We are seeing increased scrutiny over reviews of IR&D costs, particularly if they are justified as research and development or should be considered production costs. Certain precontract costs, losses on grants and contracts, overruns on other projects, postcontract costs, contractors’ portions of cost sharing contracts and costs chargeable to research and development costs are not supposed to be included as IR&D costs and auditors can be expected to determine if these conditions exist. When these assertions are made the effect is usually to eliminate the cost from the G&A pool and allocate it directly to the contract that is overrun and hence make the cost unallowable. We have even seen circumstances when auditors inappropriately recommended penalties on these "unallowable" costs.

Deferred Independent Research and Development Costs

We should say a word about a unique opportunity to recover certain IR&D costs in a period later than when they were incurred. This is an opportunity that not even generally accepted accounting practices (GAAP) allow. Generally, GAAP as well as government accounting rules require that IR&D costs be expensed as incurred. In certain limited circumstances, these costs can be deferred for government cost and pricing purposes. Such deferral can be quite beneficial when, for example, a contractor wants to lower proposed costs in earlier years or more properly match expenses with products or services developed and sold.

IR&D costs incurred in prior periods are allowable if a contractor has developed a specific product at its own risk in anticipation of recovering those costs in the sales price of the item. To do so, four other conditions must exist:

the total IR&D costs applicable to the product must be identifiable

the proration of the IR&D costs to product sales must be "reasonable" – from the government’s perspective, the allocation must be equitable

either the contractor must not have had government business when the IR&D costs were incurred or else IR&D costs must never had been allocated to government contracts and

no incurred IR&D costs for any project can be allocated to government contracts except for the deferred costs related to the specific product.

Court and appeals cases (e.g. Sperry Rand Corporation, Ford Instrument Company Division) have held that for deferred IR&D costs to be considered allowable the costs must first be capitalized and then amortized. For other than fixed price contracts, the deferred costs to be recognized should have a specific provision in the contract setting forth the costs than can be allocated or otherwise they will likely be considered unallowable.

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