(Editor’s Note. Government contractors, like most firms, are continuously faced with a variety of third party lawsuits whether theybe allegations of mistreating employees, environmental contamination, professional liability or personal injury lawsuits. Most firms make business decisions on how much effort and expense they want to put into challenging these suits, choosing an array of optionsranging from “fighting them to the Supreme Court” to settling the issue to avoid long drawn out, expensive fights. In recognition ofthese business expenses, the government has traditionally allowed legal and settlement costs associated with most of these cases as anecessary cost of doing business unless such legal actions were involved in one of the legal issues explicitly made unallowable by FAR31.205-47 (e.g. mergers and acquisitions, patent infringements, pursuit of claims under the Contract Disputes Act (CDA),defense of fraud allegations, etc.) In recent times, there have been some conflicting cases that have narrowed the opportunities torecoup these costs which had the affect of making contractors think twice before settling these disputes. The following alludes to a fewof these cases and creates significantly expanded grounds to disallow those costs that have traditionally been allowed as normal costs of doing business.)
Background
Tecom was awarded a negotiated cost reimbursementcontract for military housing maintenance at FortHood, Texas. The contract incorporated by referenceFAR 52.222-26, Equal Opportunity which prohibitscontractors from discriminating against any employeebecause of race, color, religion, sex or national origin.There was no dispute by any of the parties that sexdiscrimination in violation of Title VII of the Civil Right Act of 1964 would constitute a breach of theEquality Opportunity clause of the contract.
During performance of the contract a formeremployee sued Tecom under Title VII, alleging sexualharassment and firing in retaliation for filing a sexualharassment charge. The alleged conduct occurredwhile the employee was working on the governmentcontract where if the allegations were proved, therewould be a violation of Title VII.
In defending the Title VII litigation Tecom incurredlegal fees totaling $96,000 and ultimately decided tosettle the matter for $50,000. In the terms of the agreement no “back pay” was provided for andTecom did not admit any wrongdoing. Tecomrequested payment for $146,000 for the defense andsettlement costs in its incurred cost proposal.
Tecom claimed it did not violate the law and that the allegations were false but settled because trying thecase would have exceeded $300,000. Tecom argued the defense and settlement costs were allowable under the contract and FAR and that the costs were reasonable because the settlement costs were far less than the costs of going to trial, even if Tecomprevailed. The government denied these expenseswere allowable and converted the request for paymentinto a contracting officer’s final decision and Tecomfiled an appeal to the Appeals Board.
Board Decision
During cross motions, the government argued thatthe attorney’s fees and damages associated with ajudgment of liability under a Title VII claim were notallowable costs and that under Boeing (298 F.3d at 128889) the cost of settling such claims are unallowableunless the contractor proved the suit had very littlelikelihood of success on the merits. Tecom arguedthe costs of settling a Title VII suit is always allowable(except for an explicit backpay award which isunallowable per FAR 31.205-6(h)) and that the Boeingcase was irrelevant because it involved fraud and similar misconduct which is not alleged here. The Appeals Board sided with the contractor noting thatBoeing did not apply where there were no charges thatTecom had engaged in criminal conduct, fraud orviolations of the Major Fraud Act of 1988. The Board said the contractor should be reimbursed a reasonable amount in accordance with the Allowable Cost and Payment Clause. The government appealed to theUS Court of Appeals for the Federal Circuit.
Discussion
The issue is whether the costs of defending and settlinga Title VII suit are allowable under this contract. The Court cited the five requirements for a cost to beallowable under FAR 31.201-2: (1) reasonableness (2) allocability (3) CAS, if applicable (4) terms of thecontract and (5) limitations set forth in the costprinciples of FAR Part 31. It noted that FAR 31.204 does not cover every element of cost so failure toinclude any item of cost in the contract or costprinciples does not imply it is either allowable orunallowable. Where neither the contract nor cost principles explicitly address a particular cost, whichis the case here, the cost principles must be looked atfor treatment of “similar or related” selected items.
As described in Boeing, even though professionalservices and costs of settling litigation are generallyallowable, this is not always the case. Where claimed costs are associated with a settlement agreement twosteps of inquiry must be made: (1) if an adversejudgment is made (e.g. guilty) should damages, costsand attorney fees be allowable and (2) if not, shouldthe settlement costs be allowable.
Should the Judgement costs be allowed?
The Court states right off that the attorney fees shouldnot be allowed if there is a violation of Title VII. The Court’s decision, which had issued the decision on Boeing, relied heavily on the case where first Boeing wasconvicted by the government for fraud. After this conviction and fines and penalties a shareholder broughta private lawsuit against 14 directors of the companywhere based largely on the criminal fraud convictionsit was alleged the directors had failed to “establishinternal controls sufficient to prevent fraud.”
The Court stated that under Boeing, in order todetermine whether the costs of defending against theshareholder suit was allowable, the court inquired intowhether the suit was “similar or related” to the costs of the underlying convictions. They first said the costs of the shareholder suit are not similar to costs incurred in connection with criminal convictions or other disallowed costs identified in FAR 31.205-47. However it held that the shareholder suit was “related” to the convictions. That is judgment againstthe contractor in the suit would require adetermination that the directors had failed to maintain adequate internal controls which the Court concludedhad a “sufficiently direct relationship to the disallowedcosts of the criminal convictions and hence the costs of defending against an adverse judgment in the suitshould therefore be disallowed.”
