Contractor Gaming the System to Control Sustainment

[Zauberer]

Here's the situation:

Development contract for a major system - no physical deliverables; only CDRLs. Contract contains the following clauses:

-DFARS 252.227-7013 & Alt I RIGHTS IN TECHNICAL DATA--NONCOMMERCIAL ITEMS (NOV 1995) AND ALTERNATE I (JUN 1995)

-DFARS 252.227-7014 & Alt I RIGHTS IN NONCOMMERCIAL COMPUTER SOFTWARE AND NONCOMMERCIAL SOFTWARE DOCUMENTATION (JUN 1995) AND ALTERNATE I (JUN 1995)

-DFARS 252.227-7027 DEFERRED ORDERING OF TECHNICAL DATA OR COMPUTER SOFTWARE (APR 1988)

-FAR 52.245-1 GOVERNMENT PROPERTY (JUNE 2007)

Hypothetically speaking, what would stop the contractor from doing the following:

1) Intentionally developing key parts of the system with capital funds in order to prevent the government from obtaining more than limited/restricted rights in tech data/computer softare/documentation, thereby allowing the contractor to limit the Government's ability to compete follow-on contracts for sustainment of the system.

2) Intentionally purchasing key items of hardware that will go into the contractually-required support system with capital funds and charging them as indirect costs against the contract in order to keep the hardware from becoming contractor-acquired property. This will allow the contractor to maintain control over the support system and thereby maintain a lock on future sustainment contracts. Government tech folks have stated that even if Government requests all tech data related to this effort, they would still need the actual hardware in order to figure out how to replicate the system.

Thoughts?

There are CAS issues here, but I thought that the overall issues merited putting this topic into the contract administration thread. I realize that the issues are complex, but I eagerly anticipate your thoughts on these matters.

Thanks!

[Guest Vern Edwards]

If I understand what you wrote, you said that the contractor developed key parts of the system at its own expense. It also purchased key items of hardware and allocated the cost to an indirect cost pool.

In scenario 1, did the contractor receive the development contract before it began developing key parts of the system at its own expense?

In scenario 2, did the contractor receive the development contract before it began purchasing the items of hardware at its own expense?

[Zauberer]

Vern,

Sorry, that was a critical piece of information that I left out. Yes, the contractor received the development contract before developing key parts of the system and purchasing items of hardware at its own expense in both scenarios.

[Guest Vern Edwards]

Thanks.

Now with regard to scenario 1, is the contractor charging the costs of development at its own expense to IR&D?

As for scenario 2, what reasoning is the contracting using to allocate those costs to an indirect cost pool?

[here_2_help]

Sorry for butting-in here, but Vern stepped on my "pet peeve landmine".

When a contractor charges development costs to "IR&D" it is almost certainly not paying for them "at its own expense". Instead, the contractor is recovering those expenses through allocation to its contracts, usually through the G&A expense rate. When there were ceilings on recoverable IR&D, it might have been accurate to state that the contractor was funding IR&D at its own expense when it exceeded the negotiated ceiling, but no longer.

Sorry for the interruption, please continue.

H2H

[Retreadfed]

H2H, of course you realize that is not the way the DFARS defines developed at private expanse.

Going back to Zauberer's original post, you say the only deliverable under the contract are CRDLs. However, does the contract spcifically call for the development of the"key items of the system"? In other words does it say something like "the contractor shall develop a better mousetrap and provide the government with technical data regarding the trap"?

[Guest Vern Edwards]

Retread:

The comments of you and here_2_help are not adding much to the inquiry or making anything clearer. The usual idea behind a contract to develop a major system is to build a better mousetrap, including its key elements, and provide the government with technical data. Don't you agree?

Is it possible to pursue a single line of questioning, at least for a while, or are we doing free for all? Please let me know, because if you want to do free for all, I'll move on.

Vern

[Zauberer]

Responding to Vern:

Scenario 1: I apologize for misleading you, but this has not actually happened yet, at least that we know of. The contractor has suggested that it has possibly done this, but has not outright admitted it. We are just trying to protect the Government's interests in case the contractor has done so. If they have in fact done so, then I believe that they would have charged the expenses indirect to G&A as IR&D. Here, I mostly just want to know if there is anything that would keep the contractor from doing so. In my opinion, the 7013 data rights clause doesn't seem to cover this sufficiently.

