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

OFFICE OF MANAGEMENT AND BUDGET

Office of Federal Procurement Policy

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: Notice of proposed rulemaking.

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summary: The Office of Federal Procurement Policy, Cost Accounting

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

(CAS) 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 9904.404, ``Capitalization of Tangible

Assets'' and CAS 9904.409, ``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 Notice of Proposed

Rulemaking (NPRM). This NPRM addresses the Board's proposal to amend

CAS 9904.404 and CAS 9904.409 to deal with the issue of gains and

losses subsequent to a merger or business combination.

dates: Comments should be received by May 8, 1995.

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. 91-06N.

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 [[Page 12726]] 26(g)(1) of the

Office of Federal Procurement Policy Act, 41 U.S.C. Sec. 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 three in the four step process.

B. Background

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

(SDPs) were issued.

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

Pricing of Changing Capital Asset Values Resulting from Mergers and

Business Combination by Government Contractors.'' (56 FR 42079) raised

broad 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 the 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 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,

entitled ``Treatment of Gains or Losses Subsequent to Mergers or

Business Combinations by Government Contractors,'' was issued on

November 4, 1993 (58 FR 58882). On the basis of comments received to

the SDP, an Advance Notice of Proposed Rulemaking (ANPRM) was developed

and published in the Federal Register on August 24, 1994 (59 FR 26774).

The responses to the ANPRM were of significant assistance to the Board

in developing this NPRM.

Public Comments

Fourteen sets of public comments were received from government

contractors, professional and industrial associations, Federal

agencies, and accounting and consulting firms.

All three Government commenters supported the basic approach and

format incorporated in the ANPRM. All the other commenters, with one

exception, were clearly opposed to the basic approach adopted in the

ANPRM., i.e., the no step-up, no step-down approach. One industry

commenter, although critical of the ANPRM, did not reject its basic

approach out of hand and reserved his most critical comments to the

current FAR provision that, in effect, sanctions the use of

``historical cost or fair value, whichever is lower'' principle in

cases of mergers or business combinations.

Irrespective of their support or opposition to the basic approach

incorporated in the ANPRM, a number of commenters offered additional,

detailed comments on the various specific provisions of the document.

Some of these comments were clearly editorial while others were more

substantive in nature.

These comments are discussed below in greater detail, under Section

E., Public Comments. The Board and the CASB staff express their

appreciation for the generally constructive and thoughtful responses

provided by the commenters.

Benefits

After consideration of all the comments received in response to the

ANPRM, the Board continues to believe that amendments to CAS 9904.404,

``Capitalization of Tangible Assets,'' and CAS 9904.409, ``Depreciation

of Tangible Capital Assets,'' as set forth in the ANPRM and essentially

restated in this NPRM, will significantly improve and clarify the

implementation of CAS and related procurement regulations in accounting

for tangible capital assets after completion of a merger or business

combination. In particular, the Board continues to believe that the

proposal embodied in this NPRM will clarify the current ambiguities in

this area and thus should lead to reductions in negotiations and

litigation. 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 additional mergers and

business combinations among defense contractors. The Board believes

that the potential benefit to the audit, negotiation, and general

contract administration processes accruing 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 contract costing purposes tangible capital

assets following 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 charged either as

direct or indirect costs 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 charged either as direct or indirect costs to Federal

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 9904.409 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 Board 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 [[Page 12727]] 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 NPRM was developed after consideration of the public comments

received in response to the Board's ANPRM published on May 24, 1994 (59

FR 26774). 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: Most non-Government commenters disagreed with the Board's

proposed ``no step-up, no step-down'' approach. They opposed the

exception from generally accepted accounting principles (GAAP) and

expressed the opinion that the proposed approach does not represent

sound accounting. They also pointed out that the proposed approach

would lead to inconsistencies in the accounting practices applied in

cases of CAS-covered contracts as contrasted with non-CAS-covered

contracts. In general, the alternative approaches suggested involved

either continuation of the ``status quo'', combined with proposals to

rescind FAR 31.205-52, or suggestions to explore ways to insure that

the government participates, when appropriate, in gains and losses

recognized from assets involved in mergers or business combinations.

