Guidance on What is an Accounting Change

Whether an alteration in accounting is considered to be an accounting change requiring notification and possible cost impact analyses is a pressing concern. Sometimes contractors are reluctant to make the change even though it is not an accounting change while others make the change not realizing they are making one. In our consulting work we commonly help clients evaluate whether the number and nature of indirect cost rates best match their changing pricing objectives where we may recommend either the adoption or elimination of an indirect rate or more commonly, we may recommend altering what elements of costs are included in the cost pools, deleting or adding some elements or transferring others out of one pool into another.. One of the first questions that arise is has an accounting change occurred and if so, how do we disclose the changes to the government.

Though a comprehensive understanding of what is an accounting practice and what is considered to be a change must await a more detailed treatment in the future, we thought we would briefly address some of the accounting change rules that commonly arise in addressing the consulting issues described above. The Cost Accounting Standards, DCAA Contract Audit Manual, several texts and guidance issued by the Director, Defense Procurement in 2002 provide excellent guidelines on this issue.

In summary form, ACOs and auditors are told that the following should be used to determine whether a change has occurred: an accounting change occurs when there is a change in the method or technique for determining (a) whether a cost is direct or indirectly allocated (b) the composition of the cost pools (c) the selection of the allocation base or (d) the composition of the allocation base.

• Direct vs. Indirect
  

Specific identification of a cost to a final cost objective or to a business segment is a direct allocation method. Accumulating a cost in a specified indirect pool or home office pool for purposes of allocating to multiple cost objectives or segments is an indirect allocation method. Be aware that determinations of whether there is a change are commonly determined by the company’s established practices – if a given cost is treated only as direct or indirect then an alteration would be considered a change; however, if the disclosed practices specify that similar costs incurred under dissimilar circumstances may be treated as both direct and indirect then an accounting change would not have occurred.

• Determining the composition of cost pools
  

(Editor’s Note. Though we have expressed doubt in the past whether changes in the composition of costs within cost pools are accounting changes, a review of the material for this article has convinced us that many, but not all such changes do represent accounting changes.)

Functions and activities. Indirect cost pools are composed of “activities” and “functions” where the latter is defined as “an activity or group of activities that are identifiable in scope and have a purpose or end to be accomplished.” A change to the composition of a cost pool occurs when a contractor changes the functions or activities that compose the indirect cost pool.

Combining indirect cost pools. When two or more pools are combined, there is a change in the composition if the functions or activities of the previously separate pool(s) are not generally the same as the functions or activities of the new combined pool.

Dividing indirect cost pools. When a company divides a single indirect cost pool into two or more pools, a change occurs in pool composition because the functions and activities in the divided pool(s) are not generally the same as the functions and activities of the former single pool. For example, an accounting change has occurred when a single overhead pool includes two functions, building maintenance and security and then divides the single overhead pool into two separate cost pools consisting of maintenance and security functions.

Transfer of functions. A transfer of a function or activity from one pool to another is not considered a change in pool composition if the transferring pool (i.e. the pool from which the function or activity is transferred) receives an allocable cost of the function or activity from the receiving pool. Otherwise, the transfer represents a change for the transferring pool. If the receiving pool contained that function or activity prior to the transfer then a change has not occurred.

The DOD guidance provides an example where the engineering overhead pool contains a production engineering supervision function while its production overhead pool does not. If the production engineering function is moved from the engineering overhead pool to the production pool a change to both pools has occurred because the engineering overhead pool no longer contains the supervision costs while the production overhead pool now contains the supervision costs.

Variations in costs. Costs that are associated with a function of a pool may vary, even significantly, from one point in time to another. These variations do not result in an accounting change as long as the defined pool functions do not change. For example, if a contractor buys a building and the maintenance costs fall within the defined building maintenance function of the pool the increase in size of the pool does not affect its composition and hence no change has occurred.

• Determining the selection of the allocation base
  

The selection of the allocation base refers to the base measure (e.g. direct labor dollars, direct labor hours, direct material costs, total cost input or a resource consumption measure like computer usage or square footage). A change in the selection of the allocation base is a change in accounting practice.

• Determining the composition of the allocation base
  

A change in the composition of the allocation base occurs when (a) a change in the elements of the base or (b) a change in the activities that are included in the base. However, a volume change in the base (e.g. addition or deletion of a contract or a business segment) does not, in itself, represent a change. The elements include not only the type of base (e.g. direct labor) but the composition of that type (e.g. direct labor dollars plus overtime premium or fringe benefits). A change in the elements making up the base is an accounting change. For example, a change from a direct labor dollar to a direct labor dollar plus overtime premium is a change in the composition of the allocation base.

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