The Court said this aspect of Boeing was found in the Southwest Marine case (Southwest Marine Inc. US 535 F.3d1012 (9th Cir. 2008). There a court ruled Southwest was liable for civil penalties under the Clean WaterAct in a citizen suit. Whereas the FAR makes costs unallowable in connection with any proceedingbrought by a third party in the name of the U.S. underthe False Claims Act, the Court held that citizen suits under the Clear Water Act that resulted in civil penalties were “similar” to costs disallowed in theFAR under the FCA.
In the current Teton case, the parties agree that neitherthe statute nor FAR explicitly discusses the allowabilityof costs associated with adjudicated Title VIIviolations. The Court says the costs would beunallowable because a contractor violation of Title VII would breach the contract and costs related to such a breach would be unallowable. The Court alludes to one of the criteria of allowability – costcomplies with the terms of the contract. Here, the contract specifically requires the contractor to notdiscriminate on the basis of sex and sexual harassment claimed in the suit is a form of sex discrimination. If sexual harassment and subsequent retaliation werefound at trial then the defense and judgment wouldcertainly result from a breach of the contract. As an earlier case decided, Dade Brothers Inc. US (325 F.2d239, 240 (Ct.Cl. 1963) concluded that costs resultingfrom a breach of contractual obligation are notallowable costs under the contract.
In this suit the alleged discrimination would clearlyviolate the contract and thus costs associated with an adverse judgment would not be allowable. This conclusion according to the court is underscored bythe clear public policy of Title VII. In NAACP v Federal Power Commission the Supreme Court ruled thatcosts resulting from violations of Title VII wereunreasonable and should rightly be excluded fromutility rates passed onto consumers. The Court concluded just as it is not “just and reasonable” for acompany to pass the costs of Title VII on toconsumers, similarly it is unreasonable to pass suchcosts on to the government in a contract context.
Are the Settlement Agreement costs allowable if the adverse adjudication costs are unallowable?
Here, the Court stated its position on Boeing clearlyaddresses the issue. The decision should follow the rules of a private suit brought under the False ClaimsAct (FCA) where there the FAR states the costs maybe allowable if the CO determines there was little likelihood the third parties would be successful onthe merits. So here, there should be an inquiry whetherthe plaintiff was likely to prevail. Though the FAR“most clearly reflected” FCA related issues, the Courtsaid it should not be limited to that situation. So under Boeing the court held that whenever the costs of a judgment would be unallowable, the cost of asettlement would also be unallowable unless the contractor could prove the private suit had littlelikelihood of success.
Tecom states that apart from fraud situations clearlyspelled out in the FAR settlement costs should beallowable regardless of how clearly meritorious theclaim and states Boeing got it wrong by applying arule limited to fraud settlements. The Court, who ruled on the Boeing case, “clearly adopted a broaderrule applicable to private settlements generally.” The Court responded that this was the point of Boeing –to determine an applicable rule for similar or relatedcases not those covered by the regulation.
In response to Tecom’s assertion that applying thelikelihood of success test to private settlement wouldbe unwise the Court said that if it sided with Tecom it would allow a contractor who engaged in conductprohibited by the contract – where defense andjudgment costs would be disallowed if it were tried tojudgment – to nonetheless recover defense andsettlement costs if it resolved the case before judgment.It cannot be the policy of FAR to permit this.
Dissent
One of the three judges dissented from the majorityopinion. He first recounted the basis for the Boeingdecision and stated the conditions were not similar. He said the Boeing court, in looking at a prior Citron lawsuit, presumed that meritorious suits should betreated differently from those that lacked merit andlooked to the FAR for guidance as to whether thesettlement costs of the Citron suit were allowable. In referring to treatment of settlement of private suitsbrought under the False Claims Act where thegovernment does not intervene, the Boeing court saidsuch costs may be allowable if the CO determinesthat there “was very little likelihood that the third party(plaintiffs) would have been successful on the merits”FAR 31.205-47(c)(2).
The dissenting judge states this very little likelihoodof success standard may have been appropriate under the facts addressing Citron but should not apply here.The FAR quote applies to settlements brought by athird party under False Claims Act; it does not applyto “any and all” settlements of lawsuits brought byprivate parties involving “any and all types ofallegations.” The Citron suit that settled Boeinginvolved several instances of fraudulent behavior and the making of false statements. The dissenter agreesthat the FAR reference does address private suitsunder the FCA and so does lend support to the Boeingcourt decision.
Here there is “no nexus” between the facts of the private suit in this case, a sexual harassment suit filedby a former employee, and a suit brought by a thirdparty on behalf of the government alleging fraud orsimilar misconduct. To apply Boeing here would beextending the reach of that decision to any settlementof a lawsuit brought by a private party when the costsof an unsuccessful defense would be allowed. Such an extension is unwarranted and agrees the Board wascorrect in refusing to apply the Boeing standard.
In addition, the dissenting opinion stated thatdetermining the likelihood of success is, in practice,not easily done. If it were, there would not be so many suits, appeals and reversals of decisions. It is one thing to have that standard be a criterion ofallowability of costs in defending a suit when fraudagainst the government is alleged but it is quite anotherto have that standard apply when the criteria in a suitinvolving two private parties, even if the subjectmatter relates to a government contract. The standard should be higher for fraud allegations than for whentwo private parties are contending with each other.The dissenting judge “recoils from judicially extendingthat difficult-to-apply likelihood of success rule beyond its current borders,” concluding the Courtshould not extend the application of a regulation tosettlements beyond fraud cases.
