(Editor’s Note.  The following case study represents a response to a client’s request that we provide some “talking points” for them to prepare a response to DCAA questioning amortized costs of developing a software system.  We think an edited version of our opinion would provide some interesting insights because it touches on many relevant issues like differing treatments of software costs, ability to submit new incurred cost proposals, challenging DCAA positions, etc.)

Basic Facts

During the period of 2001-2005, Contractor developed an Enterprise Resource Planning (ERP) system to be used internally with the intention of eventually selling the system to both commercial companies and the government. The system was significantly different than its core professional services work but since it had the capabilities in-house, it devoted resources to develop the system. The Contractor recently sold the system to another commercial company where they retained the rights to use and sell the system to government agencies. The Contractor has been discussing the ERP capabilities with several government agencies where there is apparently definite interest.

The contractor stated that, in conformity with SOP 98, it capitalized the costs and amortized them over several years.  During their review of Contractor’s 2002-2005 incurred cost proposals, the Defense Contract Audit Agency questioned those costs stating they (1) they were not properly expensed in the periods they were incurred and (2) they were not allocable to government contracts since they benefited only commercial contracts. They are awaiting a response and this paper is intended to provide some ideas for preparing a response.

Comments

In general, when the FAR cost principles are silent on the accounting treatment of specific costs, generally accepted accounting principles (GAAP) will govern how costs will be charged to government contracts. The FAR is silent on software development costs but GAAP certainly is not.  Both Statement of Position (SOP) 98 and Financial Accounting Standards Board (FASB) 86 address different types of software development expenses and DCAA has addressed the impact of these on government costing.

• Government Benefit

It would seem that DCAA simply does not possess certain facts in asserting there is no benefit to government work. First, as you state, the ERP was from its inception, intended to benefit both commercial and government concerns.  Second, subsequent interest by both commercial and government entities demonstrate the system benefits both commercial firms and the government.  If you want to continue challenging the government on their position, I would recommend detailing for the government (1) the nature of the ERP system (2) how it was envisioned to be of benefit to both classes of clients and (3) what current benefits the system now provides.  Lastly, as we discuss below, if it is appropriate to consider the expenditures in question as IR&D, the issue of non-benefit disappears because IR&D costs are (1) allocable to all contract work in the same way G&A costs are allocable (see discussion of CAS 410 above) and (2) allowable costs of those contracts in accordance with FAR 31.205-18, IR&D/B&P.

DCAA’s position that SOP 98 precludes amortizing the costs is incorrect for two reasons.  First, SOP requires software costs to be capitalized and then amortized over several accounting periods.  The only costs to be expensed are those incurred before the “preliminary project stage” is completed and those incurred after substantial completion of the project (e.g. maintenance, training).  Secondly, and most important, SOP does not apply to the costs in question. SOP 98, issued March 4, 1998, provides that certain costs used to develop software for internal use be capitalized and amortized over their economic life. DCAA has addressed the requirements of SOP 98 as they pertain to government contract costs where in its Contract Audit Manual (DCAM) Chapter 7.104-2 it states that SOP 98-1 applies to “Internal-Use Computer Software.”  The guidance goes on to define the characteristics of “internal use."

• “the software is acquired, internally-developed
or modified solely to meet the entities internal
needs; and

• during the software development or modification,
no substantive plan exists or is being developed to
market the software externally."(emphasis added)

It appears that neither the condition of “solely” being used for internal needs nor there being no substantive plan to market the software externally applies here. The intention to market the ERP system to various organizations from the beginning undermines the applicability of SOP 98 to the ERP system.

However, FASB 86 is a different story. Financial Accounting Standards Board 86 applies to computer software that is intended to be “sold, leased or marketed to others”, which is the case here. The DCAM Chapter 7-106 addresses this and stresses that “before technological feasibility” is established costs of developing the software is expensed as research and development in the period incurred while costs incurred after are capitalized and amortized over the periods revenue is expected to be generated. 

• Are the Costs Incurred in 2001-2005 IR&D Expenses?

So should the costs of the software be expensed or amortized? Since the cost principles and even the cost accounting standards are silent on this issue, FASB 86 (not SOP 98) should govern. Those costs incurred before “technological feasibility” is established should be expensed while those costs incurred afterward should be amortized. First, expensing those cost would seem to benefit the company. Since a substantial amount of your business in those years were cost type government contracts, a significant amount of the IR&D costs would be allocable to those contracts. Though the direct and indirect costs rates for 2001 are closed, the remaining years are still open. So you are entitled to withdraw the other incurred cost proposals and resubmit revised ones (where IR&D costs would be added) as long as they are not closed out, which is the case here. Though there may continue to be a dispute about whether the amortized costs benefit government contracts, it would be an unreasonable position to deny IR&D costs as not benefiting government contracts since there is a long history of cases substantiating the position that IR&D costs are allocable and allowable to government contracts no matter whether a particular IR&D project is “commercial” or “government.” 

Second, the costs incurred in developing the ERP system is consistent with the definition of IR&D costs. FAR (see FAR 31.205-18(a)) defines IR&D costs. There are four elements of IR&D, any of which if satisfied would constitute IR&D: 

1 Basic Research.
2 Applied Research
3 Development
4 Systems and other concept formulation  studies. 

Though the definitions of basic research would not apply here, the descriptions of Applied Research and Development would seem to describe the efforts related to the ERP project. In the definition of Applied Research it states “…Applied Research does not include efforts whose principle aim is design, development or test of specific items or services to be considered for sale; these efforts are within the definition of the term ‘development’ defined below."

The definition of Development is “the systematic use, under whatever name, of scientific and technical knowledge in the design, development, test or evaluation of a potential new product or service (or of an improvement in an existing product or service) for the purposes of meeting specific performance requirements or objectives. Development includes the functions of design, engineering, prototyping and engineering testing…” It seems that the effort related to developing the ERP system would fall under the category of Development which would clearly allow for classifying the effort as IR&D. 

One word of caution. Recent court cases have raised the issue of whether the research and development costs FASB 86 calls for qualify as IR&D.  If not, then the R&D costs would be considered direct expenses of the final cost objective that caused the R&D expenses to be incurred. Several recent cases have established limitations on whether the R&D costs can be considered IR&D. (Editor’s Note.  Though we summarized the impact of these cases in our position memo we will spare the reader this section of our report since the cases and issues have been detailed in prior GCA DIGEST issues.) Suffice is to say the ERP system was never funded by an external source nor was it sold until long after it was developed so there is a good basis to treat the expenses as IR&D. 

Conclusion

The fact the ERP system was designed for both commercial and government customers and both types of clients are clearly interested in it, it would seem as if you can demonstrate “benefit” for government contracts. Though SOP 98 is not applicable, FASB 86 does provide for amortized costs and there is no cost principle that makes such costs unallocable. If some of the costs are expensed they would meet the definition of IR&D.

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