Cost Accounting Standard 415 - Preambles

Preamble A

Preamble to Original Publication, 7-30-76

The following is the preamble to the original publication of Part 415, 41 FR 31797, July 30, 1976.

The Standard on Accounting for the Cost of Deferred Compensation being published today is one of a series being promulgated by the Cost Accounting Standards Board pursuant to 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 provides criteria for the measurement of the cost of deferred compensation and the assignment of such cost to cost accounting periods.

Early research included an extensive review of available literature, the Disclosure Statements filed with the Board, and decisions of boards of contract appeals. This information was then supplemented by visits and mail solicitations to contractors in order to elicit more specific data concerning company deferred compensation plans.

In May 1975, a questionnaire/issues paper was sent to a wide mailing list soliciting responses to several basic issues identified in the Board’s early research. Seventy responses to the questionnaire/issues paper were received from interested parties, the majority of whom were companies that had deferred compensation plans. Based on the responses received, a preliminary draft Standard was developed in December 1975 and sent to a large cross section of companies, Government agencies, industry and professional associations, and other interested individuals. The Board received 53 responses to the draft Standard.

After several changes were made to the draft Standard, based on consideration of the comments made by respondents, a proposed Standard was published in the Federal Register of April 7, 1976, with an invitation to interested parties to submit written views and comments to the Board.

The Board received 34 sets of written comments from companies, Government agencies, professional associations, industry associations, public accounting firms and others in response to the Federal Register proposal. All of these comments have been carefully considered by the Board. The Board’s views on each of the major issues discussed by the commentators are outlined in the following sections, together with explanations of the changes made in the Cost Accounting Standard being promulgated.

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

Relationship of Standard to Current Procurement Regulations

Under current procurement regulations, deferred compensation is allocable as a cost of Government contracts only to the extent that such costs are deductible for the same fiscal year for Federal income tax purposes. A few commentators expressed concern that the proposed Standard would require the assignment of the cost of deferred compensation to a cost accounting period that would be different than that determined under the Internal Revenue Code for Federal income tax purposes.

Under the Internal Revenue Code, a deduction for tax purposes for the cost of many incentive or bonus type plans is not permitted until the deferred compensation is paid to the recipient. Under the Standard, however, the cost of deferred compensation is assignable as a contract cost in the period the contractor incurs an obligation to pay such cost which, for many deferred compensation plans, will be the period in which the award is made. (See 415.40(a).)

The Board has recognized that contract costing often deals with the same expenditures as are of interest in income tax accounting. Except for differences in tax rates, shifts of income or expense from one year to another generally do not have a significant effect on total tax paid over a period of time. Similar shifts of cost, however, from one year to another could have a decided impact on the costs chargeable to Government contracts. This impact occurs because the mix of Government and commercial contracts often changes significantly from period to period. Therefore, the Board believes that application of the criteria provided in the Standard to assigns the cost of deferred compensation on an accrual basis of accounting is needed to better assure that such cost of deferred compensation will be assigned to appropriate cost accounting periods.

Allocability and Allowability of Contract Costs

Several Government agency commentators pointed out that under present procurement regulations deferred compensation is not allowable until the period in which paid. These commentators also noted that the cost of stock options, under present procurement regulations, is unallowable although these commentators generally recognized that the provisions of the Standard involve allocability, they questioned whether the Standard would encroach on the allowability prerogatives of the procurement agencies.

The Board believes that recognition of the cost accounting concept that all costs incurred in carrying on the activities of an enterprise are allocable to the cost objectives of the enterprise is essential to the maintenance of sound and consistent contract cost accounting. Cost Accounting Standards should result in determination of costs which are allocable to contracts and other cost objectives. The use of Cost Accounting Standards, however, has no direct bearing on allowability determinations.

