Government contractors are rapidly approaching the date when generally accepted accounting principles ("GAAP") will require them to capitalize the costs they incur to develop or obtain software for the company's internal use. The new rule is inconsistent with certain requirements of the Federal Acquisition Regulation ("FAR") and the Cost Accounting Standards ("CAS"). However, contractors wishing to avoid the need to account for the same costs using two different accounting methods may be able to show that these inconsistencies are immaterial and do not require separate accounting practices to comply with government contracts regulations.
Complying with the new rule may require contractors to change their accounting practices. Contractors may be required to provide notice to the government of any such change and to resolve any cost impacts on CAS-covered contracts.
I. THE NEW REQUIREMENTS UNDER SOP 98-1
For fiscal years beginning after December 15, 1998, contractors are subject to Statement of Position ("SOP") 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use," issued by the American Institute of Certified Public Accountants on March 4, 1998. SOP 98-1 requires companies to capitalize, instead of expense, the cost incurred to obtain or develop software for the company's internal use. The new rule defines the type of software effort that is subject to the capitalization requirement and should be reviewed carefully. Capitalized costs are to be amortized on a straight-line basis, unless another basis, such as an accelerated amortization schedule, better represents the expected usefulness of the software. The estimated useful life should consider obsolescence and other economic factors that can contribute to a relatively short useful life.
SOP-98 limits capitalized costs to the following types of costs that have been incurred to develop or obtain internal-use software:
External direct costs of materials and services. Payroll and payroll-related costs (e.g., benefits) for employees working directly on the software project. Interest costs incurred while developing internal-use software.
General and administrative ("G&A") costs and other overhead costs are expressly excluded from the costs that may be capitalized.
II. CONFLICTS BETWEEN SOP 98-1 AND
GOVERNMENT CONTRACTS REGULATIONS
The requirements of SOP 98-1 are inconsistent with the FAR and CAS in two respects. First, capitalized costs under SOP 98-1 may not include G&A or overhead, with the exception of payroll related costs for direct labor. However, both the FAR and CAS require contractors to allocate indirect costs to all benefiting cost objectives, which will force contractors to allocate all applicable indirect costs to the direct costs of an internal-use software project. Second, interest costs on borrowings that may be made to finance an internal-use software project are expressly unallowable under the FAR cost principles and, therefore, must be separately identified and removed from allocations to government contracts.
Compliance with SOP 98-1 presents some potential difficulties for contractors. To comply with SOP 98-1, contractors must capitalize only a portion of the costs attributable, under FAR and CAS rules, to the software project. Further, SOP 98-1 requires contractors to capitalize interest costs that cannot be charged to the government. These difficulties have at least two potential resolutions, one that is administratively burdensome and the other that is less burdensome.
III. POTENTIAL RESOLUTIONS
Under certain circumstances, there may be no difference in the costs of an internal-use software project under SOP 98-1 and under government contracts accounting regulations. This could occur if there are no indirect costs allocable to in-house labor (except fringe benefits) or outside purchases for the project, no interest expense applies to the project, and no cost of money is claimed. A software development project could be viewed as similar to an IR&D project which, under CAS 420, does not receive an allocation of G&A expenses because the project benefits the company as a whole. Moreover, an in-house software effort may be performed by a management information systems group whose costs receive no allocation of overhead costs and are included entirely in G&A under the contractor's accepted accounting practices.
Where the accounting required by SOP 98-1 differs from the accounting required by government regulations, an obvious approach to complying with both requirements is to account for the costs using two accounting methods. One method, which complies with SOP 98-1, would be used for financial reporting purposes and would exclude allocable G&A and overhead costs, but would include interest costs. The other method, for government contracts costing, would include allocable G&A and overhead costs, exclude unallowable interest costs, and include the allowable amount for cost of money under FAR 31.205-10(b) (for intangible capital assets being developed). Although SOP 98-1 prohibits capitalizing G&A and overhead costs for financial reporting, those costs theoretically should be capitalized for government contracts costing because CAS, which requires the allocation of such costs, applies in the event of a conflict with GAAP. Because the direct costs must be capitalized, the indirect costs presumably must be treated in the same manner.
The dual accounting method described above clearly represents an administrative burden on contractors. However, audit guidance issued by the Defense Contract Audit Agency ("DCAA") has suggested an approach that may permit contractors under certain circumstances to use their financial accounting practices under SOP 98-1 for government contracts costing and, thus, eliminate the need to establish government-unique accounting practices for these costs.
DCAA audit guidance, issued on July 22, 1998 (98-PAC-113(R)), suggests that auditors should work with the contracting officer regarding how best to address the inconsistency between SOP 98-1 and CAS regarding overhead costs "without unduly burdening the contractor or the government." In this connection, auditors are directed to consider the materiality of G&A and overhead costs allocable to capitalized software costs. DCAA Headquarters apparently recognizes that maintaining and auditing a dual accounting system for these costs may cost the government more than any potential increases in contract pricing the government is likely to experience by not capitalizing the G&A and overhead costs. The DCAA guidance also suggests that capitalized interest cost, while unallowable, may not be materially different than the cost of money, which is allowable if calculated in accordance with CAS 417.
DCAA apparently is prepared to accept the contractor's cost accounting practices under SOP 98-1 for government contract cost accounting purposes, if the difference in costs allocated government contracts is demonstrated to be immaterial. Therefore, contractors wishing to avoid the need to follow two different account procedures for these costs should be prepared to provide such a demonstration. This demonstration should compare forecasted G&A and overhead rates under accounting procedures that comply with SOP 98-1 with rates using procedures that comply with CAS and FAR, described above. The CAS and FAR compliant procedures should include additional estimated costs to implement the dual accounting method, including increased audit support. Unless an internal-use software development project represents a large percentage of a contractor's material and labor dollar bases, there likely will be little, if any, difference in G&A and overhead rates between the SOP 98-1 and CAS-compliant accounting methods. Contractors should highlight to their local auditors the direction given in their own guidance to consider materiality issues in assessing the contractor's accounting practices for these costs.
Contractors subject to CAS also should note that any change in accounting practices made to comply with SOP 98-1 triggers the requirement to provide a description and general dollar magnitude of the change 60 days before implementing the change. The change could result in increased costs to the government and a requirement to adjust the prices of CAS-covered contracts downward. On the other hand, the change could actually reduce the contractor's recovery of costs under its CAS-covered contracts. This could occur, for example, where a fixed-price contract receives a higher allocation of costs under the new accounting practice and, thus, would have been negotiated at a higher price had the parties known at the time of award of the requirement to change accounting practices. In this case, the contractor can argue that the change was required by GAAP, is thus a "desirable" voluntary change, based on CAS regulatory history, and that an upward equitable adjustment is appropriate.
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| Thomas F. Burke - | Washington, D.C. - (202-496-7500) |