In its Contract Audit Manual, the Defense Contract Audit Agency states "environmental costs are normal costs of doing business and are generally allowable if reasonable and allocable" (7-1920.1). Costs are considered on a case-by-case basis and DCAA generally applies a high standard of what is "reasonable". It requires the contractor conduct business prudently and acts promptly to minimize damage. Though environmental costs are considered a normal business expense, they are not all allowable. DCAA distinguishes between costs to prevent environmental contamination (usually always allowable) and costs to clean up prior contamination (discussed below).

Allocability

Prevention costs are generally indirect costs allocable to contracts on a "causal and beneficial base". Cleanup costs for a prior period will generally be considered a period cost included in a company’s appropriate G&A pool. Though the guidance does not address it, we have seen instances where direct costing of a contract was considered proper (e.g. the materials to be remediated were used solely for one contract).

If costs arose from a closed segment, the cleanup costs would usually be allocated to the segment where the work was transferred. If a segment is closed and none of its former work remains in the company, proper allocation of costs should be made on a case-by-case basis – allocated to other segments, residual home office cost or an adjustment of costs associated with closing a segment.

Capitalization of Environmental Costs

Costs should generally be expensed in the period incurred unless they constitute an improvement or betterment or are fixing up a property for sale. Normal capitalization versus expense rules of GAAP and CAS 404 apply:

1. Costs used to restore a property to its acquisition condition is expensed while costs used to extend the property’s useful life or improve it beyond its original acquisition condition is capitalized.

2. Costs incurred to fix-up a property for sale is mixed. If the fix-up costs are not realizable from the sale, then they can be expensed (e.g. a book value of $80K, fix up cost of $20K and a sale price of $50K); if the fix up expenses are realizable from the sale, then the fix-up costs should be capitalized (e.g. same book and fix up value as above and a sales price of $200K). The exception to this is related to contamination existing at the time of acquisition – the amount not realizable should, nonetheless, be capitalized on the assumption the contractor overpaid.

3. Costs incurred to prevent future contamination if the clean-up costs have an economic value more than one year should be amortized over their useful life should.

PRPs for Environmental Costs

The environmental laws usually require each Potentially Responsible Party (PRP) for a contamination to be individually liable for the complete cleanup of a site. Only the contractor’s share of the clean-up costs based on their actual percentage of attributed contamination is allowable. When the contractor pays more than its share, it is up to them to collect from the other PRPs who did not pay their share. If a contractor cannot collect from other PRPs, they and associated collection costs (e.g. legal) are considered bad debts and hence unallowable according to FAR 31.205-3. This bad debt prohibition to cost recovery does not apply if three conditions are met: (1) contractor is legally required to pay another PRP’s share of clean-up costs (2) the PRP is out of business, and (3) there is no other successor company assuming the PRP’s liability.

Environmental Wrongdoing

The contractor should not be denied recovery of cleanup costs if it complied with the laws, regulations and permits in effect at the time of contamination. Auditors are instructed to obtain documents sufficient to demonstrate how the contamination occurred, including information from the contractor and Environmental Protection Agency’s rationale on PRP determination. To disallow costs, the government (DCAA will usually request technical support) must show a "preponderance of evidence" showing the contractor violated a law, regulation order or permit, or the contractor disregarded contamination warnings. DCAA interprets "preponderance" as "it must be more likely that the government’s allegations of wrongdoing is correct than that it is not". If fines and penalties are imposed they are unallowable under FAR 31.205-15.

Contingencies

Many clean-up costs are uncertain. DCAA looks to FAR 31.205-7, Contingencies for evaluating these uncertainties which distinguishes between contingencies that arise from presently known conditions (allowable) and unknown conditions (unallowable).