FAR 31.205-11 governs the allowability of depreciation costs. Contractors subject to cost accounting standards must comply with CAS 409, Depreciation of Tangible Capital Assets and CAS 404, Capitalization of Tangible Assets. In the few cases where CAS conflicts with FAR (e.g. demonstration of economic or useful lives, valuation of assets after a business combination), CAS will supercede a conflict with FAR for CAS covered contracts only. We will focus on the FAR rather than CAS because there are not that many conflicts and most contractors are not subject to the more detailed requirements of CAS 409 and 404.

Normal depreciation is generally considered allowable contract costs if they are reasonable and allocable. When depreciation expenses are treated the same for financial and income tax purposes, costs are considered reasonable under FAR 31.205-11(d) if the contractor follows its policies and procedures which must be (1) consistent with those followed in the same cost center for non-government businesses (2) are reflected in the contractor’s books of accounts for financial reporting and (3) used for federal income tax purposes. Even when these conditions are met, DCAA reminds its auditors that "inequitable charges to the government" may still occur and certain depreciation costs may need to be questioned.

Since 1986, the Internal Revenue Code has been periodically revised to allow use of accelerated methods of depreciation to defer payment of taxes and improve cash flow. When contractors choose to take advantage of these IRS changes, the amount of depreciation charged may differ for financial reporting and income tax purposes. Where book and tax methods differ, FAR 31.205-11(e) allows contractors to follow IRS methods of depreciation as long as the resulting expense does not exceed the amount recognized for book/financial statements. If a dispute occurs, auditors will tell you that the mere fact the IRS does not specifically reject use of a particular depreciation method does not establish the acceptability of that method for government costing purposes.

Allocation Requirements. CAS generally covers cost allocation issues and even when not CAS covered, the standards provide contractors a level of legitimacy if they follow CAS allocation prescriptions. CAS 409 does provide for direct charging of depreciation costs as long as the charges are made on a usage basis (e.g. units-of-production method) and the depreciation costs of similar assets used for similar purposes are charged in the same manner. The standard also recognizes that depreciation charges not only may but must be included in service center costs. That is, when tangible capital assets are part of a function or an organizational unit whose costs are charged directly to cost objectives on the basis of services provided, then the depreciation costs of those assets must be included in the service center costs. When not direct charged or part of a service center, the standard recognizes that the "normal procedure" is to include depreciation costs in appropriate indirect cost pools. FAR does not conflict with CAS but it recognizes that depreciation expenses are usually allocated to contracts as an indirect cost.

DCAA audit guidance in DCAM 7-404.1 states that depreciation is usually an indirect expense and states it is preferable to have depreciation recorded at the lowest organization level as possible such as the department or cost center level so that the cost is identifiable as closely as possible with the benefiting work or activity. Auditors are advised that plant or company-wide rates may not be equitable because, for example, government work may be performed in only a part of the facilities or the contractor may be replacing assets faster in a part of the plant performing primarily commercial work than where government work is performed. When plant or company rates are used, auditors are advised to make sufficient tests to determine that the end results are substantially the same as those achieved by more refined methods.

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