These basic decisions have major implications on the cost and pricing rules government contractors must follow:

Many owners keep as many assets as possible in the business that include not only the essential assets needed to conduct business but additional ones from autos to hunting lodges and chalets. Many of these assets can be a source of additional cost recovery on government contracts as depreciation, cost of money, etc. Of course, contractors should be prepared to demonstrate the assets have a business purpose and the advantage of added cost recovery must be weighed against the resulting higher contract prices that can make contractors noncompetitive. If the owners do decide it is in their interests to keep wealth within the company yet fear their cost structure makes their government pricing too high, they may voluntarily delete the costs associated with many of their assets when computing their indirect rates.

Many business owners choose to transfer wealth out of the company, buying then leasing to the company assets needed to run the business. The amount the company (government contractor) pays the owner of the asset is often problematic, especially when owners want to maximize the cashflow they receive from the business. Auditors consider such arrangements as related party or less-than-arms-length transactions and they receive considerable scrutiny. Where the contractor often rents the use of assets at market value, the government usually requires the lower of "cost of ownership" or market value. However, rental costs may be allowable when the same asset is rented to non-affiliated entities so as to constitute a commercial rate.

The allowable costs of ownership the contractor pays the related party is supposed to be the same costs as if the company owned the asset. Such costs include depreciation, taxes, insurance, repairs and maintenance and cost of money. FAR 31.205-36 states and several board cases have ruled that cost of money may be included as an element of ownership even if it was waived as a factor in the price or estimates of individual contracts.

Depreciation costs are primarily covered by FAR 31.205-11 and CAS 404 and 409. There is considerable latitude how these costs are computed. For example, the period of capitalization of the asset can vary depending on its "economic life". Also the method of depreciation (e.g. straight line, accelerated methods) can provide considerable latitude. The level of audit scrutiny will often vary by class of asset. Real estate arrangements are always examined (auditors will ask to see copies of leases) while other classes of assets may be scrutinized less, especially if the amounts are not significant. Be aware that arguments that the rental amount is the "going market rate" is seldom accepted unless you can show (1) there is a "commercial market" for your assets – you lease the same assets to non-related parties or (2) the market rate is less than the ownership costs.

If the assets are older, and fully depreciated, then cost of ownership costs must be replaced by unique rental arrangements. Like usage rates of fully depreciated assets in the company, use charges of assets owned by related parties and leased to the company need to be negotiated and documented in advance agreements. FAR 205-11 states that in computing a reasonable use charge, consideration should be given to (1) the replacement cost and estimated useful life at the time of negotiation (2) the effect of increased maintenance costs and decreased efficiency because of the age of the asset and (3) the amount of previous charges made to government contracts and subcontracts. Many government departments maintain schedules of costs they charge contractors who use government furnished property on commercial contracts and those schedules might be useful in providing bases for usage charges. As previous board cases have ruled (e.g. S.S. While Dental Manufacturing Co., ASBCA No 4102) use charges need not be recorded in the books and records of the contractor for it to be charged to the government.

Compensation of business owners of closely held firms are closely scrutinized by the government. As we discussed in "Executive Compensation" (Vol.4, No.4 of the GCA DIGEST), DCAA has rewritten its guidance to ensure senior executives and owners of small companies receive close inspection. First, "high risk" individuals have been broadened to include employees who can exercise influence over their compensation to include owners, partners, individual executives and officers as well as their family members. Auditors are told to determine if the individual level of compensation is "reasonable" where the burden of the reasonableness test often falls on the contractor to demonstrate their level of compensation is reasonable. Auditors are instructed not to limit their review to only those employees holding high level positions. Auditors attempt to determine if the level of compensation is matched to the job class and to ensure high risk individuals have the same duties as other members of the same class. For example, if the President’s son is an engineer the auditor must confirm (sometimes with technical assistance) the son is not over-graded at a higher level of engineer or is overpaid for the work they perform.

Certain perks (e.g. memberships, etc) will likely be scrutinized closely while others (e.g. auto leases) may not. We have seen auditors attempt to disallow many perks, claiming they are unallowable "entertainment" expenses or they should be included as compensation and then disallowed as "excess compensation" if the total exceeds certain benchmarked amounts or is a "distribution of profits." You should be able to defend the expenditures as business related. You should also be able to defend your compensation level as "reasonable" if the perks are included as compensation. Comparison of your practices with those in your industry would also help.

Certain recreation costs are clearly unallowable costs while others would likely be considered appropriate business expenses not considered unallowable according to FAR cost principles. For example, sporting events, golf club membership, etc are explicitly unallowable as entertainment costs. Others may be allowable such as meals where business is conducted (unlike IRS guidelines, 100% is allowable). Others fall into gray areas and contractors take varied approaches to including or deleting such costs. Those more conservative will identify all gray area costs as unallowable while others will consider a hint of business purposes as justification for maintaining the costs are allowable. Remember, auditors will most likely select certain expense accounts, examine all or a sample of transactions and make determinations of allowability from there. If a transaction is subject to penalties (e.g. "explicitly" unallowable costs) contractors may want to take a more conservative approach with those while other costs not subject to penalties could justify a less conservative approach.

Auditors are now instructed to conduct more frequent financial capability reviews of contractors. One of their first steps is to obtain financial statements, compute common ratios (e.g. profit margins, return on equity, return on assets, working capital levels, asset levels, etc.) and compare the results against established standards to determine if there is any financial risk. If your ratios are outside of the norm, you want to avoid any assertions that you do not have the financial wherewithal to perform your contract. The guidance followed by auditors has, in the main, been drafted to reflect sound financial decisions found in the public sector rather than less optimal but nonetheless sensible financial decisions taken by smaller business owners. If the resulting financial ratios cause concern, the auditor may need to take into account certain decisions made by the business owner. For example, if the owner chooses to minimize assets in the company and instead buys them outside the firm and leases them back then the auditor needs to reflect this in the report. Or, for instance, if return on equity is low, you may want to indicate the reasons retained earnings are higher than normal. Or, again, if equity levels are excessively low, you may need to demonstrate how certain "loans" are really disguised equity.

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