FAS 121 and the Interim FAR
Rule: Sound Strategies for Avoiding
or Minimizing an Impairment Loss
by
Howard N. Kenyon, Jr. CPA
and
Gregory L. Fordham, CPA, CIA
(This article appeared in the April 29, 1996 issue of Federal Contracts Report
Vol. 65, No. 17, Bureau of National Affairs )
TABLE OF CONTENTS
Introduction
The Accounting Issue
The Allowability Issue
The Dilemma
Is There a Way Out?
Available Options for Cost Recovery
The Decision to Dispose of an Asset
Strategy to Avoid Loss
Other Considerations
Conclusions
End Notes
An interim Federal Acquisition Regulation (FAR) rule was recently issued that requires government contractors to deviate from Generally Accepted Accounting Principles (GAAP) with respect to impaired assets and threatens to diminish a government contractor's cost recovery and revenue stream. Interestingly enough, what might seem to be an instance of impaired assets in any other environment can prove to be nothing more than impaired judgment if followed by government contractors.
Since the decision to characterize an asset as impaired under GAAP is a decision founded in market based pricing, the issue for government contractors is whether or not impairment can occur for contractors doing business in a cost-based environment. The FAR Cost Principles provide several possibilities for recovering the undepreciated carrying value of assets that otherwise would not exist for commercial enterprises. But these cost recovery potentials can be used fully only if there has been no write-down of the asset to recognize an impairment loss for financial statement purposes. Once an impairment loss has been recognized, the interim rule and existing cost principles work to preclude recovery of the write-down.
Consequently, a government contractor must carefully assess the status of underutilized facilities in order to avoid their unwarranted characterization as "impaired" and the associated potential loss of cost recovery. The following explains the requirements of the new accounting principle, the new interim FAR rule and how those contractors that would be affected most can legitimately avoid the effect of these requirements.
The Financial Accounting Standards Board (FASB) which establishes GAAP to be followed by commercial enterprises in reporting financial position and results of operations recently addressed impairment of the carrying value of assets held for use and those to be disposed of. The FASB Statement (FAS) No. 121, Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of, generally requires a write-down from carrying value to fair value of assets whose expected future cash flows are less than the carrying value. Indicators for the need for testing to determine whether the criterion applies are prevalent in the government contracting community. Examples include loss of value, less usefulness from reduced market potential, obsolescence.
FAS 121, ¶ 6, considers an asset to be impaired if expected future cash flows from its use are less than its carrying value. It generally requires that an asset having a carrying value less than the expected future cash flows be written down to fair value of the asset for financial statement presentation. And assets selected for disposal pursuant to a plan committed to by management (that are not already covered by provisions of Accounting Principles Board (APB) Opinion No. 30 (1)) must be written down to fair value less cost to sell. Losses recognized from these required write- downs must be reported currently in the income statement as part of continuing operations. This Statement is effective for financial statements for fiscal years beginning after Dec. 15, 1995.
Reacting to the possibility that many contractors may be subject to the requirement to write down assets and then attempt to recover the costs of the write-down under cost-based contracts, the FAR Councils have issued an interim rule in Federal Acquisition Circular (FAC) 90-35, dated Dec. 14, 1995 which prohibits recovery of the write-down in the period in which it was taken. The interim rule reaffirms the existing requirement that losses on disposition of capital assets be recognized only in the period of disposition in accordance with FAR 31.205-16.
FAR 31.205-16, Gains and losses on disposition of depreciable property or other capital assets, has been changed to "Gains and losses on disposition or impairment of depreciable property or other capital assets." [Emphasis added.] And paragraph (g) has been added to deal specifically with impairment losses:
With respect to long-lived tangible and identifiable intangible assets held for use, no loss shall be recognized for a write-down from carrying value to fair value as a result of impairments caused by events or changes in circumstances (e.g., environmental damage, idle facilities arising from a declining business base, etc.). Depreciation or amortization on pre-write-down carrying value of impaired assets not yet disposed of shall continue to be recoverable under established depreciation or amortization schedules to the extent it is not otherwise unallowable under other provisions of the FAR.