Definition

A commentator was concerned that the proposed Standard may apply to the cost of some pension plans that are subject to Accounting Principles Board Opinion No. 8, Accounting for the Cost of Pension Plans, and that different measures of cost might result for the same plan from application of the proposed Standard and from application of APB Opinion No. 8. The commentator questioned whether an amount paid to an employee after retirement for a specified period of time, e.g., 10 years, would fall under the definition of deferred compensation as used in this Standard. If a payment for a specified period of time after retirement is, in effect, equivalent to a life income settlement, this payment falls within the definition of a pension plan as provided in Cost Accounting Standard 412, Composition and Measurement of Pension Cost. If the payment is not a life income settlement, it is not a pension plan and the award is covered under the definition of deferred compensation. The Board does not believe that the Standard being promulgated today applies to any pension plan covered under APB Opinion No. 8.

Determination of Obligation

One of the criteria contained in the Standard for determining whether a contractor has incurred an obligation for the cost of deferred compensation is whether or not there is reasonable probability that certain required conditions precedent will occur before an employee is entitled to receive the benefits (see 415.50(a)(5)). The proposed Standard stated that, in determining whether certain events are likely to occur, one of the factors to be considered was the reasonableness of the time interval between the award and the expected occurrence of the event. A few commentators suggested that the proposed Standard specify the length of time that would be reasonable. The Board does not believe that a particular time period can be specified to cover all circumstances. Each category of award must be analyzed on a case-by-case basis because there are several factors involved in determining whether employees should be entitled to receive the benefits of an award. Among the factors that should be considered, in addition to the time interval, are the employer’s experience with similar awards and other restrictive terms which may be involved in the terms of the award.

Since there are numerous factors to be considered, the Board has deleted from 415.50(a)(5) of the Standard mention of two specific factors in order not to give undue weight to these factors. In addition, the Board has added 415.50(a)(6) to make clear with respect to stock options, that an obligation is deemed to have been incurred only if there is a reasonable probability that the option ultimately will be exercised.

Future Service Requirements

Section 415.50(a)(3) provides, as a condition for the assignment of deferred compensation, that the amount of future payment be capable of being measured with reasonable accuracy. In this connection, several commentators suggested that this provision should override the provision for prorating the cost if future service is required. The commentators stated that the service to be rendered after the period of award does not influence the basis for the award. These commentators believe that if there is a strong likelihood that the recipients of the awards would remain with the company for the periods of future service then the costs should be charged in the year of award.

The Board does not agree that the reasonable accuracy of measuring the cost should override the appropriate assignment of the cost to the periods of current and future service based on the facts and circumstances of the award. The Board believes that, where future service is required, such compensation related to the service rendered in those future periods and therefore the related cost should be assigned to those periods. In this regard, the Board believes that the concepts embodied in Accounting Principles Board Opinion No. 12 Omnibus Opinion, are appropriate for contract costing. This Opinion states that “If elements of both current and future service are present [for deferred compensation awards], only the portion applicable to the current service should be accrued.” To make certain that this concept is clearly understood to be incorporated in the Standard being promulgated, a provision has been added to 415.50(a).

Variable Interest Rate

Several commentators expressed concern over a provision in the proposed Standard which stated that if the interest rate included in the award is not fixed at the date of award, the interest was to be assignable only to the periods in which the interest was paid. A few of these commentators stated that generally accepted accounting principles require that the estimated amount to be paid should be assigned in a systematic and rational manner. The commentators stated that, if the amount of interest is known in each period, it should be assigned in each such period.

The Board agrees that the variable interests amounts should be assigned to periods in a systematic and rational manner provided that the terms of the plan specify the basis under which variable interest amounts will be derived and the interest applied in each period is determinable at that time. Consequently, the Standard being promulgated today has been revised to provide in 415.50(d)(2), that variable interest included in awards shall be assigned in the same period as the principal of the award, provided that the rate is based on a specified index and is determinable in each applicable period. The Standard also provides that since the interest rate used at the time of the award is likely to vary from the actual rates in future periods, adjustments shall be made in any future period in which the variation in rates materially affects the cost of deferred compensation.

Section 415.50(d)(3) was added to the Standard to provide for those situations in which the interest rate was not based on a specified index or not determinable in each applicable year. In these situations, the present value of the principal amount of the award is assignable in the year of award and the interest cost is assignable to the period or periods in which the payments are made.

