Cost Accounting Standard 408 - Preambles

Preambles to Cost Accounting Standard 408, Accounting for Costs of Compensated Personal Absence

Preamble A

Preamble to Original Publication, 9-19-74

The following is the preamble to the original publication of Part 408, on Sept. 19, 1974, at 39 FR 33681.

The Cost Accounting Standard on Accounting for Costs of Compensated Personal Absence is one of a series being promulgated by the Cost Accounting Standards Board pursuant section 719 of the Defense Production Act of 1950, as amended, Pub.L.91 379, 50 U.S.C.App. 2168, which provides for the development of Cost Accounting Standards to be used in connection with negotiated national defense contracts. This Standard deals primarily with the amount and time recognition of costs of compensated personal absence.

Work preliminary to the development of this Cost Accounting Standard was initiated as a part of the study of the larger subject of accounting for labor costs. The costs of compensated personal absence are an important element of labor costs, but under existing procurement regulations there is no assurance that the costs of compensated personal absence are assigned to the cost accounting period in which the related labor is performed and in which the related wage or salary cost are recognized. Because the volume and mix of contracts of a particular Contractor may vary significantly from period to period, the assignment costs to the proper cost accounting periods is important.

Early research on this Cost Accounting Standard included a study of available literature and relevant decision of boards of contract appeals a Courts. Initial meetings were held with major procurement agencies and with a number of Contractors, and certain issues were tentatively identified. The relationship of Government procurement regulations to Federal Income Tax laws which govern the accounting for costs of compensated personal a sense was explored. It was noted that the exact nature of the employer’s ability to employees under a specific plan was an important consideration in determining the income tax treatment which might be permitted. A review of Disclosure Statements file indicated a disparity in existing accounting practices.

A questionnaire and a statement issues were then sent to 117 companies, 40 Government agencies, and 53 others, including industry and professional associations, to obtain detail information, particularly in regard to benefit plans and the reasons for selecting a specific accounting method. Data on benefit plans and accounting practices were received from 68 companies and comments on the issues were received from 37 respondents. Analysis of the data and Comments indicated that the issue could be classified broadly into two group -- those relating to the amount and timing of recognition of costs of compensated personal absence and those relating to methods of allocation of these costs to cost objectives. Some problems were noted in connection with the charging of costs of compensated personal absence directly to final cost objectives at the time of payment; these have been addressed in the Standard. Detailed criteria for the allocation of costs of compensated personal absence are not included in this Standard. Additional study of other labor-related costs is being undertaken and when it has been completed such criteria may be provided.

Based on analysis of the responses to the questionnaire and issues paper and on further discussions, a preliminary draft Standard was developed and widely distributed for comment. Comments and suggestions were received from 87 respondents; these comments were considered in developing a revised Standard which was published in the Federal Register off March 4, 1974, with an invitation to interested parties to submit written views and comments to the Board. The Board also supplemented the invitation in the Federal Register by sending copies of that issue to several hundred organizations and individuals who had provided the Board with Comments or the earlier proposal or who had otherwise expressed interest in the proposal.

Following the Federal Register publication, the Board received 86 sets of written comments from companies, Government agencies, professional associations, industry associations, public accounting firms, universities, and others. All comments have been carefully considered by the Board and those addressing areas of significance are discussed below, together with explanations of the Changes made in the Cost Accounting Standard being promulgated from the proposal published in the Federal Register Of March 4, 1974.

The Board wishes to take this opportunity to express its appreciation for the helpful suggestions and constructive criticisms it has received, and for the time devoted to assisting the Board in this endeavor by the many, organizations and individuals involved.

(1) Need for a standard

The most significant problems and issues relate to the amount and timing of recognition of costs of compensated personal absence appear to stem from the reliance of existing procurement regulations on the Internal Revenue Code and income tax regulations to govern accounting for these costs. Three disadvantages arise from this reliance. First, current regulations and prior rulings permit, but do not require, the use of accrual accounting for vacation pay, and they do not specify the amount to be accrued if accrual is elected; of three contractors with identical vacation plans, one may elect to recognize vacation costs pro-rata as the related work is performed, the second in the year the related work is completed, and the third only at the time vacation is taken. Consequently, current regulations do not require uniformity in the measurement of such costs among years. Second, the Internal Revenue Code and Treasury Department rulings have imposed different criteria at different times; of two contractors with identical plans, one historically may have been permitted to recognize costs of compensated personal absence on the accrual basis, while the other, who applied at a later date, is denied the same privilege because of a subsequent ruling. Finally, a change in the Internal Revenue Code or income tax regulations may not be appropriate for contract cost accounting.