Scenario 2: The contractor charged the hardware expenses indirect to G&A. Unfortunately, I can't disclose too many specifics here (due to program sensitivity), but the contractor is arguing that the hardware in question is classified as "computing costs" in its disclosure statement, thereby justifying its classification as an indirect charge. They are also arguing that the hardware is not specifically listed as a contract deliverable, so it is not a direct contract requirement. Of course, they have purchased hardware for similar system components, but have charged those costs as direct costs against the contract, which I believe violates CAS 9904.402-40, which states that "All costs incurred for the same purpose, in like circumstances, are either direct costs only or indirect costs only with respect to final cost objectives."

Hope that helps, I look forward to hearing your thoughts!

[Guest Vern Edwards]

Scenario 1: I cannot think of anything that would prevent the contractor from doing the development "at its own expense" (as defined by the DFARS clause). Whether it could do so by charging the cost to IR&D is another issue, since in order for the cost to be a cost of IR&D it cannot work required by a contract. See the definition of independent research and development in FAR 31.205-18. If it wanted to spend the money without seeking reimbursement I don't see how you could stop it from doing so. However, whether that approach would succeed in limiting the government's rights might depend on when the private development took/takes place, which is a complicated question.

Scenario 2: As for allocating the hardware cost to an indirect cost pool, the question is whether the hardware is, in fact, an indirect cost. In order for the contractor to charge it as an indirect cost it would have to show that the costs are properly allocable as indirects pursuant to FAR 31.203. The fact that the items are not specified as deliverables is not determinative. It sounds to me that there might be real cost allocability issues that could prevent the contractor from adopting its strategy.

[here_2_help]

Apologies if my previous comment was derailing.

Scenario 2: Vern, I believe that capitalized fixed assets are not indirect expense items, though the traditional (but not exclusive) approach is to allocate depreciation/amortization to an indirect expense pool. Can you point to a regulatory definition of "capital asset" that prohibits contractually required hardware from being treated as a capital asset? I don't believe you can do so.

Hope this post is more helpful.

[Guest Vern Edwards]

help:

The only definition of capital asset that I know that seems pertinent is the definition of "tangible capital asset" at FAR 31.001, which reads as follows:

Tangible capital asset” means an asset that has physical substance, more than minimal value, and is expected to be held by an enterprise for continued use or possession beyond the current accounting period for the services it yields.

So you are suggesting that a contractor would buy "key items of hardware that will go into the contractually-required support system," declare it to be a tangible capital asset, and depreciate it rather than charge the government the full purchase price of the item?

[Zauberer]

Vern,

Thank you for the thoughts about scenario 1. As I mentioned, I don't know what particular funds the contractor would have used, but I appreciate your having made me aware of FAR 31.205-18. As for scenario 2, we are hoping to prevent the contractor from allocating costs inconsistently.

If anyone else has any specific thoughts on the issues raised, I would love to hear them!

[here_2_help]

Vern,

A tangible capital asset is an item that is capitalized rather than being expensed. Accordingly, it is neither direct nor indirect. The acquisition cost of a capital asset is depreciated/amortized over time. It is the depreciation that is recognized as an expense, not the acquisition cost of the asset. The allowability of the depreciation expense is governed by 31.205-11.

It is certainly possible for a contractor to use capital assets to perform contracts. For example, a contractor may acquire test equipment that is used to perform contractually required testing. There is no prohibition (that I know of) that would prevent a contractor from deciding to capitalize a piece of hardware instead of charging it as a direct expense. There is no prohibition (that I know of) that would prevent a contractor from allocating depreciation directly to a particular contract.

If a contractor capitalized an item of hardware, and then allocated the resulting depreciation expense directly to an individual contract, title would not pass to the customer, yet by the end of the period of performance the contract would have paid for the item's acquisition cost.

Hope this helps.

[Retreadfed]

H2H, I have to disagree with your last statement. if a contractor capitalizes a piece of equipment and allocates its cost to only one contract, the cost of that item will have been charged as a direct item of cost to that one contract although it is spread over a number of years. There is no requirement that a direct cost has to have been incurred in only one fiscal year (i.e., expensed) by the contractor before title passes to the government. In fact, under the Government Property clause, title passes to the government if the contractor is entitled to be reimbursed for the cost of the property as a direct item of cost.

