Cost Accounting Standards Board; Treatment of Gains or Losses Subsequent to Mergers or Business Combinations by Government Contractors

OFFICE OF MANAGEMENT AND BUDGET

48 CFR Part 9904

Cost Accounting Standards Board; Treatment of Gains or Losses

Subsequent to Mergers or Business Combinations by Government

Contractors

AGENCY: Cost Accounting Standards Board, Office of Federal Procurement

Policy, OMB.

ACTION: Advance notice of proposed rulemaking (ANPRM).

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SUMMARY: The Office of Federal Procurement Policy, Cost Accounting

Standards Board (CASB), proposes to amend the Cost Accounting Standards

relating to treatment of gains or losses attributable to tangible

capital assets subsequent to mergers or business combinations by

government contractors.

To resolve the problems that have been identified in this area, the

Board proposes to amend CAS 404, ``Capitalization of Tangible Assets''

and CAS 409, ``Depreciation of Tangible Capital Assets''. The proposed

amendments are based on an approach involving a ``no step-up, no step-

down'' of asset bases and no recognition of gain or loss on a transfer

of assets following a business combination by contractors subject to

CAS.

Section 26(g)(1) of the Office of Federal Procurement Policy Act

requires that the Board, prior to the promulgation of any new or

revised Cost Accounting Standard, publish a report and an ANPRM. This

ANPRM addresses the Board's proposal to amend CAS 404 and CAS 409 to

deal with the issue of gains and losses subsequent to a merger or

business combination.

DATES: Comments should be received by July 25, 1994.

ADDRESSES: Comments should be addressed to Dr. Rein Abel, Director of

Research, Cost Accounting Standards Board, Office of Federal

Procurement Policy, 725 17th Street, NW., room 9001, Washington, DC

20503: Attn: CASB Docket No. 91-06(2).

FOR FURTHER INFORMATION CONTACT:

Dr. Rein Abel, Director of Research, Cost Accounting Standards Board

(telephone 202-395-3254).

SUPPLEMENTARY INFORMATION:

A. Regulatory Process

The Cost Accounting Standards Board's rules and regulations are

codified at 48 CFR chapter 99. Section 26(g)(1) of the Office of

Federal Procurement Policy Act, 41 U.S.C. 422(g)(1), requires that the

Board, prior to the establishment of any new or revised Cost Accounting

Standard, complete a prescribed rulemaking process. This process

consists of the following four steps:

1. Consult with interested persons concerning the advantages,

disadvantages and improvements anticipated in the pricing and

administration of government contracts as a result of a proposed

Standard.

2. Promulgate an Advance Notice of Proposed Rulemaking.

3. Promulgate a Notice of Proposed Rulemaking.

4. Promulgate a Final Rule.

This proposal is step two in the four step process.

B. Background and Report

Prior Promulgations

The issues addressed in this proposal were first identified by

commenters in response to the Board's request for suggested agenda

topics in November 1990. Subsequently two Staff Discussion Papers (SDP)

were issued.

The first, dated August 26, 1991 and titled ``Recognition and

Pricing of Changing Asset Values Resulting from Mergers and Business

Combination by Government Contractors,'' raised some broader issues

such as the scope of the proposed project, the basis for any Government

claim to gains or losses resulting from a business combination and the

likely economic consequences of a policy that would prohibit

revaluation of assets following a merger.

The responses to this SDP were used by the Board as basis for

discussing the basic issues involved in this case. As a result of this

discussion, the Board decided to issue a second SDP dealing with a

series of questions mostly concerning the specific procedures needed to

deal effectively with the recognition, allocation and recovery of the

gain or loss subsequent to a merger or business combination. The second

SDP, titled ``Treatment of Gains or Losses Subsequent to Mergers or

Business Combinations by Government Contractors,'' was issued on

November 4, 1993. The responses to this SDP were of significant

assistance to the Board in developing the current ANPRM.

Public Comments

Fifteen sets of public comments were received. Three of these were

from government agencies, five from government contractors, four from

trade and professional associations and three from individuals and

other commenters. The comments were most useful to the Board in its

decision-making process and, represented a wide spectrum of views on

the various issues that were raised. The SDP included a series of

questions dealing with the measurement of the gain or loss subsequent

to a merger or business combination, its allocation between the

government and the contractor and the possible methods of recovery that

the government could employ in trying to recover its share of a gain or

loss. In many instances, the responses to these questions indicated

that the commenters believed that a comprehensive and equitable process

of allocating gains or losses between the Government and contractors

would entail use of complex and cumbersome procedures that would add

significantly to the implementation cost of any Standard that would

sanction revaluation of tangible capital assets subsequent to a merger

or business combination. The comments that were received are discussed

below in greater detail, under Section E., Public Comments. The Board

and the CASB staff express their appreciation for the thoughtful and

generally constructive responses provided by the commenters.

