Defense Acquisition: Historical Insights Into Navy Ship Leasing

Published by the Government Accountability Office on 1999-04-21.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                     United States General Accounting Office

GAO                  Testimony
                     Before the Subcommittee on Seapower, Committee on
                     Armed Services, U.S. Senate

For Release
Expected at
2:30 p.m. EDT
                     DEFENSE ACQUISITION
on Wednesday,
April 21, 1999

                     Historical Insights Into
                     Navy Ship Leasing
                     Statement of James F. Wiggins, Associate Director,
                     Defense Acquisitions Issues, National Security and
                     International Affairs Division

                   Madame Chairwoman and Members of the Subcommittee:

                   I am pleased to be here today to provide some historical insights into Navy
                   ship leasing. At the request of this Subcommittee, we are reviewing the
                   Navy’s decisions in the early 1970s and early 1980s to lease Sealift tankers,
                   Maritime Prepositioning Ships (MPS), and T-5 replacement tankers, and
                   more recently, Chouest specialized support vessels. My remarks today are
                   based on this work and earlier GAO reviews. Specifically, I will discuss the
                   basis and support for the Navy’s decisions to lease rather than purchase
                   these vessels, the concerns that surrounded the decisions, and the
                   legislative and regulatory changes that have been implemented which will
                   influence future lease versus purchase decisions. Our report on these
                   issues will be available in July.

Results in Brief   The primary reason the Navy decided to use long-term leases to acquire
                   auxiliary vessels in the early 1970s and early 1980s was because available
                   procurement funds were needed for higher priority combat ships, and
                   leasing arrangements allowed the Navy to acquire the support ships
                   without a large, up-front obligation of procurement funds.1 The Navy also
                   believed that leasing was cost-effective and helped support the industrial
                   base. At the time, the Navy complied with existing requirements to
                   perform lease versus purchase cost comparisons. These comparisons
                   concluded that leasing was cheaper than purchasing.

                   The Navy’s decision to enter into long-term leases in the early 1970s and
                   early 1980s raised concerns regarding the budget authority needed to make
                   such large long-term funding commitments. Congress expressed concern
                   about whether the Navy Industrial Fund could adequately cover the total
                   obligations that would accrue from these leases.2 To address this concern,
                   the Navy requested and received specific congressional authorization to
                   carry out the acceptance provisions of the long-term leasing contracts.
                   There were also concerns regarding the cost-effectiveness of these leases.

                   1At 10 U.S.C. 2401 a long-term lease is defined as a lease, charter, service contract, or conditional sale
                   agreement that lasts for a period of five years or longer (including options to renew or extend the initial
                   term of the lease), for a period of more than one-half the useful life of the vessel, or for a period of three
                   years or longer (including options to renew or extend the initial term of the lease) when certain
                   investment tax credits or depreciation are claimed by the lessor.

                    At that time, the Navy Industrial Fund was a revolving fund that provided products and services and
                   was reimbursed for those products and services by its customers out of operation and maintenance

                   Page 1                                                        GAO/T-NSIAD-99-141 Navy Ship Leasing
             When the leasing decisions were made, there were limited standardized
             governmentwide guidelines for conducting lease versus purchase analyses.
             As a result, the studies used different assumptions and methodologies in
             analyzing the alternatives and drew different conclusions. In 1983, our
             report and a congressional staff study questioned the validity of the
             assumptions used in the Navy’s studies and their conclusions.3 Had the
             Navy’s studies used assumptions that more fully reflected the government’s
             total costs, they would have concluded that purchasing was the cheaper

             Since the long-term leasing decisions of the early 1970s and early 1980s, a
             number of changes have occurred that will affect future long-term leasing
             decisions by increasing oversight and improving cost analyses. Through
             legislation, Congress has increased visibility of and control over these
             types of decisions. Additionally, budget-scoring guidelines increase the
             emphasis on up-front budget authority by providing Congress with a
             mechanism to assess the cumulative impact of long-term leasing decisions
             prior to the obligation of funds. Tax benefits that favored leasing have been
             reduced. Finally, as part of the decision-making process, more detailed
             guidelines require that the Navy perform lease versus purchase analyses
             that better reflect the government’s total cost of long-term leasing

Background   Traditionally, the Navy has purchased its combat ships but used long-term
             leases, called charter and build arrangements, to acquire Sealift tankers,
             MPS vessels, and T-5 replacement tankers. Under these arrangements, the
             lessors arranged for the construction, long-term financing, and delivery of
             the vessels. The Navy leased the vessels for 20 to 25 years and agreed that
             it would pay scheduled termination costs if, for some reason, it canceled
             the leases.