[Guest Vern Edwards]

A tangible capital asset is an item that is capitalized rather than being expensed. Accordingly, it is neither direct nor indirect. The acquisition cost of a capital asset is depreciated/amortized over time. It is the depreciation that is recognized as an expense, not the acquisition cost of the asset. The allowability of the depreciation expense is governed by 31.205-11.

Help:

A tangible capital asset is what FAR and CAS say it is. As for the explanation of depreciation, thanks. It reminds me of something I learned as an undergraduate, oh so long ago.

Depreciation has to be allocated, and it is allocated as a direct cost or an indirect cost in accordance with the cost principles and CAS. According to Karen Manos in Government Contract Costs & Pricing, at Sec. 70:9:

Depreciation costs must be allocated to the cost objectives for which the assets provide service through inclusion in the appropriate indirect cost pools except in two circumstances. First, depreciation cost may be charged directly to a cost objective if (1) the charge is made on the basis of usage (using average usage rates and, (2) the depreciation costs of all like assets used for similar purposes are charged in the same manner. Second, if an asset is part of, or functions as, an organizational unit whose costs are charged to other cost objectives based on the services provided by that unit, the depreciation cost of the asset must be included as part of the cost of the organizational unit.

Footnotes omitted. Now, you say:

If a contractor capitalized an item of hardware, and then allocated the resulting depreciation expense directly to an individual contract, title would not pass to the customer, yet by the end of the period of performance the contract would have paid for the item's acquisition cost.

Okay. Some questions:

1. A development contract would probably be FPI(F), CPIF, or CPFF. Just how is it that title would not pass to the customer?

2. Moreover, in a development contract the contractor would probably have to deliver one or two prototypes for testing. Who would own the capitalized assets incorporated into the prototypes?

3. If the contractor bought a quantity larger than the quantity needed for the prototypes, how would it recover its costs? Would the depreciation of the items incorporated be charged as direct and the rest as indirect?

4. If it didn't buy more than the quantity needed, how would scenario #2 work?

[here_2_help]

Okay, I see I'm now perpetuating one of those WIFCON threads that's taken on a life of its own. This will be my last post in this thread.

1. Retreadfed, you are absolutely correct and I was wrong. If the depreciation expense is allocated to only one contract, then it is in fact a direct expense of that contract. We continue to disagree as to title passage.

2. Vern, a contractor cannot capitalize an asset--i.e., record an asset on its fixed asset register and depreciate the acquisition value of that asset over time--if the government has title. By definition, a capital asset is one that is owned by the contractor. Title passes for any direct item of cost, but I have asserted that a capital asset is neither direct nor indirect, since it is the depreciation that is expensed and not the acquisition cost of the asset. I don't believe that the accumulated depreciation expense is the same thing as the acquisition cost. Mathematically, they are the same (over time), but I don't believe that title passes unless the acquisition cost is treated as a direct cost item.

Materials incorporated into an end item lose their individual identity. (See, e.g., the definition of "special test equipment" at 2.101, which establishes that general purpose items lose their identity when incorporated into STE.) So if a contractor acquired a capital asset and incorporated it into a deliverable, then it would be gone. (I think this would violate GAAP, but I suppose it could happen.)

Let's not confuse "inventory" with "capital assets". Both are assets on the books, but they are different. (See CAS 411 as well as 52.245-1.)

Vern, when I re-read Scenario 2 (based on the 9:44 AM post) I see that the contractor did NOT treat the items as capital assets. Instead the items were expensed to G&A, while similar items were expensed as direct costs. I would agree that this is a potential CAS 402 noncompliance and presents allocation problems. I guess that makes my entire point about capital assets moot, but I hope you and others found it interesting nonetheless.

H2H

[Guest Vern Edwards]

I did find it interesting. I would genuinely like to discuss the subject of title, but I guess that is not going to happen. I notice that when you are questioned or challenged you tend to call it quits. What's up with that? I respect your knowledge of the topic at hand and would like to hear more. For instance, if the contractor acquires the hardware for the performance of the contract, capitalizes it, and charges depreciation directly to the contract, why wouldn't the title provisions of the Government Property clause apply? How does capitalization of the hardware overcome the provisions of the clause? And how does capitalization work if the hardware is going to be incorporated into a deliverable item?

Oh, well. No big deal.