PART 2

 

This PART 2 is a continuation of the information shown under PART 1.

 

Interest has been increasing with many members on this topic. I have been receiving increasing requests for information pertaining to the cost, pricing, and audit considerations for JV's and TA's as well as clarification on what an SBU is.  So I have decided to share the many audit, cost and pricing issues to be considered.  And there are a lot!  As a result, this topic will be covered in several parts.  I would recommend you share the information with your CPA's, Audit/Accounting Staff, and Legal Representatives.

 

Often, firms go into great detail on the technical and legal side of these arrangements but fail to put the effort and resources in ensuring the arrangements will stand muster under potential future audit and review.  So, here I am to put this forth for your information and to show you where to go to find out for yourself what you and your support personnel need to know. 

 

In this part we will continue by sharing the last seven (7) of eleven (11) areas of consideration as outlined by DCAA in providing guidance to their auditors.  To those that have attended, or viewed the DVD, of my training class, do you remember my discussion on "subject to interpretation"?  Well, there is much on this subject where interpretation applies.  So, do your homework, get proper and strong counsel, and be sure to include in your pricing any projected additional cost you may incur as a result of moving in this direction.

 

This information is not proprietary.  It is available to all and I don't mind saying so.  What I have done was to identify, format, and excerpt the information that will address the many questions our member colleagues have asked.

 

5 Audit Considerations

a. The joint venture and teaming arrangement in these discussions specifically covers unincorporated joint ventures, and may not apply to incorporated joint ventures.

 

b. There are a number of audit issues and concerns related to the formation, organization, and operation of joint ventures, teaming arrangements, and SBUs. These types of business organizations can have a material impact on the contractor's existing organizations and Government business. The creation of an SBU may change the auditors prior assessment of internal controls and may cause increased costs on contracts at existing contractor segments.

 

c. The impact, however, is not always adverse, and the creation of joint ventures and SBUs may be proper and acceptable.  Contractors establish joint ventures to combine their resources and strengths to improve chances of winning procurement and performing acceptably and profitably in response to an RFP requirement

 

Contractors may also establish joint ventures in response to an RFP requirement for contractor teaming arrangements.  In these procurements it may even be the Government's acquisition strategy to have two or more contractors team together to jointly design, develop, and test some type of new technology with the intent to qualify multiple contractor sources for future production. This type of acquisition strategy is most popular on major weapon system procurements. Normally, these teaming arrangements have the characteristics of joint and equal control where neither contractor possesses a majority ownership nor exercises management control.

 

Similarly, some contractors have established wholly-owned subsidiaries or divisions for FMS (Foreign Military Service) contracting purposes. Many of these SBUs have been created to limit tax or legal liability.

 

d. There are also a number of joint ventures and SBUs that may present problems which and auditor should fully disclose to the contracting officer and other audit or government agencies to aid in making their decisions in relation to contracting with the joint venture or SBU.  This is particularly important when the performance of a joint venture or SBU contract would cause increased costs on other Government contracts or when the changes in accounting practices associated with the contract have not been fully disclosed.

 

After award of a contract to such a joint venture or SBU, the auditor will monitor the costs allocated to the SBU to assure that it absorbs an equitable share of costs.

 

e. An auditor will consider both the form and substance of the business unit by reviewing the following:

1.     Is the joint venture or SBU a business segment? (see 6)

2.     What is the actual relationship between the venturing organizations? (see 7)

3.     Is the joint venture/SBU cost accounting and tax treatment consistent with the form and substance of the business organization? (see 8 and 9)

4.     Does the joint venture/SBU accounting result in equitable cost allocations between and among the business organizations/segments? (see 10)

5.     Does the joint venture/SBU have a cost impact on the existing contracts of the venturing/parent organizations, and if so, has a change in cost accounting practice occurred? (see 11)

 

6 Characteristics of a Legitimate Business Unit/ Segment

 

a.         When reviewing the accounting aspects of a contractor's business organization, the identification of the organization as a segment or business unit is important for the following reasons:

1.     CAS consistently uses the terms "segment" and "business unit" to present its accounting guidance on business organizations.

