(Editor’s Note. Accounting changes is an important issue because most contractors need to periodically assess the way they cost and price their government contracts and make changes to achieve their objectives like maximizing cost recovery or being more competitive. We often find confusion by both contractor personnel and government representatives on what constitutes an accounting change which often leads to unfortunate results. For example, a contractor may not adopt a desirable practice for fear it is an accounting change requiring extensive justification when it really is not a change. Or conversely, a contractor may adopt a change and not realize it is a change requiring a justification or demonstration the government is not harmed. We have combined below both what the Cost Accounting Standards and DCAA consider accounting changes as well as more recent guidance established by the Defense Department where the new guidance represents current ideas on what constitutes an accounting change in clearer terms than found in the cost accounting standards and includes new examples intended to illustrate the concepts. We have updated a few thoughts over our prior treatment of this area.)
On January 17, 2002 the Director, Defense Procurement issued guidance to assist administrative contracting officers and auditors to determine when a change occurs in cost accounting practice under the cost accounting standards. The guidance, found at www.acq.osd.mil/dp, follows an unsuccessful seven year effort by the CAS Board to extensively redefine what constitutes a change in a cost accounting practices. Though the guidance formally addresses accounting changes for fully and modified CAS covered contractors, in practice, the guidance affects cost accounting changes for all contractors, whether CAS covered or not.
In summary form, the guidance states ACOs and auditors should use the following to determine if a change occurs:
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.
A change has not occurred when there is the initial adoption of a cost accounting practice for the first time a cost is incurred or a function is created.
A change has not occurred when there is a transfer of contract work from one segment to another provided the cost accounting practices at the segments remain unchanged.
4. When there is a change in cost accounting practice, only affected CAS-covered contracts are subject to price or cost adjustments. (However, for non-CAS covered contracts you can expect resistance from DCAA if a change materially increases government payments.)
What is a Cost Allocation Practice
The definition of a cost accounting practice has not changed and the guidance cites 48 CFR 9903.302-1(c):
Allocation of cost to cost objectives, as used in this part, includes both direct and indirect allocation of cost. Examples of cost accounting practices …are the accounting methods and techniques used to accumulate cost, to determine whether a cost is to be directly or indirectly allocated, to determine the composition of cost pools and to determine the selection and composition of the appropriate allocation base.
Direct vs. Indirect
Specific identification of a cost to a final cost objective
(e.g. contract, subcontract, funded task or delivery order, grant) 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. A change in direct vs. indirect allocation can occur within a business segment, within a home office, between two segments, between two or more home offices or between a segment and home office.
New examples of changes in the method of allocating costs direct versus indirect include: (1) if a company reorganizes its engineering group within a business segment and first line supervisors costs formerly charged to the engineering overhead pool is now charged directly to cost objectives and (2) payroll function was formally performed at Segment A and B but is now performed at the home office level – this is a change for Segments A and B if the home office indirectly allocates the costs of the payroll functions to Segments A and B but is not a change if the home office directly identifies the costs of the payroll functions to A and B.
Determining the composition of cost pools
Functions and activities. Indirect cost pools are composed of “activities” (e.g. machining supervision, purchasing, security, inspection, insurance administration) and functions that are defined as “an activity or group of activities that are identifiable in scope and has 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 or 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. For example, 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.
Disclosed and established practices. When determining whether a change has occurred, the ACO and auditor are instructed to focus on the disclosed and established practices that define and describe the significant functions and activities of the indirect cost pools. They are warned that the disclosed practices, whether in the form of a disclosure statement or other policies, my not identify all functions and activities.
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.
The composition of the base also encompasses the activities of the base (e.g. systems engineering, design engineering, fabrication) that are in some way related to the activities in the pool. A change in the activities is a change in the composition of the base. For example, a change from a machining direct labor dollar allocation base to an assembly direct labor dollar base is a change. However, as we have seen, volume fluctuations do not represent a change so, for example, a contractor that purchases a new segment and adds it to its home office allocation base does not change the composition of the home office allocation base.
Initial Adoption of an Accounting Practice or Elimination of a Cost or Cost of a Function is Not an Accounting Change
CFR 9903.302-2(a) states the initial adoption of a cost accounting practice is the first time a cost is incurred or a function is created. (Editor’s Note. We have often been successful in asserting a change in treatment of a cost that was immaterial in the past and then becomes material is tantamount to adopting a new incurred cost and hence is not an accounting change.) Alluding to the controversy over whether an organization change represents an accounting change, when a function is transferred between segments, between home offices or between a segment and home office this does not constitute the creation or elimination of a function for either the segments or home offices. Similarly, the merger of two or more segments does not constitute the creation or elimination of a function.