Response: The Board adopted the ``no step-up no step-down''

approach after extensive consideration of the possible alternative

approaches. In particular, the issues associated with the recognition,

allocation and recovery of the gain or loss subsequent to a merger or

business combination were extensively explored in a Staff Discussion

Paper (SDP) entitled ``Treatment of Gains or Losses Subsequent to

Mergers or Business Combinations by Government Contractors''. It was

only after careful consideration of the responses to this SDP that the

Board decided to proceed with the ``no step-up, no step-down''

approach.

The Board cannot agree with the suggestions that the status quo

should be, in essence, maintained. The issues addressed in this

proposal were first identified as significant issues by commenters in

responses to the Board's request for suggested agenda topics in

November 1990. Furthermore, the FAR 31.205-52 provisions, which are

part of the current regulatory environment in this area, have been

generally recognized as leading to inequitable consequences from the

perspective of contractors. One commenter stated: ``* * * the FAR

provision not only suffers from implementation and transition problems,

but as written is patently unfair by using historical costs when the

purchase method indicates increased asset values and using the purchase

cost when it is lower than the historical values. This allows the

government to choose the method of accounting which is most cost

beneficial to it.'' Given these circumstance, the Board cannot agree

that ``no action'' is the proper course to follow in this instance.

Comment: Several commenters discussed the need to solve the

apparent conflict between the CAS allocability provisions and the

Federal Acquisition Regulation (FAR) allowability provisions in this

area. In particular, it was suggested the OFPP Administrator address

any continuing conflict between the Cost Accounting Standards and FAR

31.205-52 pursuant to the authority conferred on the Administrator by

41 U.S.C. 422(j)(3).

Response: The Board is aware of the apparent conflict between the

provisions of CAS 9904.404 and FAR 31.205-52. Once the proposed

amendment to CAS has been promulgated, the OFPP Administrator will

determine whether any changes may be necessary in the FAR cost

principles to make them fully compatible with the amended CAS 9904.404

and 9904.409.

Comment: Several commenters stated that the proposed amendment is

unfair to contractors as it would prevent them from recouping their

investments through future contract prices. In particular, the contrast

was drawn between the acquisition of individual assets through purchase

and the acquisition of assets as part of a business combination. In one

case, the GAAP rules regarding acquisition cost would be followed,

whereas in the other, the new CAS rule would mandate adherence to

historical cost.

Response: It is the intent of the Board to apply the proposed

amendments to CAS 9904.404 and 9904.409 on a prospective basis only.

Therefore, any assets acquired in business combinations that have been

concluded prior to the promulgation of these amendments will not be

affected by the proposed changes in CAS. As to business combination

taking place after the promulgation of the amendments, it is assumed

that the parties involved will take into account, while negotiating the

merger agreement, that any future depreciation chargeable to Government

contracts and corresponding cash flow projections, will be based on the

historical costs of the tangible capital assets being transferred in

the course of the merger.

As to the treatment of purchased assets in contrast to assets

acquired through a business combination, it should be pointed out that

in cases of individual tangible capital assets acquired from a CAS-

covered contractor, any gain or loss from such a sale would be subject

to recapture by the Government in accordance with the provisions of CAS

9904.409-50(j). It is precisely because the Board concluded that such a

recapture would be impractical in cases of business combinations that

it decided to proceed with the ``no step-up, no step-down'' approach in

the proposed amendments.

Comment: One commenter argued that any Government claim to a share

in a gain resulting from changes in asset values due to price level

changes cannot be justified on the basis of payment of cost of money as

a government contract cost. The commenter argued that cost of money was

introduced as an offset to profit and therefore should not have an

impact on cost measurement.

Response: At the time the CASB separately recognized cost of money

in CAS 9904.414 as an imputed contract cost, it clearly acknowledged

that prior to the promulgation of that Standard, this cost element had

been a ``consideration in determining contract profit compensation.''

However, this acknowledgement did not imply that the Board regarded

cost of money as being part of, or having the characteristics of

profit. It clearly recognized pre-CAS 9904.414 cost of money as an

element of cost that implicitly was recognized as part of profit. CAS

9904.414 merely turned an implicitly recognized cost into an explicitly

recognized cost.

Comment: Several commenters suggested that some type of materiality

or significance criterion should be introduced to deal with those

instances where the acquired entity has allocated only immaterial

amounts of assets costs to CAS-covered contracts prior to the business

combination or where such allocations were not made during the cost

accounting period immediately preceding the business combination

although they may have been made in the course of earlier periods.