Many commentators said that they were not aware of problems relating to accounting for costs of compensated personal absence and they questioned the need for a Standard on the subject. Discussions with a number of these commentators disclosed, however, that they were unaware of the lack of uniformity created by the reliance of Government procurement regulations on income tax regulations. The Board believes that the promulgation of a Standard dealing with accounting for costs of compensated personal absence is desirable to improve, and provide uniformity in, the measurement of these costs for a cost accounting period and thereby to increase the probability that the measured costs are allocated to the proper cost objectives.

(2) Scope of the standard

Several commentators questioned the exclusion of such costs as severance pay or group insurance from the Standard and they concluded that these costs were thereby unallowable as contract costs. This conclusion is not correct. A Standard does not define which costs are or are not allowable. Moreover, these costs were excluded from this Standard because our research disclosed that the associated accounting problems are sufficiently dissimilar from those of compensated personal absence to warrant separate consideration.

(3) Basis for recognition of cost

The Standard that was published for public comment relied on the degree of certainty of the employer’s obligation as the principal criterion for accrual or nonaccrual of costs of Compensated personal absence. Some commentators suggested that costs not be recognized prior to payment unless the obligation to provide the benefits were irrevocable in all circumstances. Using this test, most company benefit plans which we have seen in the course of our research would not qualify for accrual accounting. Others suggested that the Standard set no restrictions whatsoever on the use accrual accounting for these costs.

After considering all of the comments and after additional staff research and discussions with contractors, Government agencies, and others, the Board has concluded that the distinction which it previously stated between a “certain” and a “reasonably certain” obligation for purposes of determining liability, was unnecessary. The Standard has been simplified to state directly that the proper measure of the liability and the criterion for cost recognition is the amount which would be payable if the employer were to terminate the employment for any reason not involving disciplinary action. Under generally accepted accounting principles, liabilities are usually recorded when obligations to transfer assets or provide services in the future are incurred. If the employee would be paid a give amount in the event of lay-off, then that employee must have completed the service necessary to have earned that amount of entitlement to benefits.

Some Commentators suggested that only so much of the employer’s liability as would be payable on voluntary termination be considered to “earned.” The Board does not accept this position. Even in cases where voluntary termination causes a forfeiture, the employer cannot unilaterally avoid the liability. The employer’s liability should not be disregarded merely because an employee may later act to relieve the employer of actually making the payment.

Even if the obligation is viewed as one of a contingent nature, generally accepted accounting principles provide that where the outcome is reasonably foreseeable and the contingency may be expected to result in a Cost, it should be reflected in the account based on its research, the Board believes that only a small percentage of those employees of any contractor who are entitled to benefits forfeit those benefits. Therefore, the Board believes that the obligation should properly be recognized (with appropriate adjustment for anticipated forfeitures), and to fail to do so is to misstate the costs of Compensated personal absence which are properly assignable to that cost accounting period.

(4) Utilization of benefits criterion

A number of commentators objected to the provision in the proposed Standard that if the employer’s obligation were not “certain,” then accrual accounting could be used only if at least 80 percent of the entitlement which was potentially earned in any year would ultimately be used by the employees. The intent of this provision was to assure that accrual accounting was not permitted in situations where the utilization rate was so low that it was questionable whether accruals based on estimated utilization provided any better cost accounting information than did actual cash disbursements. The Board has reviewed the utilization data of a number of contractors and finds that by adhering to the amount which is payable on involuntary termination of employment as the measure of the accrual, a utilization criterion is unnecessary. It has therefore been deleted.

