A government agency may place a fiscal funding clause in a lease, which states that the government agency has the option to break the lease if it does not receive the money to make the lease payment through the appropriation process. The government agency needs to decide whether it is likely to use this option to cancel the lease to record the lease on its financial statements properly.
Normally, the fiscal funding clause simply provides the government agency with a safety measure that eliminates the risk that it will have to pay high cancellation fees. Usually the government agency does not intend to exercise the lease and lose the right to use the property. According to the state of South Carolina website, if the government agency normally makes all the lease payments on contracts that contain this clause, it should not record the lease as a cancellable lease.
The determination of whether a lease can be cancelled is important because it affects whether the agency records the lease as an operating lease or a capital lease. For the agency to record a capital lease on its books, which is similar to a purchase on credit, it must be unlikely that lease cancellation will occur. If the agency cancelled past leases, it reports an operating lease, which the agency reports more like a rental arrangement instead.
The fiscal funding clause can affect the budget authorization process. A government agency must show that its budget allocates enough money to make the payments for the entire lease period for a capital lease, according to the National Oceanic and Atmospheric Administration. If a lease contains a fiscal funding clause, and the government agency is likely to exercise this clause, the government agency can sign the lease contract with only enough money to make payments for the first year, plus any fees for early cancellation.
The fiscal funding clause can affect whether the government agency reports incurring debt. With a capital lease, the government agency buys a property, such as a new building, and it has to immediately record the entire mortgage on the building as debt. With an operating lease, the agency can simply report its lease payments as operating costs, so it does not have to record a large amount of debt on its balance sheet.