(Editor’s Note. Several of our clients and subscribers havebeen asking us about changes to their small business size statuseither before or after winning new awards. Others have been considering various ownership or affiliation arrangements so asnot to loose their small business status while others are concerned that investment arrangements, either by outside venture capitaland equity funds or family/employee groups will affect their small business status. These concerns are particularly relevantto our readers in the light of recent proposed rules affectingsmall business size – e.g. effect of investments by venturecapitalists on small business status, companies who haveoutgrown their “small” status may still be considered small forpurposes of bidding on follow-on or similar procurements wherethey would still be small had they not been awarded the contract.So, we have been “boning up” on the SBA rules. During thatprocess we came across a particularly pertinent article addressingmany of these issues in the August 25 edition of FederalContracts Report written by Keric Chin and Richard Vacuraof the law firm of Morrison & Foerster LLP so we decided to reflect their insights in this article that are consistent with outown research. We believe these rules are relevant not only tosmall businesses but also large businesses working with smallbusiness concerns, considering various teaming arrangementsor even investments or acquisitions of such firms.)
Basic Rules
The Small Business Act defines a small business as “one which is independently owned and operated andwhich is not dominate in its field of operation.” In addition the SBA may specify detailed definitions orstandards by which a business concern may bedetermined to be “small.” SBA has established size standards which vary by industry and are matched tothe North American Industry Classification System(NAICS) codes. The size standards are based on either number of employees or annual receipts,depending on the industry, which are designed toensure the concern is not dominate.
When determining number of employees SBA countsall individuals employed on a full time basis, part-timeor other basis averaged over 12 months. When determining annual receipts it is based on the averagetotal receipts over the concern’s most recentlycompleted three years.
The contracting officer designates the NAICS code thatapplies to a particular procurement and thus the sizestandard that applies to it. A company that meets thesize standard for the designated NAICS code mayrepresent itself as “small.” A company generally certifiesits size status at the time it submits an offer or bid to the procuring agency and the agency may rely on the self-certification absent evidence to the contrary or a challengeby an interested party. Section 8(a) of the SBA providesfor severe penalties for knowingly misrepresenting thesize status of a concern in connection with a procurement.In addition there are separate certification processes forsmall business that wish to be certified an 8(a) BusinessDevelopment Program, small disadvantaged orHUBZone small business.
A recent proposal to change the small business statusof firms receiving funds from venture capital firmshave raised the issues of what rules determine whether a company is small. When small businesses are pursuing federal government work infusions ofcapital by venture capital, private equity or otherinvestment funds may change the business to otherthan “small,” making the business ineligible foropportunities that the federal government has setaside for small businesses or making the business lessattractive to prime contractors seeking to meet theirsmall business subcontracting goals.
So what is the affect of an investment on the small business concern’s size status? It depends on severalfactors including the relative size of the investmentand types of management controls the investorstypically seek to impose to protect their investment.If an investor is deemed to control the small business concern, either because of the size of its shareholdingor other factors then the two entities are considered to be “affiliates” and the investor’s revenue and employee number are aggregated with the smallbusiness concern’s numbers for size determination calculations. Even minority shareholders can be, andoften are, considered to be “affiliates” for size status. So the focus on the impact of investments to sizestatus has raised the issue of small business size eligibility provisions and standards, particularly thoserelated to affiliation.
Affiliation Rules
Making the determination of whether a companyqualifies as a small business is often tough, especiallywhen the SBA affiliation rules and the varied business models or investment arrangements may apply. In calculating the size of a business concern, the SBA aggregates the number of employees or annualreceipts of the business concern with those of itsaffiliates. This, of course, depends how the concernsare affiliated. Affiliation is broadly defined as when“one controls or has the power to control the otheror a third party or parties controls or has the powerto control.” It does not matter if actual control is exercised so long as the power to do so exists. The affiliation rules make clear that control may be eitheraffirmative or negative – the latter is when a minorityshareholder has the power to prevent a quorum orblock ordinary actions by the Board or stockholders.(The authors point to two cases in their footnotes that makethe level of control less clear. In one case, the court distinguishedbetween power to block ordinary and extraordinary actionsof the board or shareholders while in another case, the Board found affiliation even though controls were characterized aslimited to scenarios outside the normal course of business.)
The SBA affiliation rules, in Title 13, Part 121 of the Code of Federal Regulations identify circumstanceswhere affiliation will be presumed where in some casesthe presumption is often rebuttable. These are:
1. Affiliation based on stock ownership – single largeblock. Affiliation exists when any individual, concernor other entity has the power to control 50 percent ormore of voting stock or a block of voting stock thatis large compared to other outstanding blocks.
2. Affiliation based on stock ownership – minorityshareholder rule. When two are more individuals, concerns or other entities own or have the power tocontrol 50 percent of a concerns voting stock and such minority holdings are equal or approximately equalin size and the aggregate of these holdings is largecompared to other outstanding blocks. This presumption is rebuttable.
3. Affiliation arising under certain future arrangements. Affiliation may exist when ownershipor control may exist based on ownership or controlof stock options and convertible securities as well as agreements to merge.
