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How regulatory ambiguity frustrates defense contractors.

How regulatory ambiguity frustrates defense contractors News reports of $500 toilet seats and $50 hammers have reinforced the widely held belief that American defense contractors feather their own nests at the taxpayer's expense, and, indeed, the defense industry provides an easy target for headline seekers. Meanwhile, the flip side of this highly publicized phenomenon, which is itself another golden Fleece, escapes public notice. It is the almost unmanageable burden the governmental bureaucracy imposes upon defense contractors. It involves waste on a truly grand scale.

Defense firms typically face an arrya of 44,000 specifications when selling a product to the government. In fact, the instruction book on procurement runs 32 volumes and takes up six feet of shelf space. Some 50 percent of small high-technology defense contractors drop out of competition for government contracts or go out of business completely due largely to bureaucratic regulations, according to a June 30, 1989, article in The Wall Street Journal. Moreover, according to a study by the Pentagon's logistics commanders, these regulations account for one-third of procurement costs, a figure corroborated by officials at Martin Marietta Corporation and Hughes Aircraft Company.

The burden of this voluminous, meticulous recordkeeping is compounded by the uncertainty about which regulations apply and how those regulations should be interpreted in different situations. The problem of choosing between overlapping regulations is illustrated by one contractor's dispute over the policy on "banked vacation" (BV), the practice of allowing employees to save all or a portion of their vacation time for a future date.

But these same problems can apply to a variety of activities regulated by the government, such as nuclear energy and tax laws. The regulatory process involved in licensing a nuclear power plant has become so protracted and the outcome of the process so uncertain that no new licenses for nuclear power plants were initiated this decade. The sheer magnitude and expense of the regulatory process, along with the uncertainty, are the primary deterrents to the development of nuclear energy, rather than any conscious decision by society.

As for the current tax code, much of the wording of the 1986 and the 1987 Tax Reform Acts is imprecise. It was Congress' apparent intent to allow the Treasury Department to clarify the new tax law through regulatory pronouncements. The problem is that many of these interpretations are still forthcoming. Therefore, tax strategists and estate planners are operating currently with an income set of rules. When the rules are finally established, however, they may then be applied retroactively.

The example of banked vacations was chosen because of the complex issues that arise out of this common, presumably simple practice of many corporations. BV policies often contain such additional terms as time limitations (a BV can be accrued for only one year, five years, seven years, etc.); quantity limitations (an employee can accrue vacation time of only two weeks, 60 days, 90 days, etc.); and a provision that pays an employee for unused vacation time upon termination or retirement. The amount paid to an employee generally reflects his salary at the time of the vacation, not the salary that was in effect when the employee set the time aside.

Since vacation agreements like this occur commonly throughout industry and government, one might expect such a familiar, long-standing practice to inspire well-established accounting procedures for government contracts. But the proper regulatory accounting procedure is not well established, and consequently the reimbursement of BV costs has become far from predictable.

The issue of BV is technical and complicated, and the topic is raised here not to debate the mertis of one Cost Accounting Standard (CAS) over another, but to illustrate the inherent CAS ambiguities that so often frustrate defense contractors. Consequently, only the essential elements of the regulations applicable to BV will be discussed.

Which CAS applies?

Two particular standards, CAS 408 and CAS 415, appear to be applicable to the BV situation. CAS 408 is used to "measure (the) costs of vacation, sick leave, holiday, and other compensated personal absence. . . ." CAS 415 provides guidelines for measuring and assigning the cost of deferred compensation to definite periods, but it specifically excludes the issues of compensated personal absences and pension costs, which are covered by CAS 408 and CAS 412, respectively.

It appears that the provisions of CAS 408 can account for BV. These costs, after all, seem to qualify as the compensated personal absence as set forth in the main objective of this standard. But BV could also fall under the jurisdiction of CAS 415, since these costs are often deferred for many years, until the employee either uses the vacation time or leaves the firm.

On the other hand, definite problems arise when one applies either standard to BV. CAS 408 is intended for short-term use--that is, for accounting period situations. CAS 415, on the other hand, is intended to accommodate costs over a longer period, but perhaps not over as long a period as BV costs can extend. This intention is evidenced by the use of a short-term Treasury rate for present-value calculations, which, industry often argues, fails to account accurately for the time value of money.