2.     Various financial accounting pronouncements, such as those dealing with consolidated reporting, also use the term "business segment" to present GAAP that applies to business organizations in general. (Note that the CAS and FASB definitions for "segment" are not the same.) The CAS/FAR definition is the relevant definition for Government cost accounting purposes.

3.     Entities that do not satisfy the basic criteria for a segment or business unit are actually an undivided part of a contractor business unit. Therefore, separate allocations to such an SBU would often be in noncompliance with those provisions of CAS (e.g., 402, 403, 410, 418, and 420) which deal with the consistency and fragmentation of allocation bases. (see 10)

 

b.         The terms "segment" and "business unit" are defined for CAS purposes in FAR 2.101.

1.     A CAS segment is "one of two or more divisions, product departments, plants, or other subdivisions reporting directly to a home office, usually identified with responsibility for profit and/or producing a product or service." A CAS segment may include a GOCO (Government Owned Contractor Operated) facility, or a joint venture or subsidiary in which the organization exercises control. CAS does not define control nor provide criteria for determining whether an organization exercises control.

2.     A business unit, in turn, is any segment of an organization which is not further divided into segments.

 

7 Relationship Between Business Organizations

The form and substance of a contractor's business organization can significantly influence the allowability and allocability of costs incurred under Government contracts.  An auditor will determine not only the form of the business organization but the actual relationship (substance) between the venturing contractors.

Below are several criteria and appropriate review procedures. Normally no one factor should be the sole determinant of whether the relationship is a joint venture or more closely resembles a prime contractor/subcontractor relationship. The allocation of costs should reflect the causal/ beneficial relationships between and among the venture partners and other segments/home offices of the contractor.

 

a.     Review of Joint Venture Agreements

 

1.     FAR 9.603 requires contractor joint ventures and teaming arrangements to identify and disclose the arrangements in an offer or, for arrangements entered into after submission of an offer, before the arrangement becomes effective. This is normally done in a written agreement between the participating contractors. An agreement will normally contain and/or explain:

a)     the name of the venture;

b)    the customer and solicitation number;

c)     the names of the participants;

d)    any limitations on the powers and rights of the participants;

e)     the contributions that each participant is required to make with regard to the venture's capital, personnel, proposal preparation, etc.;

f)     anticipated subcontracts;

g)    funding requirements;

h)     responsibilities for record keeping and for the preparation of reports and invoices;

i)      the designated management;

j)      limitation of liabilities;

k)     term of venture and dissolution agreements;

l)      responsibilities for and restrictions on royalties, patents, copyrights, and property rights arising from venture operations;

m)   the resolution of disputes among the venturers;

n)     covenants on how litigation costs will be borne by the participants;

o)    which state's laws will govern the venture;

p)    the filings or disclosures required by the state, FAR, etc.;

q)    any technology transfer agreements; and

r)      any cost/profit sharing agreements.

 

2.     Review the written agreement to help determine the management, financial, and technical responsibilities of each contractor. In addition, review the joint venture/teaming arrangement organization chart(s) and policies and procedures. This information can be useful in determining if the characteristics of joint control and management are present or if one contractor seems to possess the control and management characteristics of a prime contractor.

 

b)    Ascertain each venturers responsibility for the financial and technical management of the joint venture. Determine the composition of the joint venture management team, the location of the joint venture program office, the procedures for preparing the joint venture financial statements, tax returns, and Government billings and technical reports. Also review each venturer's responsibility and role in the preparation of the joint venture proposal. Ascertain each venturer's responsibilities for outside subcontractor selection and material purchasing. The composition of the key personnel to the joint venture should also be analyzed. When considered together this information will help determine the actual relationship between the venturers. It will also help determine if one venturer exercises control over the joint venture.

 

c)     Review the composition of the joint venture or teaming arrangement capital and equity to help determine if one of the venturers exercises ownership control. Analyze any cost and revenue sharing agreements and asset contributions.