4. Affiliation based on common management.Affiliation exists where one or more officers, directors, managing members or partners who control the boardof directors and/or management of one concern alsocontrols the board or management of the other concern.
5. Affiliation based on identify of interest. When two or more individuals or firms have identical or substantially identical business or economic interestssuch as family members, common investments oreconomically dependent relationships throughcontract or otherwise. This presumption is rebuttable.
6. Affiliation based on newly organized concern. An affiliation may arise when former officers, directors,principal stockholders, managing members or keyemployees of one concern organize a new concern inthe same or related industry and serve as the newconcern’s officers, directors, principal stockholders,managing directors, principal employees and thepreexisting concern furnishes or will furnish supportto the new one. This broad based presumption isrebuttable.
7. Affiliation based on joint ventures. Affiliation existswhere an association of individuals and/or concerns
engage in and carry out more than three businessventures in a two year period. (In one case the SBA found affiliation between two concerns because they have formedso many joint ventures that the independent identify of one orboth concerns were blurred.) With certain exceptions, thisrule does not apply to: (1) a joint venture betweentwo or more small businesses, each of which meets the designated size standard and (2) two firmsapproved by SBA to be a mentor and protégé andthe protégé qualifies as small under the designatedsize standard.
8. Affiliation based on joint ventures – ostensiblesubcontractor rule. Certain prime contractors andtheir subcontractors are treated as joint venturers andaffiliation exits where the subcontractor performsprimary and vital requirements of the contract or theprime is unusually reliant on the subcontractor.
To complicate matters even more, the SBA willexamine multiple levels of affiliation. For example,if Company A is affiliated through stock ownershipand management control with Company B andCompany B is affiliated with Company C thenCompany A would be affiliated with both B and Cwhere employees or revenue of each affiliate wouldbe aggregated for size determination. For manyventure capital and other investment funds, theaffiliation analysis is complicated by the number ofindividuals and business entities that are within the fund’s portfolio. The SBA finds affiliation for such arrangements to be based on “the totality of thecircumstances” where no single factor by itself issufficient to determine affiliation.
There are also exceptions to the affiliation rules. For example businesses owned in whole or in part byinvestment companies licensed under the SmallBusiness Investment Act are not considered affiliates. There are also exceptions pertaining to businessconcerns owned and controlled by Indian Tribes,Alaska Native Corporations, Native HawaiianOrganizations, Community DevelopmentCorporations and labor brokers and temporaryemployment agencies.
Consequences of Status Change
In assessing potential investment opportunities, boththe small business and venture capital firm mustconsider the consequences of whether the small statuswill change and if so, what is the impact. A status change can affect business opportunities by makingthe former small business ineligible for contracts setaside for small businesses or they may become less attractive to prime contractors who are looking tosubcontract out work to meet their small business subcontracting goals.
It may affect the status of its current contracts. Prior to June 2007, contractors did not have to notify theirCOs of a change in circumstances affecting their sizestatus but that changed after that date where the FARPart 19.301-2 now requires notification under certaincircumstances: (a) execution of a novation agreement (b) following a merger or acquisition that does notrequire a novation agreement (e.g. stock purchase) (c)prior to the end of the fifth year of a long-termcontract or (d) prior to exercise of any optionsthereafter. The FAR states the status change does notchange the terms and conditions of the contract butthe agency may no longer include the value of theoption years against its small business primecontracting goals.
The meaning of this new notification requirement neednot trigger the representation requirement if a venturecapital or other investment firm invests with thecompany even if the investment impacts the size statusof the concern until the five year option period isreached. However a CO may require the smallbusiness to recertify its size status at any time includingin response to a solicitation for a multiple award (e.g.Multiple Award Schedule).
Migration Strategies
(Though the authors address venture capital firms here, we wouldsay it applies more broadly to other investment vehicles.) To mitigate the potential impact of an investment by aventure capital firm the authors state the funds shouldlimit their ownership and control of the concern’s votingstock, including options and convertible securities. Thegreater the control over a business concern the morelikely it will be considered an affiliate. This will, in turn, likely trigger an examination of the fund’s otherportfolio companies to determine whether they are alsoaffiliates. In structuring the investment, the authorscaution it is more than a numbers game where the totalityof circumstances may be examined. Do the funds own or have power to controls blocks of voting stock thatare individually or collectively large when comparedto other blocks? Implications on shareholder votingagreements, corporate charters and bylaws, commonmanagement, and mutual business or economic interestsamong other things must be considered. There are no clear bright lines here so put simply, if an investor ownsmore than a relatively small percentage of a concern’svoting stock it runs the risk of being considered anaffiliate.
The authors put forth several factors to consider whenstructuring the investment relationship to avoidtriggering “affiliation.” The SBA Office of Hearingsand Appeals (OHA) generally distinguishes betweencontracts that limit ordinary actions by the Board orstockholders (i.e. management decisions that affectdaily operations of the business) and those that limitextraordinary actions pertaining to protection ofownership stakes. For example, OHA held that asupermajority voting requirements for amendingcorporate charter or bylaws, issuing additionalcommon stock or entering any business substantiallydifferent from its normal operations are significantlydifferent from the company’s normal business andhence did not constitute negative control for purposesof triggering affiliation. The types of actions theOHA considers to be extraordinary are limited. The OHA has held the following types of actions to beimportant business operations and the investors’ability to block them would constitute negativecontrol: (1) setting compensation (2) hiring and firingcorporate officers (3) declaring or paying dividends (4) creating debt (5) alienating or encumbering assets (6) amending or terminating lease agreements and (7)purchasing equipment.