Benefits

After consideration of all the comments received, the Board

believes that amendments to CAS 404, Capitalization of Tangible Assets,

and CAS 409, Depreciation of Tangible Capital Assets, as set forth in

this ANPRM will significantly improve and clarify the implementation of

CAS and related procurement regulations in accounting for tangible

capital assets after a merger or business combination. In particular,

the Board believes that a clean-cut resolution of this issue, as

proposed in the ANPRM, will clarify the ambiguities that currently

exist in this area and thus should lead at least to some reduction in

the present confrontational negotiations and litigation in this area.

This point is of particular significance in the current economic and

budgetary environment where further reductions in the defense budget

can be expected to lead to further mergers and business combinations

among defense contractors. The Board believes that potential benefits

to the audit, negotiations, and general contract administration

processes occurring from the added clarity and uniformity in the

measurement of the cost of depreciation and cost of money subsequent to

a business combination will be substantial and will greatly outweigh

any added costs.

Summary of Proposed Amendments

A brief description of the proposed amendments follows:

a. The current subsection 9904.404-50(d) is deleted and is replaced

by an amended section that prescribes:

(1) that for Federal Government contract costing purposes tangible

capital assets after a business combination shall retain their net book

value recognized prior to the business combination provided that the

assets had previously generated costs that were chargeable to Federal

Government contracts subject to CAS.

(2) That the cost of tangible capital assets shall be restated

after the business combination at a figure not to exceed the fair value

at the date of the acquisition pursuant to a business combination where

the assets prior to the business combination did not generate costs

that were chargeable to Federal Government contracts subject to CAS.

b. A new subparagraph 9904.409-50(j)(5), is added to current

subsection 9904.409-50(j). The purpose of this new subparagraph is to

make it clear that the CAS 409 provisions dealing with the recapture of

gains and losses on disposition of tangible capital assets should not

apply when assets are transferred subsequent to a business combination.

C. Paperwork Reduction Act

The Paperwork Reduction Act, Public Law 96-511, does not apply to

this proposal, and any associated rulemaking, because this proposal

would impose no paperwork burden on offerors, affected contractors and

subcontractors, or members of the public which require the approval of

OMB under 44 U.S.C. 3501, et seq.

D. Executive Order 12866 and the Regulatory Flexibility Act

The economic impact of this proposal on contractors and

subcontractors is expected to be minor. As a result, the Chairman has

determined that this ANPRM will not result in the promulgation of a

``major rule'' under the provisions of Executive Order 12866, and that

a regulatory impact analysis will not be required. Furthermore, this

proposal will not have a significant effect on a substantial number of

small entities because small businesses are exempt from the application

of the Cost Accounting Standards. Therefore, this proposed rule does

not require a regulatory flexibility analysis under the Regulatory

Flexibility Act of 1980.

E. Public Comments

This ANPRM was developed taking into account the comments received

to the issue raised in the Staff Discussion Paper made available for

public comment on November 4, 1993. The comments have provided valuable

input to the Board's rulemaking process. The comments received and the

action taken by the Board are summarized in the paragraphs that follow:

Comment: In response to a question on the relationship between CAS

and Generally Accepted Accounting Principles (GAAP) most commenters

agreed that the Board should utilize GAAP to the greatest practical

extent, but nevertheless, the Board clearly has the authority to depart

from GAAP when deemed necessary to meet the Board's objectives.

Response: The Board is in agreement with the comment.

Comment: In response to a question as to the level of aggregation

of individual asset values that might be used as a basis for

establishing ``fair values'' for tangible capital assets, a number of

comments pointed out that the current definitions of ``asset

accountability unit'' in 9904.404-30(a)(1) would be an adequate basis

for determining the detail required. They also pointed out that asset

groupings are already adequately covered in 9904.409-50(d) and in the

relevant illustrations 9904.409-60(a) (2) and (3).

Response: The Board is in agreement with this comment.

Comment: A great variety of comments were received in response to a

question as to whether the current 9904.409-50(j)(1) cap on government

recovery in the form of accumulated depreciation, should be also

applied to gains and losses recognized subsequent to a revaluation of

assets pursuant to a business combination. About half of the commenters

believe that the current cap should be also applied to gains related to

assets acquired in the course of a business combination. A significant

number of other commenters believe, however, that no such cap should be

applied in these circumstances. One commenter advocated a modified cap

that would recognize the element of inflation in the gain. Another

commenter stressed that the Government should share not only any gains,

but also in any losses that may emerge.

Response: The Board has considered the merits of a cap adjusted for

inflation. However, the actual calculations to establish such a

modified cap seem to require establishment of a fairly complex and

possibly cumbersome procedure.