On the surface it may appear that the cost of such impaired assets can eventually be recovered through normal pre-write-down depreciation practice. But look out! For contracts not fully CAS covered, what does "to the extent it is not otherwise unallowable under other provisions of the FAR" mean, especially to a government auditor? FAR 31.205-11, Depreciation, has a requirement that in order to be allowable, depreciation cannot exceed that which is used for book or financial statement purposes and shall be determined in a manner consistent with policies and procedures used in the same cost center for non-government business. If on the financial statements an impairment loss has been recognized, wouldn't the carrying value of the asset be less and consequently the depreciation less? How then would pre-write-down depreciation be fully allowable?
If the contracts were subject to CAS 409 the limitations based on financial statement depreciation amounts would not apply, since requirements of CAS take precedence over cost principles with respect to measurement and allocation of allowable costs.
There are other hurdles. FAR 31.205-11, Depreciation, was also changed by FAC 90-35. Paragraph (o) was added:
In the event of a write-down from carrying value to fair value as a result of impairments caused by events or changes in circumstances, depreciation of the impaired assets shall not exceed the amounts established on depreciation schedules in use prior to the write-down (see 31.205-16(g)).
On the surface this too may be misleading. It does not say pre-write-down depreciation is recoverable; it only says that depreciation cannot exceed pre-write-down amounts. This language thwarts any attempt to circumvent the prohibition on recoverability of impairment loss by shortening the life of the asset to accelerate depreciation. If an impairment loss has already been recognized for financial statement purposes, the contractor is not only precluded from recovery of asset cost through a shortened life consistent with a new estimate of life, but is in danger of not recovering pre-write- down amounts for the reason discussed above.
The net result of the interim rule could very well be that an impairment loss is forever lost to the contractor. It is clear that it cannot be an allowable cost in the period in which it is recognized for financial statements; it most likely would not be allowed as normal pre-write-down depreciation charges being in excess of financial statement depreciation. And at the time of disposition, the asset's book value would be determined by "applicable" depreciation, not "allowable" depreciation. Thus, at the time of disposition, when the loss could be recognized as allowable, the loss would not be based on the unrecovered costs with respect to government contracts but would be based on the lesser undepreciated book value.
However, there are ways to avoid potential loss of cost recovery in some circumstances. Recognition of an impairment loss pursuant to FAS 121 could create a problem when none should exist. The new paragraph (o) of FAR 31.205-11 starts with, "In the event of a write-down from carrying value to fair value as a result of impairments . . ." And the new paragraph (g) of FAR 31.205-16 states, "Depreciation or amortization on pre-write-down carrying value of impaired assets . . ." Both of these statements make it clear that the new provisions promulgated by FAC 90-35 address only assets that have been written down as a result of impairment. If no impairment loss is recognized, the new provisions of FAR 31.205-11 and 31.205-16 are not invoked and business is carried on as usual. Depreciation can be continued as before, asset lives can be shortened to reflect prospective economic usefulness, cost of idle facilities may be allowed, and loss on disposition would be allowable at the actual loss amount.
But is there really a dilemma? Maybe there is only the paradox of the self-extinguishing cost principle in the interim rule. First, contractors that do only or mostly sealed bid contracting or those whose pricing is market driven, not cost driven, are not concerned with the interim rule. Their pricing structures will not be affected by unallowable costs. Second, contractors that do all or a substantial amount of cost-based pricing have available several means of recovering costs of underutilized assets. Consequently, if they can recover the costs of the questionable assets, those assets can pass the test for future cash flows and avoid the characterization as impaired. And if the assets are not characterized as impaired, the interim rule does not apply.