 

d)    Review the technical relationship between the venturers by reviewing the written agreement, any technical exchange agreements, the cost and technical proposals, the contract and/or subcontract statements of work, and other relevant documentation. Determine the assignment of technical responsibilities to each venturer, the integration of work products between the venturers, and the technical areas of expertise of each venturer. The responsibilities of each organization for technical interface with the Government can also help determine the technical relationship between the venturers.

 

8 Accounting Considerations

8.1 Accounting Considerations for Joint Ventures

a.     General. A joint venture, proposed and established as a separate business entity, should have its own set of books and supporting documentation sufficient for an audit trail. Transactions should be recorded consistent with the joint venture agreement (see 7a.), and care must be taken to ensure that the joint venture bears its equitable share of the costs. For audit guidance on the general implications of FAR and CAS in the review of joint ventures and SBUs, see 10.

 

b.    Incorporated Joint Ventures. Investors, in most circumstances, should use the equity method to account for incorporated joint ventures. The generally accepted accounting principles (GAAP) relating to this method of accounting for investments in joint ventures are contained in APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," and, to a lesser extent, in APB Opinion No. 23, "Accounting for Income Taxes-Special Areas." Paragraph 16 of APB 18 concludes that investments in common stock of incorporated joint ventures should be accounted for by the equity method, regardless of the percentage of stock held, to reflect the underlying nature of their investment in such ventures. The uncommon circumstances under which the cost method of accounting for incorporated joint ventures should be used in lieu of the equity method are noted in paragraph 16 of APB Opinion No. 18.

 

c.     Unincorporated Joint Ventures. The provisions of APB Opinion No. 18 have generally been interpreted as being applicable to unincorporated joint ventures as well as incorporated joint ventures. Therefore, in most circumstances when the investment in an unincorporated joint venture is material, the equity method should also be used to account for the investment.

 

d.    Joint Venture Accounting as a Partnership. If a joint venture elects to be treated as a partnership, or is required by either the Federal tax code or any state's partnership laws to be treated as a partnership, then the joint venture should

1.     adopt accounting practices that are consistent with the single entity concept, and

2.     maintain a complete set of books and records.

 

e.     For criteria to help determine the actual relationship between the venturing contractors see 7.

 

8.2 Accounting Considerations for Teaming Arrangements

a.     The accounting for teaming arrangements should be consistent with the form of business organization that the teaming contractors have agreed to and disclosed in their proposal(s). For example, if the agreed-to arrangement is in the form of a joint venture, then this should be disclosed in the proposal(s) and the accounting principles applicable to a joint venture should be followed. FAR 9.603 requires contractors to fully disclose all teaming arrangements in their offers. If an arrangement is entered into after submitting an offer, then disclosure is required before the arrangement becomes effective.

 

b.    When the characteristics of joint control (i.e., joint property, joint liability for losses and expenses, and joint participation in profits) are evident, then the business arrangement is a joint venture. If the characteristics of joint control are not evident, then the terms of the business arrangement should be reviewed to see if a prime contractor/subcontractor relationship exists between the parties. Note, however, that a disclaimer of a joint venture arrangement in itself does not preclude an arrangement from being classified as a joint venture if it possesses the characteristics of a joint venture. See 7 for criteria to determine the actual relationship between the contractor organizations.

 

8.3 Accounting Considerations for SBUs

A Special Business Unit or SBU, as explained in 2f., is DCAA's term to describe a contractor subsidiary, division, or other form of business organization established to accomplish certain specific tasks or to gain a competitive advantage. It is not a distinct entity form; therefore, the accounting for an SBU should follow the principles established for the actual entity involved and be consistent with the contractor's disclosed accounting practices.

9 Joint Venture, Teaming Arrangement, and SBU Federal Taxes

9.1 Tax Classification and Definitions of Organizations

a. General. The classification and definitions of organizations for Federal tax purposes are contained in the regulations of the Internal Revenue Service (26 CFR 301.7701-1 et seq.). Except for organizations of professional persons, local law will have little bearing in the determination of an entity's classification for tax purposes. The tax and common business law definitions for the various types of business organizations are usually different. Some examples of these differences are noted below.