(Editor’s Note: In an audit of one of our client’s incurred costproposals the auditors of the buying agency (not DCAA) areclaiming that the method of allocating home office costs to thebusiness segment working on a large cost type contract are notcorrect and the allocation practices may constitute fraud. Thoughwe prepared several position papers and held numerous meetingwith the auditors and agency contracting personnel on these andother issues, the following identifies the assertions being madeby the auditors and a summary of our positions put forth inrebuttal. We will disguise important facts calling the contractor“Contractor”, the agency “WA” and the business segmentresponsible for working on the WA contracts as “BU.”
Background of Allocation of Home Office Costs to BU
Since the BU business segment did not have a fullcontingent of indirect personnel available to supportWA contracts it used a small but growing group ofcorporate personnel to provide support as its large cost type contract work ramped up. Prior to 2006 timesheets were used to identify the fully burdenedcosts of these personnel that were allocated directlyto BU. Due to concerns of accuracy of usingtimesheets (employees were inconsistent in how theydistinguished work in support of BU versuscorporate-related activities), the company substituteduse of a sales metric approach (BU sales as apercentage of total sales) to directly allocate a portionof these personnel costs directly to BU and continuedthe prior practice of allocating the remaining costs tothe home office residual pool. The Government is asserting that the allocation of these corporatepersonnel costs resulted in an over-allocation of coststo BU. Specifically, the over-allocation occurredbecause (1) the group of people should not beconsidered a separate pool of costs (2) use of a salesmetric is inappropriate and (3) assigning the remainingcosts not directly allocated to BU to the residual poolresulted in “double dipping” because a portion ofthese costs were also allocated to BU. Further, there is the assertion these allocations were made without informing the employees or changing sourcedocuments or accounting records.
Applicable Rules.
Both the Federal Acquisition Regulation and CostAccounting Standards are the two main set of rulesaddressing the allocations of costs.
There is significant uncertainty when, if ever,Contractor’s WA contract became fully CAS covered(there are several issues related to measuring the dollarvalue to see if the threshold for CAS coverage wastriggered but these are too involved to recount here).However, there is no doubt about whether the contracts were subject to the FAR. The FAR Part 31 cost principles primarily address questions ofallowability where specific categories or costs aremade unallowable due primarily to public policydecisions. Sections of FAR 31.201 through 204 doprovide general guidelines for cost allocationprinciples. After providing general guidelines ofdetermining allocability and distinguishing betweendirect and indirect costs, section 31.203 addresses indirect costs. The most relevant sections are:
31.203(c). This part defines what a pool is. It states indirect costs will be grouped into “logical costgroupings” with consideration of the reasons forincurring such costs. The decision for grouping thecosts will be based as to permit use of an allocation base that is common to the cost objectives to whichthe costs are allocated. The base selected will allocate these grouping of costs “on the basis of the benefitsaccruing to the final cost objectives.” The next sentence provide even greater leeway in grouping costs
-“When substantially the same results can be achievedthrough less precise methods, the number andcomposition of cost groupings should be governedby practical considerations and should not undulycomplicate the allocation.”
(e) The method of allocating indirect costs “mayrequire revision” from time to time when conditionschange. Examples of changes in conditions includenature of the business, the extent of subcontracting,fixed assets, volume of sales, etc.
By far the most important regulation addressing theissues here, since it addresses allocation of costs incurred at the home office level is CAS 403, Allocation of home office expenses to business segments. Even if the relevant contracts are not CAS covered nonetheless, the prescriptions of CAS 403are instructive because they provide the most specificguidelines on what constitutes adequate home officeallocation guidelines. I will first provide a shortsummary of the standard.
There are three ways that corporate expenses are tobe allocated to business segments in descending orderof preference: First, direct identification of costs to a specific business segment. Second, nondirect allocation measurement where similar types of costsare grouped together and allocated to benefitingsegments on allocation bases reflecting therelationships of the expenses. For example, HumanResources costs may be grouped and allocated tosegments based on headcount. Third, residual expenses where remaining costs are to be allocatedto all segments on a base representing total activity.
Use of a sales allocation base for measuring totalactivity has been a controversial element – manycontractors, especially those not covered by CAS(which represents the vast majority of contractors)use sales as a basis to allocate some or even all of their home office expenses to business segments.Though the standard does not take issue with thispractice, DCAA auditors sometimes do assert salesdoes not measure total cost activity because salesfigure may include widely divergent profits as opposed to costs. However, many auditors will accept thepractice, especially for non-CAS covered contractors.
The allocation of home office costs or methods prescribed in the standard are almost never followedby commercial firms or even government contractorsnot required to provide estimates of costs to thegovernment for pricing purposes. This is because most firms, who have no reason to fully allocate allcosts to a contract, will not separately identifycorporate and home office expenses. Even firms that do business with the government or are even CAScovered often do not follow the home office allocation methods discussed above for their financial, tax or GAAP reporting purposes. Accordingly, both theCAS Board and even DCAA long ago recognized thatcontractors may choose to report home office costsdifferently for contract costing purposes than thoseused to report such allocations for other reporting purposes. The term “memo records,” that are widelyaccepted by the government and its auditors, refersto the reality that government contractors needed tocreate unique costing reports for contract costingpurposes that are different from other records foundin its books of accounts such as the general ledger.The memo records, commonly spreadsheets used tocalculate home office allocations, are normally thebasis to allocate these expenses.