(5) Adjustments for unrecognized liabilities

The Standard requires the recognition of costs when the entitlement to compensated personal absence is earned. Initial application of the Standard or a change of compensated personal absence plan may necessitate an adjustment to recognize the cost of entitlement already earned but not yet recognized for cost accounting purposes. The proposed Standard made no explicit provision for the disposition of such adjustments. A number of commentators cited the failure to provide explicitly for the disposition of adjustments as a deficiency in the proposed Standard. For example, it was hypothesized that a contractor who was recording vacation costs at the time of payment might not recognize any vacation cost in the year an employee was hired; on the completion of the contract, the employee might be terminated and paid for both the vacation to be taken in the year of termination and the vacation earned in that year. If the Standard were applicable to the contractor, he might be able to allocate only those costs accrued in that year. As a result, he might not recover Costs paid in that year for vacations earned before accrual was instituted. The Board recognizes the validity of this hypothesis in some instances. However, if the contractor is viewed as a going concern and Government contracting as a continuing process, then that hypothetical “last year of contracting” may be infinitely far in the future, the lay-offs may never take place, and the contractor will continue to receive “one year’s worth of Costs” in each year.

All commentators who questioned the method of adjustment, and certain other contractors who did not raise the question but who the Board believed might be significantly affected by the Standard, were asked to provide detailed information concerning involved, the number of the estimated amount of the adjustment. In addition, each contractor was asked to provide background information concerning its history as a Government contractor and, to the extent available, data on past employment, labor costs, and extent of contracts. The Board also contracted several contractors who already record costs of compensated personal absence on the accrual basis to determine the circumstances under which this accounting treatment had been adopted, whether adoption resulted in adjustment and, if so, how it had been handled.

The Board reviewed the information submitted in response to its requests. The Board has considered

(1) refraining from explicitly providing for handling the adjustment,

(2) providing a procedure by which the adjustment could all be assigned to the year of change, and

(3) providing a procedure for amortizing the adjustment over a fixed period of years. The Board finds disadvantages to each of these alternatives. If no procedure for adjustment is provided, appropriate procedures for cost recovery may not be devised by contracting parties. If the procedure resulted in assignment of the entire adjustment to the year of change, then some contractors may recover more than the appropriate cost of that year and all of the contracts in the year of change will be overcharged. The same deficiencies, albeit to a lesser extent, exist if the procedure provides for the adjustment to be amortized over a fixed period.

The Standard has been revised to provide an explicit procedure for disposing of the adjustment for unrecognized liability. Under it, the adjustment is initially placed in a suspense account. In the cost accounting period of change and in any subsequent period, if the employer’s liability for compensated personal absence under the related plan at the end of a period is less than the amount in the suspense account at the beginning of that period, the suspense account is reduced by the amount of the difference. That difference is assigned to that cost accounting period as an additional cost of compensated personal absence.

If the employer’s liability remains above that at the time of change, then costs of compensated personal absence are measured on the accrual basis. If the employer’s liability falls below that amount because of additional cash payments to employees, then the costs are measured on the cash basis. This latter condition will arise whenever employment levels fall below that existing at the time of change. Whenever such conditions occur, the costs of those periods are measured on a cash basis until the entire suspense has been written off. The contractor is not precluded from allocating costs which might otherwise have been allocable, absent the Standard but he cannot allocate more than he otherwise would have allocated, so that premature cost allocations cannot occur.

(6) Complexity

Many of the Commentators suggested that the proposed Standard was too complex, too detailed, or too procedural. As previously mentioned, the Criteria for accrual have been changed to eliminate the distinction between a “certain” and a “reasonably certain” obligation and to eliminate the utilization test. These changes permitted a significant reduction in the length and complexity of the Standard. In addition, the Board has made a number of simplifying changes in the wording of the Standard based on suggestions from commentators.

===(7)=== Adjustments for interim rates. A number of commentators objected to the requirement in the proposed Standard that where costs of compensated personal absence are allocated using an interim rate, any difference between the interim rate and actual cost must be adjusted in the same period. They objected on the grounds that the necessary computations to determine the actual cost in accordance with the provisions of the Standard could not be completed by the end of the cost accounting period. Although the Board is not persuaded by this argument, the provision involved has been deleted for the following reasons. The accrual required by this Standard is identical to that required for any other year-end accrual, and the adjustment process is not essentially different from that which is required to adjust any interim allocation for a cost difference.