For example, if a contractor establishes a new security function then this would be a creation of a new function. However, if the security function was transferred from one segment to another this would not be creation of a new function for the one segment nor the elimination of the function from the other segment.
Transfer of Contract Work
The transfer of work on a contract from one existing business segment to another is not a change in accounting practice as long as the cost accounting practices at the segments do not change.
When work is transferred from one segment to another, the contract often will not incur the same costs as originally estimated. Instead the contract will incur costs in accordance with the cost accounting practices of the segment where work was transferred. The contract may incur the costs of the transferred work under a different indirect cost pool (e.g. Segment A’s overhead pool instead of Segment B’s overhead pool) or a different cost element (e.g. intra-company transfers). This is considered a business decision in how the work will be performed (similar to a make or buy decision), not a change in the cost accounting practices of either segment. As long as the cost accounting practices of the segments remain the same no change has occurred. After all, the established cost accounting practices of the two segments were consistently used to estimate and accumulate each segment’s costs.
Affected CAS-Covered Contracts
Affected CAS-covered contracts are those contracts on which the cost accounting practice change occurred. Affected contracts are only those that are subject to contract price or cost adjustments. Contracts may be impacted by events other than cost accounting practice changes (e.g. volume changes or contract performance changes). When the practices do not change for these contracts, they are not subject to contract price or cost adjustments.
For example, a contractor merges two indirect cost pools containing basically similar functions and activities. Pool A uses a direct labor dollar allocation base and Pool B uses a direct labor hour base and the combined pools uses a direct labor dollar base. Yes, there is a change in the selection of the allocation base for those contracts in the allocation base for Pool B but no change for those in the base of Pool A. Hence the affected CAS covered contracts are those only in the allocation base of Pool B and they are the only ones subject to a price adjustment.
Additional Material on Accounting Changes
The 2002 change included new examples of changes contractor may make that either will or will not be considered “a change in a cost accounting practice.” Examples of changes that do not meet the definition of an accounting change include:
Contractor allocates separate pool costs on a direct labor base, are combined into a single cost pool with a direct labor base.
Contractor combines two indirect cost pools with similar functions and activities where allocation base does not change. Two indirect pools representing similar activities, one for Product A and one for Product B both with a direct labor base are combined into a single manufacturing pool with the same direct labor base.
Contractor separates a single indirect cost pool into two indirect pools having similar functions and the allocation base stays the same. A single indirect pool allocating on total engineering test labor is separated into two pools where the base for pool E is allocated on direct test labor from one department and pool F is allocated on direct test labor from another department.
Contractor changes the method of performing a function but does not transfer the function to another pool. Costs of preparing payroll is included in a segment’s G&A pool and after the change an outside company prepares payroll whose costs remain in the segment’s G&A pool.
Contractor transfers performance of a function from one pool to another that already contains the activity. While both the segment and home office prepares payroll, the contractor transfers payroll function from the segment to the corporate home office.
The memo also contains examples of changes that do meet the definition of a change to an accounting practice. These include:
Contractor changes its allocation from an intermediate cost pool to specific identification to another. Contractor transfers security costs from an intermediate pool allocated to fabrication and total assembly pools based on direct labor and directly charges security to the fabrication and assembly pools.
Contractor combines two pools not allocated on a base of similar activities. A company accumulates manufacturing overhead in pool J and uses a manufacturing direct labor base and accumulates engineering costs in pool K using an engineering direct labor base are combined into one pool using both a manufacturing and engineering direct labor base.
Contractor separates a single pool into two where the two pools are not allocated on a similar base. A single manufacturing overhead pool allocated on direct fabrication and assembly labor is split into a fabrication overhead pool allocated on direct fabrication labor only and an assembly overhead pool allocated on a direct assembly labor base.
In a merger, overhead pools of similar activities are combined but the selection of allocation base is different than before. Segment A allocated its manufacturing overhead on a direct labor dollar base and Segment B on a direct labor hour base and when the two pools are combined after a merger, the allocation base is direct labor dollars.
Contractor separates a single indirect pool into two having similar functions but the allocation bases are different. A single pool is divided into two pools (K&L) with similar activities and pool K uses an employee headcount base while pool L uses a direct hour base.
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