According to John Wood, president of Acquisition Analysis Institute of Rockville, Maryland, and an expert on government-related accounting practices, the Cost Accounting Standards Board was aware during the mid 1970s of the potential confusion in the BV area but avoided the issue because of its complexity. A decade later, the issue remains unresolved, while the economic consequences of its accounting treatment become even more important.

The Alias case

Alias, Inc., a large nationally known company, undertakes some defense contracting and allows its employees to bank their vacation time. Alias' conflict with the Defense Contract Audit Agency (DCAA) is not unique; several other well-known firms have opposed the DCAA over the BV issue. Wishing to maintain a cordial and continuing relationship with the DCAA, Alias has asked to remain anonymous here. Consequently, the dates of correspondence between Alias and the DCAA have been omitted. Nevertheless, all the facts reported here--which are based upon the correspondence between Alias and the DCAA and upon internal memos of the DCAA and the Department of Defense which were obtained through the Freedom of Information Act--are completely accurate and authentic.

Alias' vacation policy requires that employees take two weeks of vacation, but they may save any portion or all of the vacation time they earn in excess of two weeks. They may use any or all of this deferred vacation time in any year and add it to the regularly scheduled vacation for that year.

Those employees who are dismissed or retire received payment in lieu of the accrued vacation time figured at the rate of the employee's base salary at the time of parting. Alias uses CAS 408 to account for its BV, and it credits a vacation liability account and charges a wage expense at the employee's current salary when he earns the vacation. As employee salaries increase, the vacation liability increases. Alias increases its vacation liability through year-end accruals to reflect the earned but not yet used vacation time.

Believing CAS 415, rather than CAS 408, to be the proper standard for BV accounting, the DCAA cited Alias for failing to comply with CAS 415. The DCAA explained the noncompliance and recommended that Alias:

* Amend its BV accounting practices.

* Not charge salary increases to the government.

* Provide a cost-impact analysis.

Two months later Alias responded that CAS 415 did not apply and suggested that the DCAA's position was incorrect. First, citing Sections 415.2 and 415.3, Alias pointed out that the scope of CAS 415 is too limited to account for BV.

Second, Alias noted that Section .2(a) specifically states that CAS 415 covers deferred compensation except for compensated personal absence, which is how Alias categorizes BV.

Third, Alias cited Defense Acquisition Regulations (DAR) Section 15-205.6(f), which covers CAS 415, as evidence that CAS 415 did not apply: ". . . defered compensation does not include normal end-of-accounting period accruals." In short, Alias appears to assert that the BV account requires normal end-of-accounting period accruals.

Fourth, Alias cited DAR Section 15-205.6(g) on "Frige Benefits," which includes the cost of vacations that are allowable if reasonable and consistent with the use of CAS 408. If CAS 408 fails to address the allowance or service of the contractor specifically, then the cost is still allowable "to the extent required by law, labor agreement or established policy of the contractor."

Fifth, Alias said that even the CAS disclosure statement required by Public Law 91-379 distinguishes between deferred compensation (CAS 415) and methods of charging and crediting vacation (CAS 408).

In its second letter, the DCAA reaffirmed that CAS 415 is applicable to BV costs, but without the wage increases. The agency cited CAS 415.3(a)(1) to show that cost accruals that are deffered for more than one accounting period represent a form of deferred compensation. The DCAA noted that year-end accruals for salary increases are excluded from CAS 415 and are covered in CAS 408 if they are paid within a reasonable time. But, in the DCAA's opinion, Alias' BV is not paid in a "reasonable time" and therefore falls under the provisions of CAS 415.

Standing on its original position, the DCAA again required a cost-impact analysis to determine unallowable costs from 1977 through 1982. Acting on Alias' initial refusal to provide that information, the DCAA initiated an audit and requested copies of all company policies and procedures covering employee vacation benefits and the accounting treatment given these costs. Meanwhile, Alias, Inc., still used CAS 408 to account for its costs.

DCAA changes to CAS 408

In an abrupt change of tactics, the DCAA accepted Alias' contention that BV costs fall under Section 408, but it charged that Alias had applied CAS 408 improperly. The DCAA objected particularly to Alias' practice of adjusting the BV liability account for those salary increases that occurred subsequent to the initial liability.