Was Direct Allocation of Some Costs Appropriate
Contractor incurs significant costs at its corporateheadquarters and allocates some of these costs to BU.Since BU did not have sufficient indirect resources theyused corporate administrative resources to support theWA contract. My interviews with several of thesepeople indicated the nature of activities of supportingthe WA contract by corporate personnel differedsignificantly from their normal corporate activities. For example, HR personnel performed work related torecruiting and hiring new personnel for the contractcompared to their corporate activities of administeringhealth benefits and 401(k) plans and treasury personnelhelped process and pay vendor invoices for WA workwhile its normal corporate activities consisted of cashmanagement and financial analysis.
The corporate personnel performing a significantamount of effort on WA work was a small subset of total corporate personnel. In my opinion, it wascorrect to distinguish this group of corporatepersonnel from other corporate personnel and treatthe time worked on WA work differently than the time worked on corporate matters. In fact to do otherwise would fail to accurately allocate costs to appropriatebusiness segments. If material amounts of corporatecosts can be identifiable with a specific segment CAS403 says those costs should be distributed to thebusiness segments rather than remain in either anondirect or residual pool. If, for example, allcorporate personnel were assigned to the residual pooland allocated to business segments on a proportionatebase then those segments where personnel contributeda significant portion of time would likely have anunder-allocation of costs while other segments wouldbe over-allocated. So taking the relevant subset ofcorporate personnel into a separate grouping andproportionately allocating those costs in accordancewith FAR cost principles was sound.
Replacement of Timesheets with Sales Metric
Prior to 2006, these employees, like all other indirectemployees, used timesheets to track their activities.Those time sheets were used to identify the effortrelated to WA work where the time and burdened costs for WA work was charged to BU. (Since all otherdivisions had their own indirect costs staff, the amount of corporate support for other business segments wasconsidered immaterial and not tracked.) Time notdirectly allocated to BU work was distributed to theresidual cost pool on the grounds that all remainingcosts were essentially corporate activities and henceallocable to the residual expense pool.
In 2006, it was anticipated that additional effort bycorporate personnel for BU activity would increasesubstantially with the new large WA contract. Therehad always been some concern about the accuracy ofusing timesheets to identify effort related to BU whereit was found different employees often had differentideas about what constituted BU versus corporatework, which subjected the allocation practices toassertions of inaccuracy. With the new contract it wasdetermined that having even more employeesworking on both WA and other corporate work wouldcreate even more potential inaccuracies.
Consequently, alternatives to use of timesheets toassign corporate personnel labor costs to BU weresought. The first step Contractor took was to identifythe employees who provided activities for the BUcontract work and other corporate activities andanalyze the percent of their time allocable directly toBU. The next step was to consider alternativeallocation bases that would distribute the personnel costs about proportionately to the results generatedby the analysis. A direct labor cost base was considered but rejected since direct labor did notsufficiently capture the full scope of activitiesperformed by the personnel. These personnelprovided support to all BU direct cost effort – direct labor, subcontract and other direct cost effort. It was decided an allocation base representing total activityof the business segment contracts was needed and saleswas selected because it (1) was a good surrogatemeasurement of total activity (2) was easy to identifycausing little administrative effort and (3) was notsubject to assertions of inaccuracy.
Use of timesheets are commonly the default methodof identifying effort to either business segments,segment indirect cost pools or final cost objectives.However, as it became more apparent that timesheetuse was subject to error, it was rightfully feared that theallocation of costs to BU could be suspect which likelywould have resulted in the government questioning allcosts if timesheets were deemed to be inaccurate and possibly lead them to the conclusion that Contractor’stimekeeping, labor charging and even accountingpractices were inadequate for the WA contract. I have seen this unfortunate result many times.
So was the sales metric allocation base selected reasonable? I believe it was. The allocation base selected to allocate those corporate costs that weredeemed to be allocable to BU meets the FAR requirement to select a base having a causal andbeneficial relationship with the business segments.Since the effort of this group of corporate employeessupports most direct activities related to the BU work,an allocation base representing total activities of thecontracts would be most appropriate. So, for example, it was sensible to both consider a direct laborbase and to reject it because the effort related to BUwork supported all costs of the contracts includingsubcontract costs and ODCs rather than merely directlabor effort. In my opinion, there is more than onebase that could have been selected that representedtotal activity e.g. total segment costs, cost of sales ateach segment. Though sales do not necessary reflecttotal cost activity, in this case it represents a quiteacceptable “surrogate” measurement of total activitywhich is an explicit requirement of CAS 403.
DCAA’s Objection to a Sales Allocation Base. ThoughCAS 403 is silent on the issue, in many cases, DCAAhas taken the understandable position that sales shouldnot be used as a surrogate measurement of total cost activity because sales includes varying levels of profitas well as costs. So, a contract with a relatively lowcost portion of sales but a high profit level wouldinequitably receive a disproportionately larger shareof the allocation. However, in this case, the profitrate provided in BU contracts is relatively lowcompared to its contracts in some of its other segments. Profit rates on federal cost plus fixed feecontracts are notoriously low due to the relatively lowrisk of the contract type which was certainly the casewith the WA contract. So the fact that a higherportion of sales represent actual costs compared tothe sales in other segments indicates there is actually alower allocation of the relevant corporate costs toBU compared to other business segments.