The requirement is well established that if overhead costs are allocated to Government contracts on an interim basis, there must be an adjustment when the actual costs are known. The Board therefore has concluded that is unnecessary to restate it in the Standard, although the requirement of course, remains in effect.

(8) Requirement to maintain records

Some contractors were concerned about the nature and extent of records which might be necessary to support the determinations and computation required by the proposed Standard. In particular, the need to maintain records of benefit utilization was questioned. The benefit utilization criterion has been deleted from the Standard; consequently, the maintenance special records for this purpose is unnecessary. Others were concerned that the proposed Standard would require changes in their formal accounting records. Upon further consideration the Board believes maintaining appropriate records is implicit in cost accounting and that the inclusion of additional record-keeping requirements in the Standard is unnecessary. In determining what records are necessary to achieve verifiability for purposes of this Standard, consideration should be given to the relative ease or difficulty of making and verifying assumptions and estimates, to the materiality the amounts involved, and to the use of techniques such as statistical sampling for determining the amount of the employer’s liability.

(9) Exemptions

Representatives of educational institutions pointed out two problems with the proposed Standard. First, it required that where costs of compensated personal absence are allocated using an interim rate, any difference between the interim rate and actual cost must be adjusted in the same period. These commentators pointed out that Pub.L.87-638 authorized use of negotiated predetermined overhead rates by these institutions and that this permission is presently set forth in Federal Management Circular 73-8: Cost Principles for Educational Institutions. Second, they pointed out that many educational institutions do not record costs on an accrual basis; but use fund accounting on a cash basis; and that for state and local governmental institutions, such accounting may be required by law. While the Standard does not require any change in the formal accounting records, in many instances it would be very difficult for these institutions to comply with the Standard.

In view of the foregoing, the Board does not believe it desirable to require educational institutions or state and local governmental agencies to account for costs of compensated personal absence on the accrual basis. Accordingly, the Board has exempted such institutions and state and local governmental agencies from the provisions of this Standard.

(10) Costs and benefits

The anticipated benefits of this Standard are improved cost measurement and increased uniformity in accounting for costs of compensated personal absence, leading to increased assurance that the measured costs are assigned to the proper cost objectives.

Several commentators objected that the Standard would not increase uniformity because the accounting for particular benefit plan would depend on the provisions of that plan, and not all benefit plans are alike. The Board is aware of the diversity of benefit plans. However, under present procurement regulations different contractors with essentially similar plans could be accounting differently for them and may be prevented from using similar accounting even if they wish to do so. To the extent that uniformity is thus actually inhibited, the Standard will correct the situation. Other past problems relating to the measurement of these costs in the event of layoffs, or employee transfers would also be alleviated.

Many commentators said that they were already accounting for costs of compensated personal absence in the manner required by the Standard. Some commentators said that implementation costs would depend on the extent of detail which would be required to comply. The Board has attempted to minimize such detail: First, by its previous statements that compliance with Standards may be accomplished through the use of memorandum records; second, by eliminating the utilization of benefits test and, thereby, the necessity of maintaining the supporting utilization records; and, finally, by emphasizing the acceptability of estimates based on statistical sampling or historical data. As a consequence, the costs of implementation should be negligible.

In summary, the Board believes that the benefits to be derived from this Standard clearly outweigh any costs of implementation. The Board expects that this Standard will become effective on April 1, 1975.

Preamble B

Preamble to Document Published 6-8-78

The document published on June 8, 1978 at 43 FR 24819, revised 408.10 and 408.70. This amendment was part of a publication which added 331.30 (b)(3). Only the portion of the preamble which describes the revision to 408.10, 408.70 are printed here. The remainder of the preamble appears as Preamble K of the supplement to Part 331.

• • • •

In the Federal Register of February 16, 1977 (42 FR 9391), the Board proposed to amend section. 10, General Applicability, of standards 401 through 409 to conform these sections to the general applicability section as it appears in standard 410 et seq. No comments were received on this proposed amendment. The Board considers this change to be appropriate and is amending standards 401 through 409 as set forth below.