CAS 405, Accounting for Unallowable Costs - Practical Problems
1. Defining and Measuring "Expressly Unallowable" Costs. In the preambles to CAS 405, the CAS Board repeatedly made the point that to be fair the unallowability of "expressly unallowable" costs must be "direct and unmistakable" as well as "unequivocal".
Problems arise from the fact that regulations such as FAR 31.205 cost principles and contract terms are not unmistakable. If an unallowable cost is addressed in the FAR 31.205 cost principles, government auditors routinely label it "expressly unallowable", subjecting contractors to potential penalties (discussed below). Boards of Appeals, US Court of Federal Claims, Contracting Officers and Government auditors often confront disputes on interpretations of FAR 31.205 and hence many of these costs are far from "unmistakable". Many commentators, including us, maintain a good faith dispute of allowability should not meet the definition of "expressly unallowable" and that contractors should not be held to a standard of possessing total knowledge. They argue that noncompliance with CAS 405 should be found only when contractors have failed to identify and exclude "unequivocable" and "direct and unmistakable" costs.
2. Methods of Identifying Unallowable Costs. Government auditors have taken the position that "identification" of unallowable costs equates to "specific identification" or delineation of specific accounting transactions. Other methods where transactions are not specifically identified (e.g. use of statistical sampling for projecting unallowable costs ) used to be considered not to comply with CAS 405. However, though no official guidance has been established, we have found that DCAA auditors have often modified their position on using statistical sampling techniques for identifying unallowable costs when, for example, precise rules of statistical sampling are adhered to. Also, in the last year, the FAR Council has proposed specific criteria for acceptable use of statistical sampling (see November-December 2004 issue of the GCA REPORT). Many commentators have argued that the CAS Board was not concerned with imposing a specific methodology but with addressing cost accounting treatment once unallowable costs were identified. They state the CAS Board’s view of its mandate is not to publish "procedural guidance" on recordkeeping but accounting standards.
3. Identifying Directly Associated Costs. "Directly associated costs" is not a well- understood concept. There are no rules or formulas for identifying them and it must be examined on a case-by-case basis. Though both the CAS and FAR 31.001 definitions are identical, FAR prescribes a subtle yet different treatment than CAS 405. FAR 31.201-6(e)(2) prescribes a quantitative analysis. For example, when determining whether executives' salary is directly associated costs of unallowable social activity, the FAR says time spent on the unallowable activities should be compared to total time spent on company activities. CAS 405 asks whether salary expenses would have existed but for the activity which generated the unallowable cost. If the answer is yes, CAS 405 says the cost are not incremental and thus not directly associated costs. Though no Board or Court has definitely ruled on this issue, the Court of Federal Claims did reject the Government's assertion that corporate executive time spent on social activities was significant and hence expressly unallowable as direct associated costs.
4. Accounting for Costs Whose Allowability is Contingent on Later Events. Under FAR 31.205-47, Costs related to legal and other proceedings, legal costs incurred in a civil or administrative proceeding involving allegations of fraud or similar misconduct is unallowable if the contractor is found liable. Following the identification requirements of CAS 405, DCAA prescribes that once one of the "triggering" events occurs (e.g. lawsuits) the potentially unallowable costs must be identified and segregated.
How to treat these costs? The CO is authorized to enter into an advanced agreement and make conditional payments to the contractor for these potentially unallowable costs. The agreement generally requires the contractor to repay such costs plus interest once the proceeding is resolved and the cost is deemed unallowable. If the contractor is not paid, there is no mechanism in either FAR 31.205-47 nor CAS 405 that provides for reopening a contract once the legal costs are allowable.
5. Unallowable Costs in the Base. The question whether unallowable costs belong in the allocation base is frequently raised. Though there is a long case history of this question that is beyond the scope of this article, the short answer is yes – indirect costs are to be allocated over the entire allocation base, whether or not the costs are allowable. To do otherwise is to fragment the allocation base. Treatment of directly associated unallowable costs depends on where the unallowable costs are. If the unallowable cost is not in the base, the directly associated cost should be removed from the pool; if the unallowable cost is included in the allocation base, the directly associated cost remains in the cost pool and is allocated through the regular allocation process.
6. Unallowable Costs on One or Some contracts But Not All. Its not uncommon for a cost to be allowable on one contract but not on another or the cost may be in excess of a capped rate on one contract but not on others. The contractor must show that the the indirect rate has been adjusted for the relevant contract(s) by removing the unallowable cost from the relevant cost pool. In the case of capped rates, the contractor frequently does not know how much costs are unallowable until after the allocation is made and actual rates are determined. At that point, the contractor adjusts the actual rate downward to the negotiated rate ceiling.
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