The Board agrees with the commenter who stated that the Government

should participate in losses as well as in gains.

Comment: On the question as to whether the cap should be modified

to take into account cost of money paid in the past, the views of

commenters were clearly divided. The government commenters believed

that there should be some accounting for past cost of money payments

whereas all the other commenters did not think that any modification in

the cap was warranted. However, most commenters recognized, that any

attempt to modify the cap for cost of money would be complex and

extremely difficult to compute in practice.

Response: The Board agrees that any adequate process that could be

developed to modify the current cap on government recovery for the past

payments of cost of money would be complex and difficult to compute.

Comment: With respect to the conceptual argument as to who, the

contractor or the Government should retain the ``gain'' due to

inflation, there was no clear-cut agreement. In general, the government

commenters stated that the government was entitled to any gain

attributable to inflation on account of past cost of money payments.

The industry commenters generally disagreed, although on a conceptual

plane there were one or two exceptions.

One industry commenter pointed out, once again, that if the

Government wishes to share in the gain, it should be also willing to

share in the losses.

One commenter stated that there should be no attempt to try to

implement inflation accounting on a piecemeal basis. If it is to be

done, then asset bases should also be revalued.

However, the overwhelming majority of the commenters indicated that

whatever the arguments regarding the merit of recognizing inflationary

gains, in practice the procedures needed to implement such inflationary

adjustments would be so cumbersome and complex as to render the whole

system unworkable.

Response: The Board agrees with the commenters who state that the

calculation of any inflationary adjustment would be a cumbersome and

complex procedure.

Comment: When responding to the request in the SDP for suggestions

regarding basis for allocation of gains or losses between government

and contractors, virtually all of the commenters recognized the

construction of an index or some other factor to reflect the historical

usage of assets on CAS-covered work as contrasted with other work would

be impractical and the costs involved would clearly exceed any possible

benefits.

Three comments suggested that, in any event, it would be contrary

to the current CAS provisions to try to allocate the gain or loss on

the basis of historical usage. They point out that current CAS 409,

415, and 416, in effect, use the current activity as the base for

allocating adjustments related to the past cost measurements. Thus,

these commenters maintain that a charge against the current period

costs is all that is required.

Three other commenters suggested that it may be possible to use a

form of advance agreement that would establish, in conjunction with

incurred cost settlements or submission, the ratio of CAS/non-CAS work

at the indirect cost pool level.

It was also pointed out that no attempts at allocation should be

undertaken when the contractor is essentially all CAS covered or all

non-CAS covered, e.g., 85% or more in either category.

Response: The Board agrees with the commenters that it would be

difficult to develop an equitable and reliable, as well as, economical

basis for establishing the past usage of assets in CAS work as

contrasted with non-CAS work.

Comment: Most commenters indicated that gains or losses

attributable to misestimating of the residual value of assets

transferred in a business combination should not be treated differently

from other gains or losses attributable to assets transferred.

Several commenters pointed out, that in any event, it would be

difficult, if not impossible, to determine the amount of ``misestimated

residual value.''

Some commenters also expressed a belief that the question raised is

based on a false premise. Residual value is a concept based on

historical cost and enters into the process of determining depreciation

costs (an allocation process), whereas gains or losses based on fair

values subsequent to a business combination are derived from current

values (valuation process). Therefore, residual value should not be

compared to disposition value.

Nevertheless, a few commenters recognized the significant

discrepancy between the original residual value and the fair value

established subsequent to a business combination, may indicate a

misestimation in the residual value which could be interpreted as a CAS

non-compliance.

Response: The Board appreciates the input of comments who responded

to this issue. It notes the comments that indicate that it may be

difficult to separate the consequences of misestimates in residual

values from changes in fair values when assets are transferred in the

course of a business combination.

Comment: Practically all the commenters recognized that subsequent

to a business combination the government may have a clear-cut claim

against the seller.

A number of industry comments expressed the belief that the

government has a valid claim only to the extent that there have been

erroneous estimates of depreciation in the past.

A significant number of comments did recognize, however, that

subsequent to a business combination the relationship between the

government and the seller may dissolve. In those cases, it was

suggested that appropriate notation agreements should be negotiated

with the buyer. The government comments, in particular, stressed that

if the claim cannot be successfully pursued against the seller, then

there must be alternative ways of pursuing the claim, such as

proceeding against the buyer or trying to collect from the proceeds of

the acquisition.

Response: The Board notes the comment that the government may have

difficulties in pursing to claim against the original owner of the

assets if subsequent to a business combination there is no longer a

business relationship between the government and the seller.