             In 1972, the Navy entered into contracts with two contractors for the
             long-term lease of nine Sealift tankers. These tankers were put into service
             in 1974 and 1975 but are no longer being leased. In 1982, the Navy entered
             into contracts with three separate contractors for the long-term lease of
             13 MPS vessels. The first of these was delivered to the Navy in September

               Improved Analysis Needed to Evaluate DOD’s Proposed Long-term Leases of Capital Equipment,
             (GAO/PLRD-83-84, June 28, 1983) and “Tax Aspects of Federal Leasing Arrangements,” Staff of the Joint
             Committee on Taxation, JCS 3-83, February 25, 1983.

             Page 2                                                   GAO/T-NSIAD-99-141 Navy Ship Leasing
                        1984, and all remain under lease. Also in 1982, the Navy awarded contracts
                        for the long-term lease of five newly constructed T-5 replacement tankers.
                        The first of these tankers was delivered in June 1985, and all remain under

                        The Navy has used a different type of lease arrangement to acquire the
                        specialized support services of vessels owned and operated by Edison
                        Chouest Offshore. The Chouest vessels have generally been leased on a
                        short-term basis—less than 5 years—for transportation services and
                        special missions, such as oceanographic surveillance and research. Under
                        these leases, the Navy pays for the services of the vessel, crew, and its
                        operation and maintenance (O&M) on a daily use basis. In 1998, the Navy
                        entered into a 5-year lease for one of the Chouest vessels under the same
                        type of daily use arrangement.

                        The Military Sealift Command (MSC) is responsible for administering the
                        Department of Defense’s (DOD) auxiliary ship leases. Since 1969, DOD has
                        required its components to perform economic analyses of lease versus
                        purchase decisions. Lease versus purchase analyses are not required for
                        short-term lease arrangements.

Basis and Support for   Cost-effectiveness was not the primary reason for the Navy’s decisions to
                        lease auxiliary vessels in the early 1970s and early 1980s. According to
Lease Decisions         Navy officials, the primary reason for proposing the long-term lease
                        approach was that available procurement funds were needed for higher
                        priority combat ships and long-term leasing allowed it to meet its support
                        requirements without a large, up-front obligation of procurement funds.
                        Under these leasing arrangements, the Navy initially had assumed it could
                        spread payments over the length of the leases and use its annual O&M
                        appropriations to fund them without incurring an up-front obligation of the
                        total lease amount. If, instead of leasing, the Navy had purchased these
                        vessels, funds would have been obligated from the Navy’s Shipbuilding and
                        Conversion procurement appropriation; payments would have been
                        required prior to delivery over a relatively short construction phase; and
                        the purchases would have had to compete with combat ships for the Navy’s
                        procurement funds. The Navy also maintained that long-term leasing was a
                        cost-effective way of acquiring the services of auxiliary vessels. Navy lease
                        versus purchase analyses showed that it was less costly to lease than
                        purchase these vessels.

                        Page 3                                     GAO/T-NSIAD-99-141 Navy Ship Leasing
                            Industrial base concerns were another factor in the decision to lease the
                            MPS vessels and T-5 replacement tankers in the early 1980s. At that time,
                            the commercial shipbuilding sector was in decline. A Navy official stated
                            in a 1983 hearing that projects such as the MPS and T-5 replacement tanker
                            programs were needed to prevent the potential closing of several
                            commercial shipyards and to protect the nation’s industrial base.4

                            Flexibility and cost-effectiveness are cited as the primary reasons for
                            leasing the Chouest vessels. Since 1988, the Navy has entered into
                            short-term leases that generally consist of a firm period of 17 months or
                            less followed by multiple option periods of 17 months or less that, when
                            combined, do not exceed 5 years. Additionally, in 1998, the Navy entered
                            into a 5-year lease for the Cory Chouest. The primary reason cited for these
                            leases is the flexibility they provide because the Navy does not have a
                            defined requirement for the extended use of these vessels. Since the leases
                            are for shorter periods of time, leasing is likely to be more cost-effective
                            than purchasing. A lease versus purchase cost analysis is not required for
                            short-term leases and, therefore, such an analysis was only performed
                            when the Navy decided to enter into a 5-year lease to acquire the services
                            of the Cory Chouest.

