Assets and Business Combinations

For the past two days, we've been discussing the allowability of costs under Government contracts when there has been a business combination accounted for under the "purchase" method (virtually all business combinations are accounted for under the purchase method since 2001). In Part 1, we discussed the prohibition against amortizing Goodwill and charging it off on Government contracts. In Part 2, we discussed the idea that if acquired assets have been depreciated against Government contracts, the acquiring company cannot write-up the assets and depreciate them all over again. That would be akin to the Government paying for the same asset twice.

It would probably have been useful to define tangible and intangible assets at the outset of this series. These are terms of art that we accountants take for granted. Tangible assets have physical substance while intangible assets do not. Definitions for both tangible and intangible assets are found in FAR 31.001.

• 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.
• Intangible capital asset means an asset that has no physical substance, has 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 benefits it yield.

Tangible assets include property, plant, and equipment. Intangible assets include intellectual property such as patents and copyrights, and goodwill, among others.

There are other related FAR cost principles. FAR 31.205-10, Cost of Money, and FAR 31.205-11, Depreciation, preclude the use for cost allowability purposes of asset write-ups resulting from the the purchase method of accounting for a business combination. FAR 31.205-16, Gains and Losses on Disposition of Depreciable Property or Other Capital Assets provides that no gain or loss shall be recognized as a result of the transfer of assets in a business combination.

The entire purpose behind all of these restrictions is to ensure that the Government does not pay more that it would have had a business combination never occurred. At the time most of these restrictions were placed into the FAR (1990) there were significant and sizable mergers among Government contractors. In its promulgation comments to these rules, the FAR Councils concluded that the Government should not recognize depreciation, amortization, or the cost of money expense flowing from asset write-ups that result from the purchase method of accounting for business combinations. The Councils further stated that they did not believe that, in the special circumstances of Government procurement in which companies recorded cost structures are often directly reflected in the price, the Government should be at risk of paying higher prices simply because of ownership changes at its suppliers.

Tomorrow we will look at some of the guidance that auditors are instructed to consider when encountering business combinations.