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.

Goodwill Write-off, Allowable or Not?

Mergers, acquisitions, and business combinations are terms describing the combining of two or more entities. They occur frequently in the business world including among Government contractors. Once an agreement has been reached on the "selling price", the acquiring party has to figure out how to account for the purchase. Government contractors need to realize that some of the purchase price may not be recoverable under its Government contracts.

There are two methods of accounting for business combinations; the purchase method and the pooling of interests method. Under the purchase method, the acquiring company accounts for the business combination as if it were acquiring the assets of the acquired company. The acquiring company records the transaction as the fair value of the assets acquired less the liabilities assumed. This results of this transaction can result in either a step up or write down of the assets recorded values. The difference between the acquiring company's cost and the sum of the fair values of tangible and identifiable intangible assets, less liabilities is recorded as goodwill (usually an asset).

The pooling of interests method on the other hand accounts for a business combination as the uniting of ownership interests of two companies. The recorded assets and liabilities of the constituent companies are carried forward to the combined corporation at their recorded amounts without any revaluation. Generally Accepted Accounting Principles (GAAP) however severely limit the circumstances whereby the pooling method may be used. Therefore, the pooling method of accounting is not commonly used when companies merge.

Goodwill is an unidentifiable intangible asset. It originates under the purchase method of accounting for a business combination when the price paid by the acquiring company exceeds the sum of the identifiable individual assets acquired less liabilities assumed, based upon their fair values. The excess is commonly referred to as goodwill. Goodwill may arise from the acquisition of a company as a whole or a portion thereof. The GAAP rules for writing off or writing down goodwill have changed over the years. Under current GAAP (SFAS No. 142) goodwill is written down or written off upon impairment (impairment is an accounting term used to describe a situation where the recorded value is no longer reasonable).

Now comes the difficult realization for contractors that need to write down or write off the goodwill recorded on their books. According to FAR 31.205-49, any costs for amortization, expensing, write-off, or write-down of goodwill, however represented, are unallowable.

Knowing this, many acquiring companies will attempt to minimize the goodwill recognized in their accounting records. The easiest way to do this is to step up the value of the assets acquired in the transaction. Contract auditors are aware of this however and will probably ask to see an appraisal or other support for the values placed on the acquired assets.