 

b. Corporation. The term "corporation" as defined in the CFR is not limited to the entity commonly known as a corporation (see 2a.); it includes an association, a trust classified as an association due to the nature of its activities, a joint-stock company, an insurance company, and certain kinds of partnerships.

 

c. Partnership.

(1) The term "partnership" is also broadly defined in the CFR to encompass just about all types of unincorporated organizations including most forms of syndicates, groups, pools, and joint ventures. In other words, if a legal business entity does not constitute a trust, estate, or corporation for tax purposes, then it is likely to be considered a partnership. Further note that the tax status of a partnership is not affected by the fact that a corporation may be one of the partners, or that local law does not permit a corporation to be a partner.

(2) Notwithstanding the above, DoD contractors have established several forms of unincorporated joint ventures and joint venture teaming arrangements that they do not consider to be partnerships for tax purposes.

 

d. Limited Partnership. A limited partnership, depending upon its specific characteristics, is classified in the CFR as either an ordinary partnership or as an association taxable as a corporation.

 

    e. Association. Section 301.7701-2 of the CFR defines an association as a corporation if it has certain characteristics, including:

(1) associates,

(2) free transferability of interest,

(3) an objective of carrying on a business and distributing profits,

(4) liability for debt limited to corporate property,

(5) continuity of life (i.e., a going concern), and

(6) central management.

 

9.2 Review of Tax Returns

a. Review the joint venture, teaming arrangement, or SBU tax returns and supporting records to determine, confirm, or gain additional insight into the type and nature of the contracting entity. Tax information can answer questions on ownership and control and on whether a given organization exists as a separate legal business entity or as a component of a contractor's existing business entity. When reviewing a joint venture or teaming arrangement that may or should be treated as a partnership for tax purposes, request Schedules K and K-1, supporting Partnership Return Form 1065. These schedules address the apportionment of income, credits, deductions, etc. to the individual partners (i.e., joint venturers/team members). They also identify the individual partners and contain other information relating to the assessment of costs, degree of control, ownership of capital, percentages of profit and loss sharing, and credits.

 

b. General guidance on the review of contractor tax returns is provided in DCAAM 3-1S2, and brief descriptions of some of the applicable tax forms are also presented in DCAAM 3-1S2.

 

10 FAR and CAS Cost Allocation Considerations

10.1 FAR Compliance

a. General. The FAR does not specifically address a joint venture as a party in the procurement of supplies and services under Government contracts. It is therefore necessary to understand the purpose for and characteristics of a joint venture when reviewing the venture in terms of the FAR, specifically the FAR cost principles on allowable costs.

 

b. Material/Service Costs and Venture Control. When one of the venture participants exercises majority control over the joint venture, FAR 31.205-26(e) specifically provides that the transfer of material costs or service costs from any of that company's segments to the joint venture should be on the basis of cost incurred, unless competitive or catalog prices are involved. In the event that the venture members appear to be equal participants, the provisions of FAR 31.205-26(e) still apply, if the auditor can determine that one of the members actually exercises predominant control over the venture. To help make this determination the auditor should look at the venture agreements to ascertain if any member has significant risk or underwriting responsibility in disproportion to the others.

 

10.2 CAS Disclosure Statements.

a. General. Any contractor which, together with its segments, receives net awards of CAS-covered negotiated Government contracts totaling $50 million or more in its most recent cost accounting period must submit a CAS Disclosure Statement (48 CFR 9903.202-1(b)). Any business unit that is selected to receive a CAS-covered negotiated Government contract or subcontract of $50 million or more is also required to submit a Disclosure Statement.

 

b. Joint ventures are composed of two or more contractors each of which may have already filed a Disclosure Statement as a result of having obtained other Government contracts. Review the characteristics of the joint venture to determine if the joint venture meets the definition of a CAS segment.

 

c. The need for a joint venture CAS Disclosure Statement depends upon the characteristics of the venture itself. The determination must be made on a case-by-case basis. Where the joint venture is the entity actually performing the contract, has the responsibility for profit and/or producing a product or service, and has certain characteristics of ownership or control, a Disclosure Statement should be required. Where the venture merely unites the efforts of two contractors performing separate and distinct portions of the contract with little or no technical interface, separate joint venture disclosure may not be required. Where doubt exists, discuss the circumstances with the contracting officer.

