Cost Accounting Practice Changes – Why are They Important?

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.

The Many Complications that Will Arise from the ARRA for Government Contractors

The following article was submitted by Richard Marksberry, former Partner in the MidAtlantic practice of Tatum, LLC. During the last four years Mr. Marksberry has, as the CFO, led the selection and implementation of accounting systems for three federal contractors each with sales over $100 million annually.  He was recognized as one of the “Top 10 CFO’s in Government Contracting” by ExecutiveBiz in 2008.

The $787 billion gorilla has come out of the corner!  The Administration is finding out that it is easier to say “stimulus,” than it is to actually spend the money.  With its slow start the American Recovery and Reinvestment Act (ARRA) distributions are reminiscent of the movie Brewster’s Millions, except that the “inheritance” is a growing economy. And, although the current Administration’s desire is to cut back on government contracting, this will be one of the key ways the stimulus money will have to be spent.

The channels for this spending will be through Federal, State and local governments and will be geared toward infrastructure where possible.  This is the crux of the issue as the “rules” for the spending and its oversight will differ depending on the primary or first tier source of the funding (or the prime contract source).  The rules and reporting requirements are an “enhancement” of the Federal contracting rules under the Federal Acquisition Regulations (FAR).  These enhancements support the Administration’s desire to have greater “oversight and accountability” along with more “transparency.”  Ultimately the need to show and report results are important to the success of this effort.

As a result of these changes, there are a number of potential complications for Federal contractors. The following are some that I believe are the key ones to be prepared for during the first wave of funding:

• Extended Reporting Requirements
• Job Creation Statistics
• Focus on Buy American
• Audit Rules Extensions
• Wage Rate Specifications

 The extended reporting requirements are not very clear and are scheduled to be changed in the next quarter.  For now we know that there are two requirements to keep in mind.  The first is that if you receive funds from the ARRA you are required to report the salaries of the company’s top five wage earners.  Not a change for public or not-for-profit companies, but this is new for private companies who are not accustomed to this level of information dissemination.  Oh, and incidentally, if you are a private company with a contract initiated prior to the ARRA, and if ARRA funding is allocated to your contract in the effort to complete spending, you will find yourself in the enhanced reporting requirement for current and comparative prior years! 

The other reporting requirement, and pull out your thinking cap, is for “progress being made,” “detail” of how recovery funds are being spent, and the number of jobs “created or preserved” by the use of ARRA funds.  Systems that allow for tagging of transactional information with multiple uses will be necessary unless you want to maintain and reconcile multiple ledgers for the same transaction.  This could get complicated and hard to audit, but more on that later.  Perhaps the initial quarter reporting under ARRA will help in defining the way forward. Clarity of this kind of reporting may be yet down the road, though it is still a current requirement. 

The Buy American focus is mainly for raw materials used in construction, however, it is not altogether clear when it comes to compliance with the various international trade agreements. It appears to result in tighter restrictions at the state and local contracting level than at the Federal level.  Restrictions may vary from country to country, the type of material, and if it is a Federal, state or local project.  Due to the level of complexity here and the need to be competitive but profitable, I feel an analysis is necessary in each case before bidding the contract in question.

Audit rules have taken on a new life under the ARRA!  As soon as ARRA funding is in the mix you may expand your authoritative audit agencies by up to four or five agencies including the new “Recovery Accountability and Transparency Board.”  Additionally, the rules give new levels of access to documents, records, and personnel.  To state it plainly, when ARRA funds are used the Comptroller General and the agency inspector general are granted access to any transactional support, including the interview of contractor officers and employees related to the transaction.  The ruling applies to all contract types, not just cost plus, and extends to commercial item contracts and commercially available off-the-shelf item contracts!   And why stop there when you have a good thing going?  The extended audit rules also apply to those contracts that are at or below the simplified acquisition threshold, which was originally established by the Federal Acquisition Streamlining Act (FASA) to help level the playing field for small government contractors.

In relation to wage rates the Act specifies that the use of prevailing wage rates specified by the U.S. Department of Labor. Many construction contractors are familiar with this “contract requirement”, however under ARRA there are additional considerations for the proper level of spending for services contracted for by the government as it applies to all requisite labor types.  This may add complications of varying wage rates when an employee works on multiple contracts, and only some are ARRA funded. Again we see the need for sophisticated accounting and payroll systems for even entry level companies.

One last point is important to note.  In most federal government contracting there are “flow down rules” for requirements that must be adhered to by both the prime and subcontractors as they “flow-down” to subs.  Rule enhancements appear to apply to the prime and subcontractors in all cases.  The advantages that were often provided for small and emerging contractors do not seem to have a place in ARRA and this new need for “transparency, oversight and accountability.”

GovCon Tech Tip: Strategies for Internal Tech System Refresh

Based in Rockville, MD, SysArc is the preferred provider of network support services, computer repair and technical support services to government contractors throughout Maryland, Virginia and the Washington DC area and frequently teams with PVBS. Contact Tim Brennan via email at tbrennan@sysarc.com if you have any questions.

In these challenging economic times, companies are trying to limit capital expenditures whenever possible and many are postponing further investment in their technology infrastructure.    Is this the best strategy for your organization and are there better options?

It is certainly understandable to try and postpone spending during cash f low challenges. The answer to this question is, it depends.  If your current infrastructure is performing well, is stable and your employees are not complaining about lost productivity because your systems are crashing or they are running slow, then it might not make sense to invest in new systems.  Since the average life expectancy of a server is 3-5 years, a desktop is 3-5 years, and a laptop is 2-4 years, most companies only need to address the issue of obsolescence and replacement every few years. Organizations that follow industry best practices typically replace 20-25% of their IT equipment each year to stay current and then amortize the cost over a 4-5 year period.

The operating system and applications that are running on the server or desktop/laptop also need to be reviewed during any replacement/upgrade consideration as they might be outdated and no longer supported.  For example, if you use Microsoft Windows for your server operating system, it should be version Server 2003 or later.  However, there are still a number of companies that are chugging along using older custom application that operate on 10-year old technology.

If, on the other hand, you are experiencing poor response time, system crashes, downtime, or other problems, you may be sacrificing productivity and revenue for the relatively lower cost of new equipment.  Specifically, the cost of replacing your ailing technology will be far less than the ongoing cost to support and maintain the old equipment.

In order to provide you with additional insight into the overall health of your infrastructure, a high-level Network Assessment should be completed regularly (every 1 or 2 years).  An Assessment will not only help determine the current state your environment, but it will often include specific recommendations to enhance and optimize your technology in order to more fully support  your business initiatives. This type of assessment can be done in a few hours for small environments and a few days for larger, more complex environments.

MD CPA Association GovCon Event on September 9

The Maryland Association of CPAs (MACPA) Government Contractor conference will be held on September 9 at the Hilton in Gaithersburg, MD.  Click here for some information on the agenda.