The accrual, said the DCAA, should be recorded only when earned with no subsequent adjmustments. The agency then recommended that Alias discontinue the practice of charging the government for adjustments for wage increases. It also included an estimate that the maximum dollar impact of Alias' alleged noncompliance exceeded $16 million for the contract years 1978 through 1983. The requests DCAA made in this third letter became more insistent. It suggested that Alias:

* REview its comments.

*take corrective action.

* Provide a cost-impact analysis for 1978 through 1983.

* Amend its bidding rate submissions.

In a six-page retort, Alias countered that under CAS 408.5(b) "compensated personal absence is earned at the same time and in the same amount as the employer becomes liable to compensate the employee for such absence."

Under GAAP, Alias contended, this liability should be recorded when it occurs. Since the liability increases as salaries increase, a periodic adjustment, or accrual, to recognize this additional liability and expense would be proper under GAAP. Alias also felt that, since the DCAA had continued its acceptance of accrual accounting, it would follow that the accrued BV cost is both allocable and recoverable for contract purposes. Finally, Alias pointed out that CAS 408 does not prohibit subsequent adjustments to the amount of an employee accrual. Alias ended its letter this way: "Our conclusion is that the government's position is without substance and that any attempt at cost disallowance is unsupportable under present regulations."

On July 23, 1985, the contracting officer, upon recommendation of the DCAA, issued a formal finding of noncompliance to another defense contractor who accounts for BV in a manner similar to Alias. At this point, the debate between Alias and the DCAA ceased, as both sides waited for the decision on this noncompliance case to set a precedent for Alias' case.

The Federal Acquisition Regulation Cost Principles Committee met with the Defense Acquisition Council to deliberate the banked vacations issue. In August, 1986, they "concluded that (they) were unable to reach a consensus on the appropriate cost principle coverage."

This decision cast doubt upon the DCAA's interpretation that CAS 408 restricts subsequent period accrual adjustments. Furthermore, since no specific accounting method was prescribed and the interpretations of Alias and other defense contractors were not found to be in violation of CAS principles, the DCAA stopped pursuing banked vacation cases.

Nevertheless, the DCAA continued to believe that allowing subsequent salary adjustments for banked vacations unduly enriched defense contractors. Consequently, in order to "protect the taxpayers' interests," the DCAA told its auditors to advise the contracting officers of prospective defense contracts to initiate advance agreements with defense contractors to limi t subsequent accruals for banked vacations. Several months later, the Defense Acquisition Regulatory Council rebuked the DCAA for making these recommendations, stating that "(DCAA's) guidance to the field . . . appears inappropriate."

What is the answer?

The intention of this account is to provide an illustration of the problems defense contractors face in an overregulated environment, not to adjudicate the merits of a particular defense contracting issue. The practice of deferring vacation time for future use appears commonly in many industries and in the government. Yet, the mountain of defense procurement regulations fails to address this common practice adequately.

The DCAA initially believed CAS 415 to be the correct standard. Then it reversed itself and applied CAS 408. However, within CAS 408, various alternative treatments for BV can be deduced, and the DCAA and Alias continued to disagree. Even the Federal Acquisition Regulatory Cost Principles Committee and the Defense Acquisition Regulatory Council were unable to prescribe a specific accounting treatment within the existing regulations.

The drafting of more regulations to resolve problems like this may be inevitable, but given the existing maze of regulations, more regulations could only exacerbate the problem. As the old joke has it, "Tell Congress there is too much bureaucracy, and Congress creates a new agency to examine the problem."

The BV situation exemplifies regulatory uncertainty. Since no one is sure how to apply the regulations, no one really knows which costs will be reimbursed. The government is asking defense contractors to play the game before they know all the rules. Interpreting and complying with the regulatory maze, while defending their accounting positions, absorbs a great deal of the defense contractors' energy--energy which if saved might be reflected in lower costs and greater technological innovation. For instance, several years ago McDonnell Douglas Corp. was asked to produce an experimental plane, the YC-15. The company bid $164 million and estimated the project would take two and one-half years. When the government offered special immunity from most oversight bureaucracy, the prototypes were rolled out 10 months early and at a cost of $84 million.

Finally, the BV issue illustrates a widely unrecognized, unreported type of waste in the defense industry--the waste caused, ironically, by the very regulation that has been instituted to control costs.
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Title Annotation:Corporate Reporting
Author:Hoshower, Leon B.
Publication:Financial Executive
Date:Sep 1, 1989
Words:2478
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