 

10.3 Cost Allocation

a. There is no one cost allocation model which covers contracts issued to all joint ventures, teaming arrangements, and SBUs. The range includes everything from models where all costs are incurred at the contracting entity to models where no costs are incurred at the contracting entity. The former model is a normal prime contracting scenario and the later is descriptive of SBUs which have no employees or assets of their own.

 

b. Many contractors either have their SBUs "borrow" employees from other segments of the contractor or have the other segments perform the tasks normally performed by the prime contractor in place of the SBU. In either case, the arrangement may create a home office at the segment providing the services to the SBU. A home office provides management services or supervision to two or more segments. For CAS-covered contractors, the home office costs must be disclosed and be compliant with CAS 410.50(h) and CAS 403. The tasks performed by the home office for the SBU may include a wide range of functions; e.g., general management, bid and proposal, independent research and development, selling, contract administration, material handling, procurement, computer services, personnel services, etc. When a segment begins to perform indirect functions for another segment it may present new labor charging and timekeeping problems requiring new training and internal controls.

 

c. In extreme cases, SBUs have no employees or assets. All the deliverable services and products are designed, manufactured, assembled, and provided by operating segments of the contractor. These operating segments only transfer the costs to the SBU for billing purposes. All G&A/B&P/IR&D, any specifically identifiable contract management functions, and any other indirect costs are performed by one or more of the contractor's other segments, making those segments home offices which must allocate the costs to the SBU.

 

d. When residual home office expenses are allocated using the three factor formula, CAS 403 requires that inter-segment sales be claimed at the segment which produced the contract deliverable product or service. When determining the sales factor to be used in the three factor allocation for residual expenses at a home office or a group home office, CAS 403.50(c)(1)(ii) requires that each segment in the allocation grouping include inter-segment sales in its sales total and then reduce its sales total by the amount of purchases from other segments in the allocation grouping.

 

e. Allocation of Home Office Expenses to Joint Ventures and Teaming Arrangements.

 

(1) General. Most of the joint ventures or teaming arrangements encountered to date have been established as CAS 403 segments with the venturing companies acting as intermediate home offices for their share of the venture costs. Such arrangements usually involve the adoption of a "special" method of allocating residual home office expenses wherein each venturer allocates a portion of its residual expenses to their portion of the joint venture costs. Notwithstanding this background on the typical arrangement, follow the guidance below in the review of home office expenses relative to joint ventures.

 

(2) If the joint venture or teaming arrangement is considered a segment in accordance with the definition of CAS 403 (see a & b above), the auditor needs to ensure that each of the venturing companies:

(a) identifies and directly allocates those home office expenses that were specifically incurred in support of the joint venture,

(b) separately allocates to the joint venture its share of home office support expenses from any homogeneous pools, and

(c) adopts one of the following practices for the allocation of residual expenses:

(i) The venturer’s can request a special allocation of the residual expenses in accordance with the criteria in CAS 403.50(d)(1).

(ii) The majority or controlling contractor can treat the joint venture as a segment of its company, and include the entire operations of the venture in its formula for allocating residual expenses.

(iii) The minority contractor may also allocate its company's residual expenses to joint venture, but is not required to.

 

(3) The joint ventures and teaming arrangements that have not been formed as separate CAS 403 segments (see a & b above) generally do not have, and would not be expected to have, significant assets or payrolls (elements of the three factor formula for allocating residual expenses). Home office expenses are allocated to the contracts of these joint ventures in the same manner that the venturing companies allocate these expenses to their other contract work.

 

f. CAS 410.50(d) requires that the cost input base used to allocate the G&A expense pool include all significant elements of that cost input which represent the total activity of the business unit. Only in instances where a particular final cost objective in relation to other final cost objectives receives significantly more or less benefit from G&A expense can the contractor deviate from this requirement. All special allocations of this nature must be handled in accordance with CAS 410.50(j). Such special allocations may be appropriate in unusual circumstances that are not expected to recur. To the extent that subcontracts or any other significant element of cost input, representative of the total activity of the unit, are excluded from the base, a noncompliance occurs.