Concerns About              The Navy’s decisions to enter into long-term leases raised concerns about
                            whether (1) the Navy had sufficient budget authority to cover the total cost
Decisions and Analyses      of the leases, especially termination costs if the leases were canceled, and
                            (2) the Navy’s lease versus purchase analyses adequately reflected the
                            government’s costs.

Concerns Regarding Budget   After awarding the long-term leases in the early 1980s, the Navy became
Authority                   concerned about how to record total obligations—lease payments as well
                            as potential termination costs—associated with these leases in the Navy
                            Industrial Fund and requested a GAO legal opinion. Congress also
                            expressed concern whether the Navy’s budget authority would adequately
                            cover the total obligations that would accrue from these leases. GAO’s

                             Federal Leasing Practices Hearing Before the Subcommittee on Oversight of the Committee on Ways
                            and Means, House of Representatives, 98th Congress, First Session, February 28, 1983.

                            Page 4                                                 GAO/T-NSIAD-99-141 Navy Ship Leasing
                        opinion,5 issued in response to the Navy’s request, concluded that if the
                        Navy Industrial Fund did not have an unobligated balance sufficient to
                        cover these costs upon the delivery of all the vessels, it would be in
                        violation of the Antideficiency Act.6 The opinion contained suggested
                        actions, such as obtaining congressional authority, that the Navy could take
                        to prevent such a violation from occurring. The Navy subsequently
                        requested and received authority from Congress to lease the vessels
                        without having sufficient unobligated funds available to cover the
                        government’s total obligation under the contracts.7

Concerns Regarding      The Navy complied with DOD requirements to perform lease versus
Cost-Effectiveness of   purchase cost analyses in support of its long-term leasing decisions.
                        However, the guidelines that existed for such analyses when the Navy
                        entered into the leases for the MPS vessels and T-5 replacement tankers
                        were not detailed and specific. As a result, the outcomes of these analyses
                        were influenced by the methodologies and assumptions used in each study.
                        The methodologies and assumptions the Navy used showed leasing to be
                        cheaper. Our 1983 review of the Navy’s decision and a study by the Joint
                        Committee on Taxation used different methodologies and assumptions and
                        found purchasing to be the cheaper alternative. For example, the Navy’s
                        lease versus purchase cost comparison for the MPS vessels concluded that
                        the government would save $29.3 million per ship by leasing the 13 MPS
                        vessels. However, the MPS study conducted by the Joint Committee staff
                        concluded that outright purchase would be cheaper by $20.8 million per
                        ship. Our 1983 report concluded that it would cost between $11.9 million
                        and $38 million more per ship to lease the MPS vessels. The differences
                        between the studies’ conclusions are a result of different methodologies
                        and assumptions regarding (1) tax revenues, (2) residual values, and
                        (3) discount rates.

                        The majority of the differences between the Navy study and the
                        congressional staff study were attributed to differing assumptions
                        regarding how tax revenue should be accounted for. The Navy study

                        B-174839, January 28, 1983 (62 Comp. Gen. 143), “Navy Industrial Fund: Obligations in Connection
                        With Long-term Vessel Charters.”

                        6TheAntideficiency Act, codified at 31 U.S.C. 1341, prohibits authorizing or incurring obligations or
                        expenditures in excess of amounts available in an appropriation or fund unless authorized by law.

                            Supplemental Appropriations Act of 1983 (P.L. 98-63).