For the contractor doing substantial cost-based contracting (negotiated contracts), the necessary course of action is to convince its certified public accountants (CPAs) that it can pass the expected cash flow test of FAS 121 and thereby avoid the requirement for an asset write-down. While the CPAs will argue a need to invoke FAS 121 because of changes in business climate, etc. the contractor must be ready to counter this argument with projections of full cost recovery. To demonstrate that the depreciation (or other characterization of the asset's cost) will generate the required cash flow the contractor would have to demonstrate that the total indirect cost pool will be recovered. Recovery would be accomplished by pricing contracts using the full indirect cost rate generated by the pool to which the depreciation is charged. If the rate is being accepted in current negotiations for new contracts or for actuals on cost reimbursement contracts, the contractor would have proved its case of expected future cash flow being a likely occurrence. Arguably, some amount of profit could be imputed to the depreciation cost further assuring recoverability.
This argument, however, would have to be based on realistic projections well supported. The CPA is bound by the FASB accounting principles and will not be able to overlook a write-down requirement on weak evidence. A mere potential for recovery is not by itself enough. It must be linked to a likely realization of future cash flow.
Recovery potential is inherent in several FAR cost principles but the application of these principles can be quite different among contractors. Thus, the realization of cash flow from the assets would not necessarily be the same for all contractors. Consequently, all contractors could not necessarily avoid the write-down required by FAS 121 and the loss of cost recovery under the interim rule.
Suppose the asset in question was one associated with a program that was canceled and there was absolutely no further use for the asset or its use could be projected for only a part of its originally estimated life. Would the CPA have to invoke FAS 121? Not necessarily. When the contractor became aware of a reduced economic service value, it could:
- Continue normal depreciation if the economic life of the asset has not changed but capacity utilization has; (2)
- Adjust the depreciation to reflect the reduced service life and recover the cost within the remaining life of the program; (3)
- In the following period, assuming the asset is not being used, recover depreciation as idle facilities cost; (4)
- Recover the loss on disposition as an allowable cost; (5) or
- In the special circumstances of a contract termination for convenience or the cancellation of a multiyear contract, recover the loss of useful value of assets acquired specifically for the contract. (6)
While all the above potentials for cost recovery are in the FAR, the actual results may vary depending upon the circumstances in which they are applied. For example, Contractor A has all cost reimbursement contracts while Contractor B has only sealed bid type contracts. Both have facilities used almost exclusively for certain government work. As a result of budget cuts neither contractor gets anticipated follow-on work. Thus, both have assets that are underutilized and are candidates for impairment write-down under FAS 121. Contractor A can take advantage of the several cost principles discussed above to recover the cost of the subject assets charged as depreciation, etc., since its indirect costs will be redetermined each year. Contractor B has no such opportunity with its sealed-bid firm-fixed-price contracts.
But conditions may not be just black or white. For example, Contractor A is performing only cost reimbursement work and has its indirect costs adjusted annually based on actual cost experience. Contractor B is performing only negotiated firm-fixed-price work and projects its rates at the time of negotiating the contract. Obviously Contractor A has an opportunity to recover costs on ongoing contracts that Contractor B does not have. In the current period Contractor A can shorten the life of an asset and recover more depreciation. Contractor B is locked into rates projected earlier.
As another example, Contractor A has one large government contract and some commercial business. Contractor B has many government contracts and some commercial business. Contractor A does not get expected follow-on contracts when its current contract is completed in the current year. Contractor B does not get follow-on work when one of its several government contracts is completed in the current year. Both contractors had facilities that were used primarily for their completed government contracts. Contractor A is now no longer a government contractor and cannot recover the cost of the impaired assets from the Government under any circumstances. Contractor B still has substantial government work so it has a potential to recover under several of the FAR provisions mentioned earlier. But suppose Contractor A's contract was a multiyear contract canceled after the first year and the contract had cancellation ceilings established that would provide full recovery of the undepreciated cost of the facilities. In that case Contractor A would have no impairment loss.
So far, the discussion has concerned assets which have a diminished or terminated service potential which could have been caused by government's downsizing or obsolescence due to technology changes. But a government contractor could be exposed to other circumstances or events which appear more daunting in trying to avoid the impairment write-down. Such might be the case when laws are enacted making the operation of certain contractor facilities illegal for safety or environmental reasons. This type of sudden, and maybe sovereign, act could instantly reduce the asset's future cash flows to its expected salvage value, zero, or a negative amount resulting from the cost of disposal. Certainly it would appear to be a candidate for impairment write-down. But it is not necessarily one.