Was it appropriate to assign the remaining costs to the residual pool?
The allocation of remaining costs to the residual poolis the heart of the claim that Contractor “double dipped” or over-allocated corporate costs to BU. The auditors assert that if any contracts were covered byCAS there would be a non-compliance with CAS 403and if not CAS covered the audit report assertedseveral FAR provisions were violated including theones discussed above.
There is no question that the older timesheet systemwas in accordance with CAS 403 – in the parlance ofthe standard, it represented a combination of directidentification of some costs to business segments – those identified as BU – and the remaining costs to the residual pool.
However, when the sales metric approach wasimplemented, the auditors believe a differentapproach was taken -the adoption of the nondirectmethod in the CAS 403 terminology. This method requires the accumulation of costs into a logical pooland the allocation of those costs to benefiting segments. In this case, it could be viewed as accumulating the entire subset of corporate personnelinto one homogeneous pool and allocating them ona sales base benefiting business segments includingBU. Once this indirect allocation is made, there are no other costs left in the pool so distribution of thesecosts to the residual pool is not possible since no costsare left after allocating them to the business segments.To include these non-BU costs in a residual pool,where a portion is allocated to BU would appear torepresent an over-allocation of costs to BU.
Contractor believed otherwise. They maintained thatthe basic allocation methodology – first directly allocating those corporate costs that directly benefit abusiness segment to that business segment and then,second, distributing the remaining costs to the residualpool – had not changed. The only thing that had changedwas the method of identifying those costs that were tobe directly allocated – shifting from a less reliabletimesheet to a more accurate sales metric measurement.
I believe Contractor’s position is not only reasonablebut, in fact, has greater merit. I believe the allocation of costs using the sales metric can reasonably beviewed as providing an alternative to using timesheetsto directly allocate relevant costs to business segmentsand the remaining costs would properly be consideredresidual. My reasons are:
1. Like the earlier method, all costs identifiable to business segments are allocated to those businesssegments (which happens to be only BU since no otherbusiness segments utilized corporate personnel insupport of their contract work).
2. Neither the FAR nor CAS 403 prescribe themethod used to assign the costs directly to the segments. For example, neither timesheets nor anyother method is recommended or required. The presumption is to choose that method that mostaccurately does the job. In this case, as we discussed before, the sales metric is both an adequate surrogatemeasurement and provides more accurate results thatare less subject to auditor objections and adverseopinions than using timesheets.
3. Does use of the sales metric constitute a nondirect allocation? The government position, in the parlanceof CAS 403, is that by selecting the sales metricContractor in effect changed its methodology from acombination of direct and residual allocation to a nondirect allocation exclusively. By making thechange, all personnel costs in the “pool” had to bedistributed to business segments using the sales metric,leaving no other costs available to be assigned to theresidual pool. In fairness I do not think this positionis unreasonable but I believe Contractor’s position hasgreater merit. That is, there was no change ofapproach only the method of identifying the directportion of the allocation had changed.
4. Is it appropriate to charge the remaining costs tothe residual pool? I believe the answer to this questionlies in a determination of what were the activities of the corporate personnel. If the activities by thepersonnel in question were substantially the same, then yes, the nondirect method would apply. The costs would clearly be a homogeneous grouping of likecosts under like circumstances and allocable on a reasonable basis – the condition for nondirect allocation. However, if the activities related to supporting the segment activities, namely WA work,are substantially different than those activities forcorporate purposes then separate treatment isjustified. That is, the costs associated with WA effort should be assigned discretely to the benefittingsegment and the remaining costs associated withcorporate activities should be treated differently – inthis case, included in the residual pool.
My interviews with several of the employees indicatesclearly the latter condition is true here. That is, the activities of the corporate personnel engaged insupporting the BU contracts differ significantly fromtheir normal corporate tasks. For example, Jane Doeworked on medical and 401(k) plans at corporate butrecruiting and handling administrative efforts for newhires on WA work. John Doe worked on corporatebank reconciliation and dealing with banks at thecorporate level and worked on payments tosubcontractors, cash management forecasting andensuring cash transfers were properly made for WA.Or, Jane Doe ll worked on Accounts Payable work atcorporate but worked on several contract andsubcontract issues as well as cash reports for the WAproject.
Was it inappropriate to allocate the corporate costs without notifying employees or changing payroll records through undocumented journal entries
The assertion that costs of personnel allocated to BUwere “reclassified” from the home office to BU without “permission” from employees and withoutany visibility of these changes in relevant companyaccounting records such as payroll or timesheets isbeing asserted as not only poor cost accounting butas possible fraudulent transactions.
Based on a thorough analysis, I did not see anyinappropriate accounting. Rather, Contractor’s accounting treatment of these cost allocations fromcorporate to BU are consistent with normal homeoffice allocations practiced by most firms who allocatehome office costs for government accounting reports.
Logistics of Cost Distribution. Home office expenses areusually first booked to relevant accounts at the home office. The basis of these charges are normally sourcedocuments such as timesheets, payroll records,vendor invoices or expense reports or allocationsfrom other business units to the home office. The first step is to allocate home office expenses to therelevant business segments. Home office allocations are normally based on spreadsheet-basedcomputations where all expenses are allocated tosegments on one of the three methods of allocation – direct, nondirect and residual.
