(Editor’s Note.  Many of our clients and subscribers have been, are or will be going through restructuring arrangements – either from external corporate reorganizations stemming from mergers, acquisitions, divestments, reorganizations with other entities or extensive internal reorganizations in order to bring about significant efficiencies related to cost reductions, reorganizing product or customer lines, etc.  Though we addressed issues related to the corporate reorganization about four years ago we thought it would be a good idea to revisit the issue to explore rules related to incurred restructuring costs for both types of reorganizations. There is often some confusion that centers around “external reorganizations” versus “internal reorganizations” and when is a cost versus benefit analysis needed to make restructuring costs allowable. Even when that hurdle is surmounted there are a variety of specific FAR cost principles related primarily to facilities and compensation costs as well as cost allocation issues that present additional barriers to recovering these costs. We will present some background information on the regulations, consider the impact of certain cost principles on limiting reimbursement and what auditors will likely be looking at in making a determination of whether the resulting costs are allowable. The source of this article is a variety of texts including a revision to two of Mathew Benders’ volumes of “Accounting for Government Contracts” by Lane Anderson and several revisions to the DCAA Contract Audit Manual since our last article four years ago.)

Background

Regulations
The government was ambivalent over a rash of corporate reorganizations in the mid nineties. They recognized that lower defense spending required consolidation of defense related industries and this was a good thing if it maintained a strong defense industrial base but they worried that the riches being generated from the reorganizations would add costs to government contracts.  Such concerns led to the National Defense Authorization Act of 1997 which provided that restructuring costs stemming from business combinations after September 1996 would be allowable only if (1) audited savings for DOD contracts exceeded the costs by a factor of two to one and (2) the business combination had to result in the “preservation of a critical capability.”  Regulations implementing this legislation are at DFARS 231.205-70.

The DFARS initially addressed restructuring costs stemming only from business combinations and provided dollar thresholds for when the regulations would apply to DOD contracts and established several steps before restructuring costs could be reimbursed. The limitations the regulation puts on cost recovery apply to only those companies where the restructuring costs are $2.5 million or more of costs allocated to DOD contracts.  Costs less than $2.5 are considered immaterial and the limitations of recovery do not apply. The $2.5 million amount refers to all restructuring activities associated with a business combination and is not to be applied project by project or business segment by segment. A decision that the threshold is not met cannot be reversed in the future if conditions change (e.g. business mix differs from projected mix).

In accordance with DFARS 231.205-70 the other conditions for allowability include (1) contracts must be properly novated to the appropriate business entity (2) the contractor must submit a proposal for the planned restructuring projects that includes a breakout of costs by year and cost element showing projected costs and savings and an audit conducted to ensure unallowable costs are excluded (though too detailed to recount here, see the Defense Contract Audit Agency Manual, Chapter 7-1903 for details on what must be included in the proposal and Chapter 7-1906 how DCAA will audit it) and (3) the ACO must negotiate an advanced agreement that provides a cost ceiling for allowable restructuring costs. Until these steps are completed, the contractor must segregate the restructuring costs and make sure they are suspended from billings, final cost settlements and overhead rate settlements.

Most of the relatively new rules covering external restructuring costs came about as a result of government and contractor personnel’s’ concern over how to account for and allocate restructuring costs. The identification of these accounting issues came in the form of an Interpretation of CAS 406, Cost Accounting Period, issued by the CAS Board in the late 90’s.  Along the way the conditions for incurring restructuring costs were expanded from merely those associated with a business combination – commonly referred to as external restructuring to one where significant internal restructuring activities occurred which were not part of a business combination but one intended to significantly improve operations.  The CAS 406 interpretation deals primarily with the assignment of restructuring costs  to cost accounting period where in essence it seeks to clarify whether restructuring costs are to be treated as an expense of the current period or as a deferred charge that is subsequently amortized over future periods.  FAR 31.205-52 was added that addressed the allowability of the costs which we will also address below.

Definition
Restructuring costs result from changes to a contractor’s organization in an effort to address a declining business base or to enhance business efficiencies or capabilities.  Restructuring constitutes activities that are either driven by internal changes such as downsizing or re-engineering efforts or external changes such as acquisitions, mergers, divestments, etc. The costs associated with restructuring are those expected to result from non-routine, nonrecurring or extraordinary events. These types of costs are not “organization costs” within the meaning of FAR 31.05-27 nor do they encompass costs that are normally unallowable as a result of business combinations under FAR 31.205-52. The later represents costs related to the combinations themselves (e.g. legal, consultant, financial type expenses) rather than the restructuring of companies that may occur after the combination.

The definition of restructuring costs that was included in the Interpretation of CAS 406 states restructuring costs “are comprised both of direct and indirect costs associated with contractor restructuring activities taken after a business combination is effected or after a decision is made to execute a significant restructuring event not related to a business combination.”  The later includes “significant nonrecurring change in its business operations or structure in order to reduce overall cost levels in future periods through work force reductions, elimination of selected operations, functions or activities and/or combination of ongoing operations, including plant relocations.” The interpretation specifically excludes those activities related to ongoing routine changes an organization makes to its business operations or organizational structure. Note the reference to inclusion of direct and indirect costs sounds like costs that are accumulated by final cost objectives such as contracts, subcontracts, task orders, etc and like those cost accumulation points, restructuring costs should also be similarly treated as a final cost objective where costs are charged and accumulated by relevant restructuring project number(s). Examples of categories of costs that are restructuring costs are severance pay, early retirement incentives, retraining, employee relocation, lease cancellation, asset dispositions and write-offs and relocation and rearrangement of plant and equipment. However, these costs are not restructuring costs when they do not relate to either a business combination or other significant nonrecurring restructuring decisions.

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