Again, so long as the contractor has not designated the asset as impaired, there may be a chance to generate sufficient cash flow from the useless asset and avoid the impairment loss. The decision by others to make the asset useless is not the same as a decision by management to dispose of the asset. So if management avoids the initial impulse to make a decision, it has cleared one hurdle posed by FAS 121. The next hurdle is to elect the manner in which the unrecovered cost will be made allowable. It appears that some of the potential recovery means mentioned above are also applicable in this situation. But maybe the best solution would be to retire the asset immediately without necessarily disposing of it. An asset is treated as retired when it is permanently withdrawn from use in the business. (7) FAR 31.205-16 provides for the allowability of losses from retirement. Being a retired asset, it is no longer an asset held for use, but rather one being held for non-use. Since the prohibition of allowability of write-downs in new paragraph (g) of FAR 31.205-16 applies only to assets held for use, the loss on retirement would be allowable as it always was. For contracts covered by CAS 409, the contractor may use the provisions of 48 CFR 9904.409-50(I) or (j) for the necessary adjustment to depreciation.
Regarding the sovereign acts aspect of such an impairment, it should pose no problem. The contractor's actions of ceasing to operate the assets are merely those of compliance with the law, the cost of which is ordinary and necessary for doing business.
With these options available for cost recovery under various circumstances, many cost-based contractors should be able to project full cost recovery and, therefore, adequate cash flow to avoid the write-down criterion.
FAS 121 also requires that assets that are subject to a plan for disposition be written down to fair value less cost to sell, if fair value is less than carrying value. The write-down would not be an allowable cost under the interim rule. The interim rule maintains that losses on disposition still be recorded in the period of disposition. Thus the impact then of the interim rule is to defer the loss, not make it totally unallowable as it would be with regard to assets held for use. Furthermore, if the decision or plan to dispose were made in the same accounting period as the actual disposition, the actual disposition would obviate any FAS 121 write-down. (See attached decision tree for asset dispositions in accordance with FAS 121 and FAC 90-35 at the end of this article.)
A contractor who had redundant assets all in use at some level may consider immediate retirement (permanent withdrawal of the asset from use in the business) of the excess assets. This would result in the remaining carrying value being written off as a loss on disposal, recoverable under FAR 31.205-16 or under CAS 9904.409-50(I) or (j). By doing this, a contractor could avoid the recognition of an "impairment loss" or the need to establish that there would be no impairment loss. It may also ease the burden of establishing that the remaining assets held for use are not impaired.
The crucial and first step in a strategy for maximum cost recovery by a government contractor using cost-based pricing and having a suspected "impaired" asset should be to avoid the fatal mistake of unnecessarily writing down the value of the asset. To make the write-down is to forfeit the many options otherwise available for cost recovery. Designating the asset as impaired is generally the only impairment it can suffer. Only a careful analysis of the circumstances causing the appearance of impairment can lead to selection of the best option to avoid actual loss of some part of the carrying value of the asset. Professional advice should be sought to ensure the best means of recovery are selected.
In situations where impairment cannot be avoided by full cost recovery, its effects may be minimized by projecting a large partial cost recovery. FAS 121, ¶ 7, requires that an impaired asset be written down from its carrying value to its fair value. The usual means of establishing fair value--the amount at which the asset could be bought or sold in a current transaction between willing parties-- might not be available for highly specialized facilities of government contractors in a shrinking market. Therefore, as an alternative the present value of estimated expected cash flows could be used. Obviously the greater the expected cash flow, the greater the fair value and the smaller the write-down that would ensue.
If a write-down were made to depreciable assets in recognition of an impairment loss, it may appear that the asset book value and, therefore, the base for computing cost of money and for computing fee potential using the weighted guidelines would be reduced. But such is not the case. CAS 414-- cost of money as an element of facilities capital, techniques for application, ¶ (a) states, "The investment base used in computing the cost of money for facilities capital shall be computed from accounting data used for contract cost purposes." Since the write-down of an impaired asset is not recognized by the interim rule and pre-write-down depreciation schedules must be used for contract costing, the proper base for computing cost of money and the weighted guideline fee potential is the net book value before write-down.
