CAS 409 - Depreciation of Tangible Capital Assets

Purpose

This Standard came about in order to "enhance objectivity and consistency" in allocating depreciation costs to Government contracts.

This standard provides criteria for assigning costs of tangible capital assets to cost accounting periods and should enhance objectivity and consistency in their allocation.

Residual Values

Estimated residual values must be determined for all tangible capital assets or groups of assets. The residual values must be deducted from the capitalized value in computing the depreciable cost base, except where;

• (1) the estimated residual value of tangible personal property does not exceed 10 percent of the capitalized cost or
• (2) either the declining balance method or class-life-asset-range system is used.

The standard prohibits the depreciation of assets or asset groups below their residual value, if the residual value is greater than ten percent of the capitalized cost of the asset, or if the asset is real property. For personal property that has a residual value less than or equal to ten percent of the capitalized cost of the asset, the asset or asset group may be depreciated below residual value if the residual value is immaterial. Materiality should be determined based on the general criteria contained in 48 CFR 9903.305, Materiality.

Estimated Service Life

The estimated service life of the tangible capital asset, over which the depreciated cost is assigned, must reasonably approximate the actual period of usefulness to its current owner, considering such factors as obsolescence and required quality and quantity of output. The estimated service life can exclude standby or incidental use periods, provided adequate records substantiate the withdrawal of such assets from active use. Expected periods of useful life must be based on recorded past experience, as modified for expected changes in operating practices, obsolescence, or quantity of products produced. However, the contractor must justify estimated service lives which deviate from the previously experienced lives.

When a new asset is acquired for which the contractor has no available data or prior experience, the estimated service life must be based on projection of the expected useful life. The projection cannot be less than the midrange period for asset guideline classes established under IRS Revenue Procedure 72-10 and will be used only until the required records are available.

In special circumstances, contracting parties may negotiate a shorter estimated service life if it can be reasonably projected.

Method of Depreciation

The contractor may select any appropriate method of depreciation which reflects the pattern of consumption of services over the life of the asset. For example, an accelerated method is appropriate where the expected consumption of services is greatest in the early years of the asset life. Financial accounting methods are expected to approximate the pattern of consumption of services. Therefore, if the contractor continues to use previous methods found to be acceptable to the government on similar assets for financial accounting, no additional support of existing method will ordinarily be required.

A depreciation method selected for newly acquired assets which differs from the depreciation method currently used for like assets in similar circumstances must be supported by the contractor’s projection of expected consumption of services.

Depreciation costs are generally allocated as indirect costs to the cost objectives for which the assets provide service. They may be charged directly to cost objectives at average rates only if the charges are based on usage and the costs of all like assets used for similar purposes are also charged directly. Depreciation costs for assets included in service centers, where significant, must be charged to the service center.

Substantiation and Record Keeping

The standard requires the contractor to maintain adequate records which identify the age of the asset or asset group at retirement or withdrawal from active use. The record should contain such information as asset acquisition/disposition dates, date asset was withdrawn from active service, and any other factors that directly influence asset lives. The record need not be maintained solely for fixed asset accounting; it may be a record used for such other purposes as property insurance, income/property taxes, property control, or maintenance.

If supporting records are not available on the date the contractor must first comply with the standard, the estimated service lives should be those used for financial accounting. However, the required supporting records must be developed by the end of the second fiscal year after that date and used as a basis for estimated service lives on assets subsequently acquired.

Changes

Changes to estimated service lives, residual values, or consumption of services may be required as a result of significantly changed circumstances. Any resulting adjustment to the undepreciated cost will be assigned only to the cost accounting period in which the change occurs and to subsequent periods. No retroactive adjustments will be made.

Gains and Losses

The standard outlines the following accounting treatment for gains or losses associated with the disposition of tangible capital assets. An impairment loss under FASB Statement No. 121 is recognized only upon disposal of the impaired asset.

• (1) Where the asset is disposed of without an exchange, the gain or loss is generally treated as an adjustment to the appropriate indirect expense pool in the cost accounting period in which the disposition occurs. However, the auditor should be aware that, in such circumstances, the standard limits the gain to be recognized for contract costing purposes to the difference between the asset’s original acquisition cost and its net book value.
• (2) Where an asset is exchanged for like property, two options are available to the contractor: either the gain or loss can be recognized as discussed above, or the depreciable cost base of the new asset may be adjusted for the entire gain or loss.
• (3) Where an asset disposition results from an involuntary conversion and the asset is replaced by a similar asset, the same two options as described above for exchanges of like property are available to the contractor.
• (4) Where assets are grouped, gains or losses are not recognized. Instead they are processed through the accumulated depreciation account.
• (5) Assets dispositioned in a business combination meeting the criteria in CAS 404.50(d)(1). The revised CAS 409, effective April 15, 1996, added a new subparagraph CAS 409.50(j)(5) to make it clear that the CAS 409.50(j) provision dealing with the recapture of gains and losses on disposition of tangible capital assets should not apply when assets are transferred subsequent to a business combination meeting the criteria in CAS 404.50(d)(1). The revised CAS 409.50(j)(5) stipulates that the provisions of CAS 409.50(j) do not apply to business combinations and that the carrying values of tangible capital assets acquired subsequent to a business combination are to be established by the acquiring company in accordance with the provisions of CAS 404.50(d)(1). Consequently, since CAS 404.50(d)(1) does not recognize an increase or decrease in the asset values as a result of a business combination, any gain or loss realized by the seller on disposition of assets as a result of the business combination is also not recognized.
• (6) Assets dispositioned in a business combination meeting the criteria in CAS 404.50(d)(2). The April 15, 1996 revision to CAS 409.50(j)(5) does not apply to assets dispositioned in a business combination meeting the criteria in CAS 404.50(d)(2), i.e., the tangible capital assets acquired in the business combination did not generate either depreciation expense or cost of money charges during the most recent cost accounting period. Therefore, the provision on the recapture of gains and losses would apply to the dispositioned assets. However, for contracts awarded prior to April 24, 1998, tangible capital assets meeting the requirements of CAS 404.50(d)(2) must still comply with the requirements of FAR 31.205-16 and 52. Consequently, although the gain or loss may be recognized for CAS purposes, no gain or loss would be allowed per FAR. Effective April 24, 1998 (FAC 97-04), FAR 31.205-52 was revised to conform to the revised CAS 404 and 409. Therefore, gain or loss would be allowed for assets dispositioned in a business combination meeting the criteria in CAS 404.50(d)(2).

