Our consulting firm and the law firm met several times with DCAA and responded in writing that the disputed legal costs were properly charged to the indirect cost pool and hence should be allocated to all contracts including federal cost type contracts and subcontracts. The reasons put forth were as follows:

1. Consistent with established practices and written policies and practices. Since the contractor has always charged its E&O costs as indirect, it has an established practice. In addition, the contractor’s disclosure statement identifies specific costs that are considered direct (e.g. labor, materials, rental equipment) and legal costs are not included in this category. Though legal costs are not identified as indirect costs, “professional services” are one of the categories identified as indirect and legal costs certainly qualify. 

2. Consistent with the contractor’s own definitions of direct versus indirect cost. Though it is possible, with enough time and effort to identify any cost with a final cost objective, the contractor, like most others, recognizes such precision is not worth the effort. Instead, it limits direct charges to those costs that “add value” while charging remaining costs indirect. Hence, legal costs are direct costs only when the costs are in direct support of contract performance or contract administration (e.g. negotiations of individual task orders; otherwise they are indirect).

3. CAS takes precedence over FAR for allocation of costs. When it comes to how costs should be allocated as opposed to questions about allowability, the CAS Board has established it has “the exclusive statutory authority” to assess “cost accounting practices governing measurement, assignment and allocation of costs to contracts and subcontracts” (Pramble to Recodification” of the CAS principles in 1992). In addition, Aydin Corp. v. Widnall, 61 F.3d 1571 ruled that CAS takes precedence when it is applicable. The fact CAS takes precedence over FAR is important because CAS 418, Allocation of direct and indirect costs, puts the responsibility of defining how a cost is to be treated squarely on the contractor not the government. To ensure the contractor’s decisions are reasonable CAS 418 establishes only two criteria: (1) the classification of whether a cost is direct or indirect must be made “pursuant to a written statement of accounting policies and practices for classifying costs as direct or indirect which shall be consistently applied” and (2) a cost is either direct, which is defined as any cost identified to a particular final cost objective, or it is indirect. The contractor is provided extensive flexibility in determining how to treat a cost and is instructed to make their decision applying the above definition reasonably and in a written statement of policies and procedures.

4. Case law provides it is reasonable to charge legal costs indirect when incurred after physical performance.. Our client does not argue the legal costs must be charged indirect but only that it is reasonable to do so, meeting the criteria of CAS 418. They cite several cases holding that legal costs incurred after physical performance have no direct bearing on either performance or administration of the contract and thereby are indirect costs. In Singer Corp., the court ruled the legal costs incurred for the submission of a request for equitable adjustment (REA) after performance of a contract did not have a “sufficient nexus to the successful completion of the contract” to be allowed as a direct contract cost. In Gulf Contracting, professional fees expended for preparing an REA that were directly charged to the contract were ruled unallowable costs to the contract because only costs “related to performance or administration of an ongoing contract” can be considered direct and that expenses incurred after completion “bear no relation to production or administration”.

5. The FMC case is not relevant. In the case DCAA cited for its position, the court ruled FMC should charge costs direct to a subcontract when that subcontract was still open and FMC’s disclosure
statement stated professional services “are charged direct when specifically related to a contract task.” In the FMC case, though the subcontract was physically complete it was still administratively open and the disclosed practices clearly stated the costs should be direct. In addition, the lawsuit itself was between the actual contracting parties intended to untangle their respective contract rights and not part of a third party lawsuit where the party had nothing to do with the original contract.

6. The legal costs are really an indirect, period cost in the year it is incurred. Assignment of the cost is the means used to associate a cost to a specific fiscal year where they are assigned either to the year of incurrence or future years. In Stanwick Corp., ASBCA No 18083, the board ruled costs may never be assigned to years prior to when the cost was incurred. This is logical since even
though occurrence of a prior event may give rise to the need for legal services, there is no means at the time to estimate and hence accrue the costs prior to when they were incurred. According to FASB No. 5 a cost exists either when there is a binding liability or the expenditure of cash, whichever occurs earlier. The costs in question cannot be assigned to an earlier period since it is impossible to know what the legal liability is or even if there will be one. Such “costs” in an earlier period would be unrecognizable contingencies and not costs. A cost assigned to a fiscal year may be a direct cost only if it is identifiable specifically with a final cost objective in existence during that year; in any other circumstance, it is an indirect cost.

7. The legal costs in question are similar to environmental remediation costs. Like the legal costs questioned here, environmental remediation costs are usually incurred long after the full performance of the contract that caused the contamination. Under DCAA’s own guidance (DCAA Policy Memorandum, October 12, 1992) environmental remediation costs caused in prior years will “generally be period costs” and should be allocated to “residual G&A costs.” DCAA clearly recognizes these costs to be “period” costs to be expensed in the current fiscal year and that they should
be allocated indirectly because there is no specific cost objective in that year that benefits from or caused exclusively the costs.

8. DCAA’s Position Violates CAS 402 and CAS 401. CAS 402, requiring consistency in treating similar costs under similar circumstances, would be violated because DCAA attempts to have the contractor select a single type of cost from its indirect cost pool and reassign it in a manner inconsistent with its disclosed written policies and historical accounting practices. CAS 401, requiring consistency in estimating and costing, would also be violated because for proposal purposes the costs can only be treated indirectly because there is no way to accurately estimate future third party legal costs for a given contract.

9. CAS 418 allows immaterial direct costs to be charged indirectly. In the Preamble to CAS 418, a contractor should be required to make an accounting change only if the result has a “materially different cost impact on a government contract.” Except for one year, the costs in question represent an immaterial amount of the total indirect costs (less than 2 percent) and hence there would be an immaterial impact on the government contracts.

10. CAS 410 requires allocation to all contracts. DCAA challenged the allocation of the questioned legal costs to government contracts even if it was appropriate to charge them indirectly. The legal costs were incurred to defend the contractor from a corporate liability. Whether it is from a commercial, local or federal government contract, defense of E&O cases benefit the company as a whole by protecting the company against potentially catastrophic damages and it is appropriate that government contracts share the burden. CAS 410-30(a)(6), Allocation of G&A costs, requires that an allowable expense that benefits the entire business should be allocated equitably to all of the business customers. After the above responses were communicated to the contracting officer and reviewed by its legal staff and price analysts, the CO decided it would not support DCAA’s position the legal costs should be rejected. Rather, a “compromise” was agreed to where the legal costs would be treated as self-insurance costs and a calculation based on CAS 416, Insurance costs would be made and included as an indirect cost for both estimating and costing purposes. Any  excess would be questioned.

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