Independent Auditors’ Report on Internal Control over Financial Reporting and on Compliance (continued)

APPENDIX:

SIGNIFICANT DEFICIENCIES NOTED DURING THE FY 2014 FINANCIAL STATEMENT AUDIT

During our audit of the Architect of the Capitol (AOC) fiscal year (FY) 2014 financial statements, we identified three significant deficiencies in internal control over financial reporting, described in this Appendix. We do not consider these deficiencies to be material weaknesses.

Finding 1: Ineffective Control over Accounting for the Fairchild Building Lease Renewal

Summary Status: Significant Deficiency

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During FY 2014, the original term of a 10-year lease for the Fairchild Building expired, and AOC exercised its option to extend the lease for an additional 5-year period. Consistent with the original lease transaction, AOC recorded the lease for the option renewal period as a capital lease based on a calculation of the present value of the future minimum lease payments, treating the option period as an extension of the original lease term. AOC does not have adequate internal controls to ensure that the Fairchild Building lease renewal transaction was properly classified and recorded in conformity with accounting principles generally accepted in the United States of America (GAAP).

However, the lease renewal extension should have been recorded as an operating lease. As a result, the General Property, Plant and Equipment, Net and Other Liabilities amounts shown on the financial statements related to Assets Under Capital Lease and Capital Lease Liability were overstated by $19.4 million.

Financial Accounting Standards Board (FASB) Accounting Standards Codification paragraph 840-10-35-2b, “Reassessing Whether an Arrangement Contains a Lease,” states:

A reassessment of whether the arrangement contains a lease after the inception of the arrangement shall be made only if any of the following conditions exist: A renewal or extension of the arrangement that does not include modification of any of the terms in the original arrangement before the end of the term of the original arrangement shall be evaluated only with respect to the renewal or extension period.

In addition, paragraph 840-10-35-4, “Reassessing Lease Classification,” states:

Likewise, except if a guarantee or penalty is rendered inoperative, any action that extends the lease beyond the expiration of the existing lease term, such as the exercise of a lease renewal option other than those already included in the lease term, shall be considered as a new agreement, which shall be classified according to the guidance in Section 840-10-25.

Paragraph 840-10-25-1 states:

A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception:

a. The lease transfers ownership of the property to the lessee by the end of the lease term.

b. The lease contains a bargain purchase option.

c. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.

d. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor.

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