                        Page 5                                                      GAO/T-NSIAD-99-141 Navy Ship Leasing
reduced the total cost to the government of the lease by the taxes that
would be paid on interest income received by the lenders that financed a
portion of the ship’s acquisition. The committee staff’s methodology did
not include these taxes as a source of government revenue. Although the
methodologies and assumptions used in both studies were acceptable
under the then-existing guidelines, in our June 1983 report, we agreed with
the staff study’s assumptions because the Treasury would receive taxes on
the income earned from either a lease or a purchase.

Another key difference between the Navy and committee staff studies was
the treatment of residual values. The residual value of a vessel is an
estimate of what that vessel could be sold for at the end of the lease term,
measured in present value terms. The Navy’s study of the MPS program
assumed that the vessels would have no residual value at the end of their
25-year leases, whereas the committee staff assumed that the residual
value of the ships would be nearly 60 percent of the original cost of the
ships. While it is not clear if a residual value of 60 percent was appropriate,
a residual value of zero was not consistent with Internal Revenue Service
(IRS) requirements at the time. Had the residual value been assumed to be
20 percent, which would be consistent with the minimum IRS requirements
at the time, the cost advantage of leasing identified in the Navy’s study
would be reduced. In our 1983 review of these studies, we agreed with the
staff study’s assumption that the vessels would have a residual value at the
end of the lease terms.

Determining whether leasing is more economical than purchasing also
depends on the discount rate used to adjust the total value of lease
payments to recognize the time value of money—the lost opportunity to
invest the money and earn interest. A lower discount rate makes
purchasing a more economical option, while a higher rate makes leasing
more economical. When the lease versus purchase analyses were
performed for the long-term leasing arrangements of the early 1970s and
early 1980s, there was some flexibility regarding what discount rate should
be used in the analysis. In our prior reports, we expressed concern
regarding the discount rates used in the Navy’s lease versus purchase
analyses. In a 1973 report on the Navy’s analysis of the Sealift tanker
program, we found that the Navy had inappropriately selected a high
discount rate.8 Had the Navy used the lower and more appropriate rate, it
would have found that the cost of leasing exceeded the purchase cost. In

    Build and Charter Program for Nine Tanker Ships, (B-174839, Aug. 15, 1973).

Page 6                                                      GAO/T-NSIAD-99-141 Navy Ship Leasing
                               our 1983 report, we questioned whether the prescribed Office of
                               Management and Budget (OMB) discount rate was realistic and, in our
                               analysis, used a discount rate based on the average yield on marketable
                               Treasury obligations, which we believed was a better reflection of the
                               government’s true cost of borrowing funds.

Changes That Will              Since the long-term leasing decisions of the early 1970s and early 1980s, a
                               number of changes have occurred that will affect future long-term leasing
Influence Future               decisions by increasing oversight and improving cost analyses. Through
Leasing Decisions              legislation, Congress has increased its visibility of and control over these
                               types of decisions. Additionally, scoring guidelines now provide Congress
                               with a mechanism to assess the cumulative impact of long-term leasing
                               decisions prior to the obligation of funds. Reductions in tax benefits and
                               changes in how these benefits are treated in lease versus purchase analyses
                               minimize the loss of tax revenue and ensure that such a loss of revenue is
                               more fully considered in the decision. Finally, as part of the
                               decision-making process, more detailed guidelines require that government
                               agencies perform lease versus purchase analyses that better reflect the
                               government’s total cost of long-term leasing arrangements.

Changes to Increase            Given concerns about the budgetary impact of the leases’ long-term
Congressional Visibility and   funding commitments and uncertainties about their cost-effectiveness,
                               Congress established a number of statutory conditions and requirements
                               for entering into future long-term leases. These requirements, now codified
                               at 10 U.S.C. 2401, increase congressional visibility and control over certain
                               lease decisions and provided for the development of more detailed
                               guidelines for conducting lease versus purchase cost comparisons.