 

g. CAS 420.50(f)(2) requires that the cost input base used to allocate IR&D/B&P costs to all final cost objectives be the same as the G&A allocation base. As with G&A above:

(a) only in instances where a particular final cost objective in relation to other final cost objectives receives significantly more or less benefit from IR&D/B&P costs can the contractor deviate from this requirement, and

(b) to the extent that a significant element of cost input is excluded from the base, a noncompliance occurs.

 

h. CAS 418.50(d)(2) states that a material cost base is appropriate if the activity being managed or supervised is a material-related activity. Upon selection of a material cost base, all significant elements shall be included in that allocation base.

 

i. When reviewing joint ventures or teaming arrangements that have been established as a separate business entity and which have a CAS-covered contract an auditor will:

(1) Treat the venture as a separate contractor segment, even if the venture has few, if any, assets or employees, and no up-front investment. See 6 for further guidance relating to the determination of separate business units/segments.

(2) Ensure that all of the costs that should be allocated to the venture are appropriately allocated to the venture in accordance with the provisions of CAS. (G&A and IR&D/B&P, for example, should be allocated to the venture according to the provisions of CAS 403, 410, and 420.)

 

j. When reviewing joint ventures and teaming arrangements that have not been established as a separate business entity, an auditor will:

(1) Determine the reasons why the venture is not being treated as a separate entity or CAS business unit/segment. For example, do the venturer’s claim that a separate segment does not exist because

(a) the venture has no assets, employees, or up-front investment, and/or

(b) the cost impact of establishing the venture as a separate entity is not significant enough considering the extra administrative costs involved?

(2) Determine how the venture and venturing companies are being treated and accounted for. For example, are the venturing companies being treated as independent contractors (vs. subcontractors to the joint venture)?

(3) Develop a position based on appropriate consideration of

(a) the CAS requirements,

(b) the principle of "substance over form,"

(c) materiality of the cost impact associated with establishing a separate entity, and

(d) the intent of the contracting officer.  If a preliminary position is developed which substantially differs from, or conflicts with, the intent of the contracting officer, the matter may be elevated through normal channels to the attention of the Audit Headquarters Accounting and Cost Principles Division.

(4) Meet with the contracting officer and/or administrative contracting officer to:

(a) discuss audit findings and the contracting officer's position with respect to the arrangement, and

(b) work toward changing any unsuitably proposed or established joint ventures.

(5) Communicate any adverse impact associated with the joint venture arrangement (i.e., CAS noncompliance or accounting inconsistency) to the ACO, cognizant PCO, and other PCOs affected by the arrangement, and continue to closely monitor the arrangement for such an impact.

 

11 Changes in Cost Accounting Practices

Basic Audit Requirement. Once a CAS-covered joint venture or SBU is established, and there are no apparent CAS noncompliances associated with the allocation of costs, an auditor will next determine whether the SBU organization itself has impacted the costs on any existing company contracts, and if so, whether a change in cost accounting practice occurred. Each organizational change will be evaluated separately to determine whether a change in cost accounting practice has occurred. Specific criteria for making these determinations are provided in 48 CFR 9903.302.

 

While organizational changes by themselves are not changes in cost accounting practices, such changes may cause a change in a contractor's cost accounting practices. The decision as to whether there is a change in cost accounting practice should be made through an analysis of the circumstances of each individual situation based on the criteria being promulgated in the CAS regulations.

 

The CAS rules, regulations, and administrative requirements for changes in cost accounting practices are contained in 48 CFR 9903.3, FAR 30.602, and CAS contract clause FAR 52.230-6, "Administration of Cost Accounting Standards." 

 

When reviewing a joint venture or SBU to determine the cost impact on existing company(s) contracts, care must be taken to distinguish between:

 

1.     the cost impact due to the change in the measurement, allocation, and assignment of costs and

 

the impact due to the initial adoption of a cost accounting practice, or the partial or total elimination of a cost or the cost of a function, which are not considered changes in cost accounting practices under CASB rules and regulations.