First Example

Based on a sample of asset dispositions/withdrawals for the last three years, the contractor now estimates 10 years service life for lathes. The records in the sample supporting the 10-year life classified several machines as "withdrawn from active use" although the machines are still on hand, in good working condition, and physically located in the plant machine shop. Neither the property records nor any other records reflected any change in the assets from active to inactive status. Records reflect a comparatively low usage of these specific machines for the past year due to a slack period. Solution. The machines should not be classified as "Withdrawn from active use" unless the contractor provides adequate documentation substantiating the change in status. Machines temporarily idled for lack of work are not "withdrawn from active service." The contractor’s written policies and procedures should define (1) the conditions under which capital assets may be withdrawn from active use and (2) the property records which must be prepared for processing the asset from active to inactive status. The records should clearly support that assets "withdrawn from active service" are in actuality intended only for standby or incidental use.

Second Example

b. Problem. Contractor purchases various tangible capital assets in FY 19XX and sells them seven years later. Information pertinent to the acquisition and sale is as follows: Capital Equipment....Lathe

Acquisition Cost...$30,000 Capitalized Current Net Book Value....$10,000 Sales Price.....$32,000

Truck $5,000 $ -0- $ 100

Fork Lift $10,000 $3,000 $2,000

Depreciation expense over the seven years was allocated to manufacturing overhead. Solution. The contractor will allocate gains and losses to manufacturing overhead in the year of sale as follows: (Gain)* or Loss

Capital Equipment Lathe...($20,000) Truck...($100) Fork Lift...$1,000

• Gain or loss is the difference between amount realized on disposition and its undepreciated balance ($32,000 -- $10,000 = $22,000); however, per CAS 409.50(j)(l), for contract costing purposes, the gain must be limited to the difference between the original acquisition cost of the asset and its undepreciated balance ($30,000 -- $10,000 = $20,000).

Third Example

The capitalized cost of a lathe is $50,000. The lathe is projected to have a residual value of $4,500, which is determined to be immaterial in amount based on the criteria in 48 CFR 9903.305, and an estimated service life of 10 years. The contractor utilizes a straight-line depreciation method. The asset is sold in Year 11 for $5,000.

Because the $4,500 residual value is less than 10 percent of the capitalized cost, the annual depreciation charges may be based on a depreciable cost base of $50,000. In addition, since the $4,500 is immaterial, the asset is depreciated to zero. However, since the contractor is required to provide a credit for the difference between the sales price and the book value, a credit of $5,000 is recognized in Year 11, as shown below: Depreciable cost base $50,000 Accumulated depreciation: 10 years @ $5,000 per year 50,000 Net book value at end of 10th year $ -0- Year 11: Credit for Gain on Sale of Asset (Sales price of $5,000 less book value of zero) $5,000

Fourth Example

Contractor A acquires Contractor B and accounts for the business combination using the purchase method of accounting. Prior to the business combination, the net book value of Contractor B’s assets was $10.5 million. Contractor B’s assets generated depreciation expense and cost of money charges that were allocated to government contracts negotiated on the basis of cost in its most recent cost accounting period. The difference between the original acquisition cost of Contractor B’s assets and its undepreciated balance is $3.0 million. For GAAP purposes, the difference between the sales price and net book value of assets results in a gain of $4.0 million. The revised CAS 409 applies to the business combination.

The provisions of the amended CAS 404.50(d)(1), effective April 15, 1996, would apply to the business combination because the seller’s (Contractor B’s) assets generated depreciation or cost of money charges that were allocated to government contracts negotiated on the basis of cost in its most recent cost accounting period. Therefore, the provisions of CAS 409.50(j) dealing with the recapture of gains and losses on disposition of capital assets would not apply to the business combination. For CAS purposes, Contractor B would not recognize the gain. Consequently, the gain would not be reflected in Contractor B’s total cost input G&A base because the gain was not measured for CAS purposes.

Fifth Example

Same facts as Problem d. above, except that Contractor B has not performed government contracts for several years and consequently, its assets did not generate depreciation expense or cost of money changes that were allocated government contracts negotiated on the basis of cost, in its most recent cost accounting period.

The provisions of the amended CAS 404.50(d)(2), effective April 15, 1996, would apply to the business combination because the seller’s (Contractor B’s) assets did not generate depreciation expense or cost of money charges on government contracts in its most recent cost accounting period. Therefore, the provisions of CAS 409.50(j) dealing with the recapture of gains and losses on disposition of capital assets would apply to the business combination. For CAS purposes, Contractor B would recognize the $3.0 million difference between the original acquisition cost and the undepreciated balance and credit the appropriate indirect cost pool(s). For contracts awarded prior to April 24, 1998, the gain would not be recognized under FAR 31.205-16 and 31.205-52. However, for contracts awarded on or after April 24, 1998, the gain would be recognized.