Comment: The commenters on the whole, did not support the notion

that the government should recover its share of gain or loss subsequent

to asset revaluation from the buyer. Some comments pointed out that

such a gain or loss recovery is a contract administration issue and not

an accounting matter. It was also suggested that the matter might be

best dealt with at the time when novation and advance agreements are

negotiated between the government and the contractor.

Repsonse: The Board has taken note of the comments received on this

topic.

Comment: The last issue raised in the SDP concerned the

advisability of retaining the original asset base subsequent to the

business combination in view of the complex and costly procedures that

would have to be developed to share any gain or loss, attributable to

asset revaluation, between the government and the contractor.

There was a clear divergence of views on this topic between the

government commenters and other comments. All the government responses

indicated that assets should be not revalued subsequent to a business

combination. All the other comments expressed the views that such a

revaluation should be carried out and recognized for government

contract costing purposes. One industry comment did point out, however,

that the assets should not be revaluated if the business combination

takes the form of acquisition of shares rather than assets.

Several commenters pointed out that in any event the apparent

conflict between CAS and the Federal Acquisition Regulation (FAR)

should be eliminated. It was also pointed out that the government

should be consisted in its application of cost accounting practices in

this area. It should either allow revaluation of assets subsequent to

business combinations and then deal with the resulting gain and loss

issues, or adopt practices based on not revaluing assets and limiting

depreciation and gains and losses to historical costs without regard to

business combinations.

Response: The Board agrees with the commenters who stated or

inferred that in case of asset revaluations subsequent to a business

combination the procedures involved to develop an adequate and

equitable method to share the gain or loss between the government and

the contractor would be complex and costly. At the same time, the Board

does not agree with those commenters who maintain that the government

is not entitled to any share in the gain or loss subsequent to asset

revaluation because such a gain or loss can only accrue to a party that

bears the risk of ownership, i.e., the contractor. The Board believes

that in a business environment where cost-based pricing prevails, which

includes an allowance for cost of money, and long-term contractual

relationshps are the norm, the buyer, i.e., the government, has a sound

claim to the benefits that may emerge as the tangible capital asset

values increase in response to the interaction of various market

forces. Conversely, the Board also believes that if the government is

entitled to the benefits that may emerge as the asset values increase,

it should also be prepared to bear the additional costs when the asset

values are decreasing.

Therefore, the Board has concluded that in light of the complexity

of the procedures that are needed to deal with the revaluation of

assets and the subsequent sharing of ensuing gains and losses, the most

acceptable course to follow in pursuit of its objectives is to retain

the original asset acquisition cost as a base for calculating contract

costs after a business combination or merger has taken place.

List of Subjects in 48 CFR Part 9904

Cost accounting standards, Government procurement.

Steven Kelman,

Administrator for Federal Procurement Policy, and Chairman, Cost

Accounting Standards Board.

Accordingly, it is proposed to amend 48 CFR part 9904 as follows:

PART 9904--COST ACCOUNTING STANDARDS

1. The authority citation for part 9904 continues to read as

follows:

Authority: Public Law 100-679, 102 Stat. 4056, 41. U.S.C.

Sec. 422.

9904.404 [Amended]

2. Section 9904.50 is proposed to be amended by revising paragraph

(d) to read as follows:

9904.404-50 Techniques for application.

* * * * *

(d) Under the ``purchase method'' of accounting for business

combinations, tangible capital assets acquired shall be assigned

acquisition costs for Federal Government contract costing purposes as

follows:

(1) Where the assets prior to the business combination generated

costs that were chargeable to Federal Government contracts subject to

CAS, the assigned acquisition cost of tangible capital assets after the

business combination shall be their net book value, recognized for

Federal Government contract costing purposes, immediately prior to

entering into the business combination.

(2) Where the assets prior to business combinations did not

generate costs that were chargeable to Federal Government contracts

subject to CAS, the assigned acquisition costs of tangible capital

assets after the business combinations shall be a portion of the cost

of the acquired company, not to exceed their fair value at date of

acquisition. Where the fair value of identifiable acquired assets less

liabilities assumed exceeds the purchase price of the acquired company

in an acquisition under the ``purchase method,'' the value otherwise

assignable to tangible capital assets shall be reduced by a

proportionate part of the excess.

* * * * *

9904.409 [Amended]

3. Section 9904.409-50 is proposed to be amended by adding a new

paragraph (j)(5) to read as follows:

9904.409-50 Techniques for application.

* * * * *

(j) * * *

(5) The provisions of 9904.409-50(j) do not apply to tangible

capital assets transfers resulting from a business combination. The

carrying values of those assets subsequent to such a business

combination shall be established in accordance with the provisions of

9904.404-50(d).

* * * * *

[FR Doc. 94-12594 Filed 5-23-94; 8:45 am]

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