                               In general, 10 U.S.C. 2401 requires that:

                               • DOD’s long-term leases or charters of vessels and aircraft, or leases or
                                 charters with substantial termination liabilities be specifically
                                 authorized by law;
                               • notice of intent to issue a solicitation for such a lease or charter be given
                                 to the Committees on Armed Services and on Appropriations of the
                                 Senate and House of Representatives;
                               • a detailed description of the terms of the lease and a justification for
                                 entering into the lease rather than purchasing the vessel be provided to

                               Page 7                                      GAO/T-NSIAD-99-141 Navy Ship Leasing
                             • an analysis comparing the costs of leasing to those of purchasing be
                               submitted to Congress with any request for authorization of such a
                             • such analysis be evaluated by OMB and the Treasury Department; and
                             • OMB and Treasury jointly issue guidelines for determining under what
                               circumstances DOD may use lease arrangements rather than use direct

Increased Emphasis on        At the time the Navy entered into the long-term leases in the early 1970s
Up-Front Budget Authority    and early 1980s, Congress’ ability to assess the cumulative impact of such
                             arrangements prior to the obligation of funds was limited. Since the Navy
                             entered into these leases, mechanisms for requesting budget authority have
                             been more clearly established, which increases the transparency of these

                             The Balanced Budget and Emergency Deficit Control Act of 1985, as
                             amended by the Budget Enforcement Act of 1990 and the Omnibus Budget
                             Reconciliation Act of 1993, established statutory limits on federal
                             government spending by creating spending caps on discretionary spending.
                             To track progress against and compliance with budget enforcement
                             requirements and spending caps, budget scorekeeping guidelines have
                             been established for lease-purchases, capital leases, and operating leases.9
                             If the Navy were to now enter into the types of leases it entered into in 1972
                             and 1982, the current scorekeeping rules would require that the Navy
                             request up-front budget authority for the estimated net present value of the
                             government’s total estimated legal obligations over the life of the contract.

Changes That Eliminate Tax   Under leasing arrangements for the Sealift tankers, MPS vessels, and T-5
Incentives                   replacement tankers entered into prior to 1984, shipowners qualified for
                             special tax benefits. These benefits included accelerated depreciation of
                             the ship’s cost and deductions on interest payments that lowered the
                             shipowners’ taxes. Consequently, shipowners passed some of these
                             benefits to the Navy in the form of lower lease payments, which made
                             leasing a more attractive option to the Navy. However, these tax benefits
                             also represented a loss of tax revenue to the U.S. Treasury. While not
                             impacting prior Navy leasing arrangements, the Deficit Reduction Act of

                                 OMB Circular A-11, July 1, 1998.

                             Page 8                                      GAO/T-NSIAD-99-141 Navy Ship Leasing
                             1984 modified tax laws and eliminated the benefits available to the owners
                             of assets leased to government entities.

More Detailed Guidelines     In October 1984, OMB and Treasury issued joint guidelines for DOD’s
Will Influence Future Cost   leases. These guidelines required that any special tax benefits conveyed to
                             the shipowner be added to the cost of a lease in a lease versus purchase
                             analysis.10 Additional OMB guidance was issued in 1992 to prevent lease
                             versus purchase analyses from understating the government’s total cost of
                             leasing. Specifically, this guidance, which is to be applied governmentwide,
                             prescribe that analyses (1) should add special tax benefits to the cost of
                             leasing and (2) should not subtract the normal payment of taxes on the
                             lessor’s income derived from the leases from the total lease costs. 11 Had
                             this guidance been in place when the Navy conducted its analyses of the
                             MPS and T-5 replacement tanker lease programs, the analyses would have
                             concluded that purchasing, instead of leasing, was the cheaper alternative.

                             OMB’s 1992 guidance also addressed the issue of discount rates. This
                             guidance prescribes that lease versus purchase analyses are to use
                             discount rates that reflect the Treasury’s borrowing rate. OMB now
                             annually updates the discount rates to be used in the analyses. Current
                             discount rates as prescribed in the OMB guidance are lower than those
                             used in the past analyses, and lower rates tend to make leasing less
                             attractive today.

                             Madame Chairwoman, that concludes my statement. I will be happy to
                             answer any questions you or any Members of the Subcommittee may have.

                                    OMB and Treasury Guidelines to the Department of Defense covering Lease or Charter
                             Arrangements for Aircraft or Naval Vessels,” October 31, 1984.

                              OMB Circular A-94 “Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs,”
                             October 29, 1992.

(707417)        Leter        Page 9                                                  GAO/T-NSIAD-99-141 Navy Ship Leasing
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