The following article was included in the August 2009 PVBS High-Growth Government Contractor News. Ken Bricker, partner at Goodman & Company, LLP, has worked in the government-contracting and acquisitions arena since 1975. He has extensive knowledge of the Federal Acquisition Regulations (FAR) and the Cost Accounting Standards (CAS). Ken frequently assists clients with regulatory issues such as systems reviews, bids and proposals, rate structure development, forward pricing, wage determinations, claims, defective pricing, and incurred cost submissions.
Self-initiated (“unilateral”) cost accounting practice changes – what are they and what are the potential ramifications? Such changes are primarily specific to negotiated contracts.
The definition of a cost accounting practice (CAP) is found in the Cost Accounting Standards (CAS), i.e., a cost accounting practice is any disclosed or established accounting method or technique which is used for allocation of cost to cost objectives, assignment of cost to cost accounting periods, or measurement of cost. A cost accounting period is normally a contractor’s fiscal year; allocation of cost refers to classifying a cost as either direct or indirect; and measurement of cost means determining the baseline for cost measurement (e.g., standard or actual, historical or market, capitalized or expensed).
It follows that a unilateral CAP change is simply any self-initiated alteration in an allowable cost accounting practice to another allowable CAP, with two important exceptions, neither of which constitutes a change: (1) the initial adoption of a practice for the first time a cost is incurred, and (2) revision of a previously immaterial cost accounting practice. Examples of CAP changes include changing actuarial cost methods, depreciation method, or the method of allocating general and administrative (G&A) expenses. Examples of changes which are not CAP changes include a cost increase in fringe benefits, cost of a new pension plan, or a change in estimated depreciable lives.
The basic intent underlying the FAR is allowability of cost, i.e., a cost is allowable when its treatment complies with the FAR cost principles. One requisite for allowability is allocability of cost. Certain FAR Part 31 cost principles incorporate the measurement, assignment, and allocability rules of selected CAS and limit the allowability of costs to the amounts determined using those criteria. Upon award of a CAS-covered contract, the contractor is to consistently follow its cost accounting practices in estimating, accumulating, and reporting costs in compliance with CAS as well as the FAR cost principles.
CAP changes, by their nature, are generally considered to be prospective in nature. That is, there is no (or very limited) retrospective application to prior periods, unlike the requirements in Financial Accounting Standards Board Statement (FAS) No. 154, Accounting Changes and Error Corrections. CAP changes should be made with a view toward improving the cost accounting system. A higher level of compliance with FAR and/or CAS should result in demonstrable improvements in the costing of government contracts which should benefit both the contractor and the government.
FAR Part 31 has no regulations specific to CAP changes. The FAR states only that that excess costs resulting from inconsistent application of FAR Part 31 cost principles are unallowable. Cost accounting practices therefore need to be consistently applied and conform with FAR Part 31 for all work, regardless of contract mix. An acceptable accounting system which complies with FAR Part 31 is intended to result in fair and reasonable prices for both parties. Practices which are inconsistent (e.g., by contract type or product line) do not, taken together, represent an acceptable accounting system because the reality is that two or more accounting systems exist which almost certainly will result in perceived or actual inequities in contract costing.
CAS has a very sophisticated system of requirements when effecting a CAP change, including downward price adjustments to the universe of affected contracts. However, price reductions can even apply to contracts which are not subject to CAS-coverage but which are subject to the Truth in Negotiations Act (TINA). TINA is triggered by the submission of certified cost or pricing data. TINA requires disclosure of actual or intended CAP changes by the date of final agreement on price or the government has the right to a price adjustment after contract award for any significant amount by which the price was increased if it is determined that the cost or pricing data upon which the negotiated price was based were inaccurate, incomplete, or noncurrent (aka, defective pricing). Even if neither CAS nor TINA apply, cost disallowances can result on flexibly-priced contracts if CAP changes are determined to result in significant cost distortions.
Government customers may not view even meritorious accounting system improvements favorably if they increase funding requirements for their contracts, regardless of how well-intentioned or theoretically sound they may be. Occasionally a CAP change is involuntarily triggered by the government. To illustrate, assume that a small contractor was awarded a prime cost-type contract (not subject to CAS or TINA) under which the contractor intended to use significant subcontractor effort in accomplishing the contractual scope of work. The procurement activity established a ceiling on the G&A expense rate to be allocated to subcontract costs. The contractor utilized a total cost input G&A expense allocation base, and its G&A rate was considerably in excess of the ceiling rate. Analysis of the contractor’s ongoing contract work revealed that significant subcontract effort was atypical of its other contract work, which was fixed-price with periods of accomplishment shorter than that contemplated for the contract in question. Under this scenario, the new contract would very likely absorb an inequitable amount of G&A expenses, possibly even resulting in a loss contract. Implementing a CAP change from a total cost input base to a base which excluded subcontract costs could result in a more equitable allocation, decrease the cost to the government, restore the contract to profitability, and avoid contract financing problems.