Deferred IR&D Expense

Deferred IR&D (Independent Research and Development Costs) are those costs that were incurred in previous accounting period. Generally, deferred IR&D costs are unallowable. However there is one exception to this rule. If a contractor has developed a specific product at its own risk in anticipation of recovering the development costs in the sale price of the product, the costs may be allowable if certain conditions are met. Those conditions include:

• The total amount of IR&D costs applicable to the product can be identified.
• The pro-ration of such costs to sales of the product is reasonable.
• The contractor had no Government business during the time that the costs were incurred or did not allocate IR&D costs to Government contracts except to pro-rate the cost of developing a specific product to the sales of that product.
• No costs of current IR&D programs are allocated to Government work except to prorate the costs of developing a specific product to the sales of that product.

If the Government decides to recognize deferred IR&D, the contract must include a specific provision setting forth the amount of deferred IR&D costs that are allocable to the contract. Additionally, the Government must document in its negotiation memorandum the circumstances pertaining to the case and the reason for accepting the deferred costs.

Back in 2000 and 2001, a contractor capitalized some IR&D costs that it incurred to develop software that it asserted was a precursor to that required for an Air Force contract. It amortized the development costs in 2002 through 2005 of which some of those costs were allocated to the Air Force contract. The Air Force contract did not contain a provision allowing deferred IR&D costs be to charged.

The auditors questioned the amortization of the deferred IR&D costs. The contractor appealed to the ASBCA (Armed Services Board of Contract Appeals). The ASBCA, without deciding and commenting upon whether the costs could have been allocable to the contract, supported the auditor because there was no recognition of deferred IR&D costs in the contract. The Board stated:

"In this case, there is nothing in the contract specifically authorizing any deferred IR&D costs to be charged to this contract  as specified in FAR 31.205-18(d)(2)..."

That decision is pretty straight forward - no contract authorization, not allowable.

If you've capitalized IR&D costs that you hope to amortize over future Government work, you need to ensure that it is specifically spelled out in your contract(s).