Amortization and Depreciation in a Post-Merger Accounting Period

For the past few days, we've been discussing restrictions on depreciation and amortization costs when a business combination occurs, i.e. when one company buys another and Government contracts are involved. Today we'll conclude this series by focusing on what the contract auditor might ask for and look at when auditing incurred costs.

The first thing that the auditor will look for is whether the company (the entity) has engaged in any business combination activities, either as the acquiring party or the acquired party. If there is no such activity, there is obviously no risk to the Government so the auditor will simply move along to other areas. The ICQ (Internal Control Questionnaire), which most contractors are familiar with because they've been asked over and over to help fill it out, is used to document whether business combination activities have occurred.

If there has been business combination activities, the auditor request a certain level of data and information necessary to ensure that the Government is not overcharged. The expectation is that contractors will have all the documentation necessary for the auditor to make that assessment. And, the auditor is on solid grounds for asking for the information. For example, for contracts subject to TINA (Truth-in-Negotiations Act) FAR 52.215-19 requires contractors to notify the Government of any changes in contractor ownership which would impact asset valuations. The clause also expressly requires maintenance of the records and calculation of the expense amounts which are required in order to comply with FAR 31.205-52 (Asset Valuation Resulting from Business Combinations). As noted yesterday, this cost principle limits the amount of allowable amortization, depreciation, and cost of money to the total amount that would have been allowable had the combination never taken place.

Once the auditor has acquired the necessary records and documentations, audit guidance requires auditors to make three determinations.

First, the auditor must verify that contracts do not receive increased costs flowing from asset revaluation resulting from business combinations.

Secondly, the auditor must verify whether the acquired tangible capital assets generated depreciation or cost of money charges on Federal Government contracts or subcontracts negotiated on the basis of cost during the most recent cost accounting period. For tangible capital assets that generated such depreciation expense or cost of money charges, no write-up and no write-down of asset values is permitted and no gain or loss is recognized on asset disposition. For tangible capital assets that did not generate such depreciation or cost of money charges, asset values are written-up or written-down in accordance with CAS 404)

Finally, the auditor must verify that for contracts awarded after 1998, whether or not subject to CAS, the allowable depreciation and cost of money would be based on capitalized asset values measured and in accordance with CAS 404.50(d). This is one of those areas where CAS (Cost Accounting Standards) have been incorporated into FAR Cost Principles.

Refer to the DCAA Contract Audit Manual (CAM) Sections 7-1705 for further details on this audit guidance.

The most common problem encountered by contractors in this area involves the adequacy of records. Sometimes, after a few years, the visibility into asset valuations and historical depreciation amounts is lost. It doesn't help when the auditors have years of backlogged incurred cost audits waiting to be performed. If there are record retention issues that arise during an audit, contractors are advised to bring their contracting officers on-board right away to help resolve any issues that may arise.

Asset Valuations Resulting from Business Combinations

Yesterday, we wrote about the FAR (Federal Acquisition Regulation) prohibition against expensing goodwill against Government contracts (see FAR 31.205-49). Today we address a related matter - how to value assets resulting from business combinations. Or rather, how to value assets for Government cost accounting purposes, which may or may not be the same as for financial reporting purposes. As you recall, under the purchasing method of accounting for business combinations, assets of the acquired company are recorded at their fair value by the acquiring company. Usually, but not always, this results in a write-up of assets. Assets may have been fully depreciated but there is still economic life to those assets. Land, which is not depreciated, is carried on the books at its acquisition cost when typically, the value increases with time.

FAR 31.205-52 addresses asset valuation from business combinations. FAR distinguishes between tangible and intangible assets and states:

• (a) For tangible capital assets, when the purchase method of accounting for a business combination is used, whether or not the contract or subcontract is subject to CAS, the allowable depreciation and cost of money shall be based on the capitalized asset values measured and assigned in accordance with CAS 404, if allocable, reasonable, and not otherwise unallowable.
• (b) For intangible capital assets, when the purchase method of accounting for a business combination is used, allowable amortization and cost of money shall be limited to the total of the amounts that would have been allowed had the combination not taken place.

To figure out what the foregoing really means, one must refer to CAS 404.50(d). CAS 404 states, concerning capitalized values of tangible capital assets acquired in a business combination:

• (1) All the tangible capital assets of the acquired company that during the most recent cost accounting period prior to a business combination generated either depreciation expense or cost of money charges that were allocated to Federal government contracts or subcontracts negotiated on the basis of cost, shall be capitalized by the buyer at the net book value(s) of the asset(s) as reported by the seller at the time of the transaction.
• (2) All the tangible capital asset(s) of the acquired company that during the most recent cost accounting period prior to a business combination did not generate either depreciation expense or cost of money charges that were allocated to Federal government contracts or subcontracts negotiated on the basis of cost, 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 ... the value otherwise assignable to tangible capital assets shall be reduced by a proportionate part of the excess.

So, to simplify things, Government contractors cannot write-up the value of tangible capital assets that have already been charged to the Government through depreciation - the Government doesn't want to buy the assets twice.

Intangible capital assets other than goodwill (e.g. intellectual property such as patents and trademarks) bear no such distinction. Amortization is limited to the amount that would have been allowed had the combination not taken place. It doesn't matter whether the Government was previously charged for the amortization. There can be no write-up of values.