As military downsizes, contract termination becomes a challenge.

Most cost accounting systems are designed to handle contracts performed to completion, but with widespread military cutbacks, federal contracts are being terminated prematurely, creating complex technical problems for CPAS.

Companies generally are entitled to recoup their full costs when a federal agency terminates a job in midcontract for its own convenience the usual parlance for contracts terminated for reasons other than cause. But working out how much money the government subsequently owes the business can be difficult.

DIRECT VS. INDIRECT COSTS 

A major hurdle is establishing which business costs are direct and which indirect. Direct costs are charged directly to the contract; indirect costs go into cost pools, such as general and administrative, and are allocated to the contract only via some kind of rate mechanism. Differentiating between the two can be a problem when contracts are terminated because established allocation procedures often are not appropriate in these cases.

To illustrate the problems, consider this typical case:

A contractor enters into a five year, fixed-price development contract with the military. The job calls for a significant investment in test equipment, to be used exclusively in the project. However, equipment cost is not treated as direct in the original contract for these reasons.

n The equipment does not meet the special-test-equipment definition in the Federal Acquisition Regulations FAR), which regulate federal contracting. Specifically, FAR 45. 101 defines special test equipment as "single or multipurpose integrated test units engineered, designed, fabricated or modified to accomplish special purpose testing in performing a contract. "

The practice is to charge special test equipment as a direct cost and general test equipment as indirect.

* Cost Accounting Standard 409 to which the company is subject, requires consistent charging; for example, depreciation costs of all like assets used for similar purposes must be treated consistently, either as direct or indirect costs.

* Depreciation of the test equipment will be included in engineering overhead in current and future years.

If the contract is terminated after the test equipment is acquired but before most of the direct costs for contemplated engineering efforts are incurred, only a minor amount of equipment depreciation can be charged to the contract using the usual engineering overhead-allocation methods.

DOUBLE COUNTING 

One possible recourse for the contractor is to be more flexible in assigning costs. But a contractor that departs from its usual, accepted accounting practices runs the risk of reasonable modifications necessary to outfit an existing facility for contract performance.

* In an appeal filed by Fiesta Leasing & Sales, Inc., (AFBCA no. 29311, January 30, 1987, 87-1 BCA 19622), the board allowed depreciation on buses purchased for a busleasing contract terminated shortly after the contract was awarded. The board allowed depreciation over the full 18-month contract period, saying, "Such depreciation costs are appropriately recoverable as continuing costs .... There is ... a clear connection between the costs claimed and the terminated contract and it is clear to us that these costs could not be discontinued immediately upon termination. "

ot all the cases involve military contracts. In an appeal brought by Essex Electro Engineers, Inc. (DOT CAB no. 1025, 1119, December 11, 1980, 81-1 BCA 14838), the Department of Transportation Contract Appeals Board allowed recovery of the full cost of the net book value of equipment remaining at a plant when the contract was terminated for convenience. The contractor could not retain the equipment without sustaining a loss because the equipment was in excess of current and future operational requirements.

NO WINDFALLS

CPAS should recognize that the total termination settlement is limited to the contract price of the items terminated, plus settlement expenses. In other words, the government guards against a company gaining a windfall from a scrapped contract. FAR 49.203 provides that, if a contractor would have suffered a loss on a fixed price contract if completed, the anticipated loss rate must be reflected in the termination settlement.

The loss adjustment is calculated by comparing the total contract price with the estimated cost at completion (that is, total cost incurred before the termination, plus the estimated costs to complete the contract if the termination had not occurred): The allowable termination settlement cost then is computed by multiplying the loss adjustment factor by the allowable costs incurred by the contractor excluding settlement costs:

Proposed settlement Loss adjustment factor x Allowable costs

SETTLEMENT EXPENSES

Accountants should be aware that FAR 31.205-42(g) also allows recovery of the following:

* Accounting, legal, clerical and similar costs incurred in preparing and negotiating settlement proposals and in terminating and settling subcontracts.

* Costs for storage, transportation, protection and disposition of property acquired for the contract.

In fact, when a contractor's personnel are involved in these contract termination activities, the company can add applicable indirect costs such as the expenses for employees' payroll taxes, fringe benefits, occupancy costs and immediate supervision.

Clearly, significant settlement expenses must be separately identified for both the associated in-house costs and outside legal and accounting fees. Such costs must be excluded from indirect cost pools that are allocated to other contracts.

In the Baifield Industries case, the ASBCA ruled such costs can be included in the settlement when

* The charges are supported adequately and the time and rates charged are reasonable considering the termination claim complexity and the nature of the work that was performed.

* The contractor has limited experience in termination claims and the outside legal and accounting advisers have the necessary expertise.

Naturally, those involved in supporting a termination settlement proposal (both in-house and outside resources) should keep a contemporaneous record of their activity.

Contract terminations are never good news. However, the adverse effects can be mitigated by thoroughly analyzing the costs associated with contract performance and pursuing the equitable recovery of costs. N