 which they
labelled interest cost and challenged under an interpretation of OMB
Circular A-21 Sec. J.16 disallowing interest on borrowed capital
"however represented." The coincidence of the equivalence between
the
Region's computed "interest" figure and the amount of the "service"
figure, and the fact that the interest rate thus computed is equivalent
to a 14% interest rate while the University was able to borrow money at
5 to 7% should have been tell tales of something amiss with this
analysis.
There are indeed many reasons why this approach is untenable.
Every long-term transaction, a simple lease for example, can be analyzed
as covering a payment for the use of borrowed funds or for foregoing
alternative investment opportunities. In some sense that is equivalent
to interest, but such interest charges implicit in every long-term
transaction and hidden in the transaction itself are not disallowed.
The lessor or seller has interest costs which are obviously passed on to
the lessee or buyer. If they are blanketed in within an overall price
they are not disallowed. If they are passed on in a separately
recognizable form they may be. Transactions are thus, often and without
impropriety, shaped to meet this peculiarity of federal practice. The
University asserts that in good faith it cast the transaction into what
it believes and now claims was an acceptable format. There is nothing
improper
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in the University's frank effort to do this and a comment on the part of
one of its employees that the transaction had to be so shaped does not
warrant a characterization of "hiding" or "concealing" the
interest
element in the transaction.
The Region's effort here to extract from this transaction an interest
element emphasizes one of the weaknesses inherent in the extreme
interpretations sometimes given to Sec. J.16 of A-21. It forces
acquisition of major equipment to be made in disregard of sound
managerial decision-making and channelled artificially into formats that
meet artificial tests. Sounder approaches to this problem than the
approach the disallowance here would encourage are shown in Attachment O
to OMB Circular A-102, par. 3c(1), (FMC 74-7); 45 CFR 74.154(a); Cf.
also Attachment O par. 3(c) (1) to "A-102 1/2" Notice of Proposed
Rule-Making, 34 CFR Part 258, 40 FR 6304 (Feb. 10, 1975); Comptroller
General's Report B-115369 (July 24, 1975), An Opportunity for Savings of
Large Funds in Acquiring Computer Systems Under Federal Grant Programs,
esp. at ch. 3; GSA Guidance to Federal Agencies on the...Acquisition of
Automatic Data Processing Systems (February 14, 1975) esp. at pp 6-7;
FMC 74-5 Management, acquisition, and utilization of automatic data
processing (ADP) 6d and e, and other government studies.
The excess of total payments over the sum of initial cost plus
maintenance cannot be equated to an identified interest charge. To
attempt to do so overlooks the substantial but not objectively measured
value of the option right to cancel at the beginning of a fiscal period
or to buy at an agreed price roughly equivalent to expected fair value.
More important, the services agreement cannot be treated as the
equivalent of a cash payment. Burrough's right to call for services
from the system is not so much an addition to the cost, as a potential
diminution of the property made available. Moreover it must be fairly
obvious that there never was a realistic expectation that the right
would be substantially exercised. In response to specific inquiry, the
grantee confirmed that there was no expectation that Burroughs would
ever make other than casual use of the privilege, and refers to a letter
from Burroughs dated July 12, 1971 allocating 70% of the potential usage
to the faculty and students of the University. Burroughs has used in
total $77,033 worth of services of which only $64,760.67 was unfunded
usage. No further services will be supplied, this provision having been
terminated effective December 31, 1974.
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Thus, even if we counted Burroughs usage as a payment, the excess of
payments over initial price plus maintenance amounts to only $64,760.67.
Even if we otherwise accepted the Region's analysis, this amount cannot
be identified as interest since there is no showing that it exceeds the
fair economic value of the option to cancel and the option to buy in the
agreement. Under Chapter 1-77, it might be disallowable under the
Long-Term Lease provision without attempting to label it as interest,
but that conclusion is not certain, indeed the case seems likely to fall
as the University contends, under an exception to the Long Term Lease
rule. In any case, both parties have agreed that 1-77 should not be
applied.
DECISION
The appeal is allowed. The disallowance of $1,050,000 is set aside.
The University is claiming only the cash payments plus $64,760.67 on
account of services and that limited amount should be allowed. Recharge
rates should be adjusted if necessary to reflect allowance of that
amount but not of potential Burroughs use in excess of that amount.
May 7, 1992