Response: CAS 9904.404 and 9904.409 apply only in the case of full

CAS coverage. Therefore, after the recent changes in the applicability

criteria, the threshold for full CAS coverage has been increased to $25

million in contract awards during a cost accounting period. It is hard

to conceive [[Page 12728]] of circumstances where such an amount in

contract awards would result, on a consistent basis, in insignificant

depreciation and/or cost of money charges.

Comment: Some commenters believed that the term ``generated costs

chargeable'' was too ambiguous.

Response: The word ``chargeable'' has been replaced by ``charged

either as direct cost or as indirect cost''.

Comment: Several commenters were concerned about the perceived

potential recordkeeping burden including massive studies and protracted

audits.

Response: When CAS has been applied continuously, the proposed

amendments do not create any need for new or additional data regarding

tangible capital assets. The only requirement is that records regarding

the net book values that were maintained prior to the business

combination should be retained and kept up to date after the business

combination.

It is only when the contractor believes that the historical costs

used for CAS purposes do not represent the fair value to be used for

financial reporting purposes that the creation of additional records

(or at least additional entries on existing records) becomes necessary.

Comment: One commenter stated that an adequate definition of

``business combination'' is required.

Response: ``Business combination'' and ``purchase method'' are

financial accounting terms that are already used in the current version

of CAS 9904.404. CAS uses these terms in a derivative sense, i.e., it

prescribes certain courses of action when events so described have been

recognized for financial reporting purposes. The CASB is not an

originator of these terms.

Comment: One commenter suggested that issues dealt with in the

proposed amendment also apply to intangible assets and that these

should also be addressed in this proposal.

Response: The proposed amendments are necessarily a part of CAS

9904.404 and 9904.409. Since the application of these two Standards is

limited to tangible capital assets, the proposed amendment is not a

suitable vehicle for extending the coverage to intangible assets. A

separate project on intangible assets would be necessary for such a

purpose.

Comment: One commenter in particular offered extensive editorial

comments on the proposed amendments.

Response: Most of these editorial comments were accepted.

List of Subjects in 48 CFR Part 9904

Cost accounting standards, Government procurement.

Richard C. Loeb,

Executive Secretary, Cost Accounting Standards Board.

For the reasons set forth in this preamble, chapter 99 of title 48

of the Code of Federal Regulations is proposed to be amended as set

forth below:

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

follows:

Authority: Public Law 100-679, 102 Stat. 4056, 41 U.S.C. 422.

PART 9904--COST ACCOUNTING STANDARDS

9904.404 Capitalization of tangible assets.

2. Section 9904.404-50 is proposed to be amended by revising

paragraph (d) to read as follows:

9904.404-50 Techniques for application.

* * * * *

(d) For Federal Government contract costing purposes, acquisition

costs of tangible capital assets acquired in a business combination and

accounted for under the ``purchase method'' of accounting shall be

assigned to these assets as follows:

(1) Tangible capital assets that generated costs charged either as

direct costs or as indirect costs to Federal Government contracts prior

to a business combination shall retain the same net book value(s)

subsequent to a business combination as if the business combination had

not taken place.

(2) Where acquired tangible capital asset(s) did not generate costs

that were charged to Federal contracts subject to CAS at the time of

the business combination, the asset(s) shall be assigned a portion of

the cost of the acquired company not to exceed their fair value(s) at

the date of acquisition. When 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.

* * * * *

3. Section 9904.404-63 is proposed to be amended by designating the

existing paragraph as (a) and by adding a new paragraph (b) to read as

follows:

9904.404-63 Effective date.

(a) * * *

(b) The effective date of 9904.404-50(d) is [30 days after date of

publication of the final rule in the Federal Register].

4. 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 this subsection 9904.409-50(j) do not apply

to business combinations. The carrying values of tangible capital

assets subsequent to a business combination shall be established in

accordance with the provisions of 9904.404-50(d).

* * * * *

6. Section 9904.409-63 is proposed to be amended by designating the

existing paragraph as (a) and by adding a new paragraph (b) to read as

follows:

9904.409-63 Effective date.

(a) * * *

(b) The effective date of 9904.409-50(j)(5), is [30 days after date

of publication of the final rule in the Federal Register].

[FR Doc. 95-5566 Filed 3-7-95; 8:45 am]

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