What then of a non-depreciable asset that has been written down as impaired, such as contaminated land? Its net book value may be zero while it is still being used to support contract activity. Appendix A to CAS 414, under Basis, states, ". . . land which is integral to the regular operation of the business unit shall be included." [Emphasis added.] And since any write-down would not have been recognized by the interim rule, the full value of the land should be included for computing cost of money.
The interim rule was intended to avoid a surge in write-down losses that otherwise would have resulted from FAS 121 and thus maintain the existing means for a contractor to recover the cost of depreciable assets. While it should not be viewed as a new means to disallow yet another cost, the contractor's own actions of mistakenly recognizing impairment losses could trigger the provisions of the interim rule which could then result in an actual loss of write-downs, not only in the current period but forever.
There is no concise formula to determine whether a government contractor has impaired assets. There are variables in circumstances, contract provisions, and differences between CAS and the cost principles, all of which have a bearing on impairment. Each situation needs careful analysis to determine the factors and their effects on cost recovery.
More regulations always come as bad news, but the good news here is that there are sound strategies to avoid the potential loss brought by the interim rule.
1) Accounting Principles Board (APB) Opinion No. 30, Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, Extraordinary, Unusual and Infrequently Occurring Events and Transactions, requires that certain assets to be disposed of be measured at the lower of carrying amount or net realizable value. The disposals covered by this Opinion are business segments as defined by this Opinion.
2) FAR 31.205-17, Idle facilities and idle capacity costs, ¶ (c), "Costs of idle capacity are costs of doing business and are a factor in the normal fluctuations of usage or overhead rates from period to period. Such costs are allowable provided the capacity is necessary or was originally reasonable . . ."
3) FAR 31.205-11, Depreciation, ¶ (a), "Depreciation is a charge to current operations which distributes the cost of a tangible capital asset, less estimated residual value, over the estimated useful life of the asset in a systematic and logical manner. It does not involve a process of valuation. Useful life refers to the prospective period of economic usefulness in a particular contractor's operations as distinguished from physical life; it is evidenced by the actual or estimated retirement and replacement practice of the contractor." 48 CFR 9904.409- 50 Cost accounting standard--depreciation of tangible capital assets, Techniques for application, ¶ (I), "Estimates of service life, consumption of services, and residual value shall be reexamined for tangible capital assets (or groups of assets) whenever circumstances change significantly. Where changes are made to the estimated service life, residual value, or method of depreciation during the life of a tangible capital asset, the remaining depreciable cost for cost accounting purposes shall be limited to the undepreciated cost of the assets and shall be assigned only to the cost accounting period in which the change is made and to subsequent periods."
4) FAR 31.205-17, Idle facilities and idle capacity costs, ¶ (b) "The cost of idle facilities are unallowable unless the facilities-- (2) Were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen."
5) FAR 31.205-16, Gains and losses on disposition or impairment of depreciable property or other capital assets, ¶ (a), "Gains and losses from the sale, retirement, or other disposition (but see 31.205-19) of depreciable property shall be included in the year in which they occur as credits or charges to the cost grouping(s) in which the depreciation or amortization applicable to those assets was included."
6) FAR 31.205-42, Termination costs, ¶ (d) Loss of useful value, "Loss of useful value of special tooling, or special machinery and equipment is generally allowable . . ." FAR 17.103-1(d), Cancellation, ¶ (2), "In determining cancellation ceilings, the contracting officer must estimate reasonable . . . nonrecurring costs . . .Nonrecurring costs include such costs, where applicable, as plant or equipment relocation or rearrangement, special tooling or special test equipment . . .allocable portions of the costs of facilities to be acquired or established for the conduct of the work . . ."
7) DCAA contract Audit Manual (DCAM 7640.1, January 1996) 7-407.4a.
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