There are two common accounting treatments ofthese allocations. Most frequently, these reallocationsare for government costing purposes made as memorecords. No actual changes are made to the originalbooks of account (e.g. the original home officeaccounts) but rather are distributed on a memo basisusing a spreadsheet computation where the results arereflected in government contract reports andproposals. Other times, as is the case with Contractor, these home office allocations are actually made in thebooks of account where home office accounts are credited and the relevant receiving business segmentsand corresponding accounts within those segmentsare debited for the allocated amounts.
The same principle of distributing costs from oneaccounting entity to another is a common principleapplicable not only to corporate allocations made forgovernment costing purposes but applies for all purposes. For example, capital assets are commonlyamortized on a straight line basis for financialreporting purposes. However, depreciation costsmay be charged differently for tax purposes orgovernment accounting purposes (e.g. usingaccelerated depreciation). Another example arecomputer costs where the costs reflected on a vendorinvoice may be charged to one cost center but if thecomputer equipment is used by numerous divisionscosts may be distributed to the benefiting divisionsfor monitoring costs at the division level. These costsmay simply be distributed on a memo basis or throughactual journal entries but the invoice itself is notaltered to reflect the revised distribution of costs to multiple divisions for reporting purposes.
Changes to Accounting Documents. Whether or not home office costs are distributed only on a memo basis oractual journal entry transfers of expenses from thehome office to business segments, I have never seenany contractor actually change the source documents.In other words, the original payroll records, timesheets,invoices, expense reports are not altered, changed orsubstituted by different ones. Rather the amounts are distributed for government costing purposes.
“Permission” of Employees. The assertion that “permission” from the employee whose costs aretransferred is needed is based on a confusion of propertreatment of timesheets and cost allocations of indirect personnel costs after those costs have beenassigned to a cost pool using either memo records orjournal entries. It is true that an employee’s timesheetis sacred and there are extensive controls over them (e.g. audit trails for change, initialing any changes).However, care over timesheet accuracy has nothingto do with the accounting treatment of employee costswith respect to allocation of those costs from oneindirect pool to another. It is quite common, forexample, to reassign indirect personnel costs fromoverhead to G&A, from one division or business segment to another or from a home office to a businesssegment or vice versa. No change to the actualtimesheet is ever contemplated just as no change toan invoice for a capital asset is made if the depreciationmethod for amortizing it is altered.
RECENT DECISIONS ON TRAVEL
“Special Circumstances” Can Be Invoked if it Saves the Government Money
Rather than fly from his home in New Mexico to LosAngeles for his househunting trip in anticipation ofhis relocation, Damon found out that flying out ofNew Mexico was significantly more expensive thanflying out of Colorado so he and his family drove the500 miles and flew out of Colorado. When he submitted his claim that included miscellaneous and incidental expenses incurred in Colorado thegovernment denied them saying he was entitled totemporary lodging and M&IE expenses at the old ornew duty station and nowhere else. The Appeals Boardsupported Damon noting the travel regulations forhis agency stated he was not entitled to be reimbursedfor expenses outside of proximity of the old and newduty station “unless justified by special circumstances.”The Board rules the fact he saved the government asignificant amount of money was precisely the kindof special situation that “special circumstances”applied to (CBCA 1314-RELO).
Limits on Moving Person Vehicles
Lou Ann drove her car to her new duty station andshipped the second one by train. Her agency deniedthe cost asserting (1) she was entitled to reimbursement for only one personal owner vehicle (POV) and (2)the weight of the car should be included in themaximum weight of her household goods (HHG).The Board denied payment saying she was entitled toonly one vehicle unless she had a dependent in whichcase she was entitled to one or two (she had nodependents). However the Board rejected theargument about inclusion of the car in the HHGquoting the JTR saying HHG does not include autos,trucks, vans or similar motor vehicles (CBCA 1505RELO).
“New Hires” Entitled to Limited Relocation Reimbursement
Torralba received notification for a position at adifferent duty station where at the time he lived in ahome he owned. After receiving the notice hecompleted a contract of purchasing a house he washaving built at his old duty station. His agency rejectedhis claim for reimbursement of expenses related toselling the new house. The Board sided with his agency quoting the FTR 302-11.5 – to be reimbursedfor expenses incurred in your residence transactions,you must occupy the residence at the time you arenotified of your transfer (CBCA 1524-RELO).
(Editor’s Note. Though the Federal Travel Regulations havelimited applicability to private contractor employees, we havefrequently seen auditors question costs like those foundunallowable below on the grounds the FTRs do not allow it.
The following case illustrates the need for contractors to explicitlyidentify costs that will be reimbursable in their company policieswhere if they are not, the FTR will often become the “default”regulation in the eyes of auditors.)
Evester resigned from a government position in Aug2006 and was hired by another Department in Oct2006. His claim for relocation included temporaryquarters, storage expenses, mileage expenses for hisspouse, miscellaneous expenses and real estatetransaction costs for his move to Washington DC.His agency denied the real estate transaction costsasserting he was a “new hire” which in accordancewith 5 USC Section 5720 excluded such costs for new hires. The Board agreed he met the definition of anew hire – first appointed as well as appointed after abreak in government service – and though he wasentitled to most of his relocation costs those did not include real estate transactions expenses (CBCA 1582RELO).
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