Forfeitures

Two commentators stated that the forfeiture provision should be expanded to recognize that losses on the initial payment for irrevocably funded plans, as well as earnings, may occur within the framework of such a plan. The Board had intended that both gains and losses be recognized and has changed the provision to clarify this point (see 415.50 (d)(7)).

Another commentator stated that the forfeiture provision should not include interest to the date of the forfeiture. The commentator stated that it seems inequitable to require that the value of the forfeiture be determined at a level which was not fully allowable as a cost during the accounting periods affected. The Board does not share the view that including interest in the credit for forfeitures is inequitable. The interest factor represents the time cost of money which the contractor should pay to the Government for having been provided with funds. The forfeiture is calculated to be the present value of the future benefit at the time of forfeiture and thus is equivalent in present value terms to the amount of deferred compensation that was originally assigned. However, as stated in the Standard, the failure of the recipient to voluntarily exercise a stock option is not considered a forfeiture.

The Standard has been amended to provide that if a recipient of an award of stock options voluntarily fails to exercise such options, such failure does not constitute a forfeiture. (See 415.50(e)(6).)

Stock and Stock Options

A few commentators cited the requirement of 415.50(a)(3) of the proposed Standard which provides that the amount of the future payment must be capable of reasonable estimation, and expressed their opinion that the value of award of contractor stock that is to be distributed in a future period or periods should not be assigned to any period prior to payment because the amount of payment to the employee cannot be reasonably estimated before that time.

The Board believes that the compensation cost of stock or stock option plans should be measured by the quoted market price of the stock at the measurement date less the amount, if any, that the employee is required to pay. Further, the measurement date for both stock awards and stock option plans should be the first date on which are known both the number of shares to be distributed and the option price, if any. These views are embodied in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, which already must be followed by contractors for financial reporting.

If the market price of the stock on the date of distribution is used, the Government, in effect, would be sharing in financial risk taking with the contractor. Subsequent fluctuations of the price of the stock should not influence the measurement of the award. However, the Board recognized that the proposed Standard was not consistent with respect to the measurement of the cost of stock and stock option. Consequently, 415.50(e)(1) has been changed to provide for the measurement of the cost of stock to be at the measurement date rather than the time an obligation was deemed to have been incurred.

In order to further clarify the Board’s intent, 415.50(e) had been revised to provide that the measurement of the award of stock, stock options, or other assets as set forth in the Standard shall be deemed to be a reasonable measure of the amount of the future payment.

Two commentators stated that the cost of stock options should be based on the value of the options on the date they are exercised.

Similar to the reasoning expressed above, the Board does not believe that it would be appropriate to base the cost of stock options on the value prevailing at the date of exercise. Stock options which are awarded at a value which equals the market value of the stock would involve no cost under the provisions of the Standard. However, if the award of stock options were based on their value at the date exercised, a cost of the award would have to be recognized by the Government even though the contractor could purchase an appropriate number of shares at the time of the award to defray any cost resulting from future increases in the market value of the stock. The Board believes, therefore, that stock options should be a measured at the date on which both the option price and the number of shares are established (see 415.50(e)(1)).

Several commentators suggested that the requirement for prorating the cost of stock options over the period of future service and taking the present value of the prorated cost should be eliminated because the price of the stock is the present value of the stock price. The Board agrees with these commentators. Consequently, the requirement for discounting the cost of stock options has been eliminated from the Standard.

Transition Provision

Several commentators suggested that a transition provision be included in the Standard to amortize costs of deferred compensation accumulated in periods prior to the promulgation of the Standard, but not previously charged to contract costs. Several of these commentators suggested various methods to amortize the recovery of all prior deferred compensation on an accelerated basis. Among the methods suggested was to charge all such prior costs in the period that the Standard became effective or to charge such costs over the remaining work life of the employee or five years, whichever is shorter. However, one commentator recommended that the Board use a suspense account, as used in Cost Accounting Standard 408, Accounting for Cost of Compensated Personal Absence. The use of a suspense account would delay recognition of the cost of deferred compensation awarded before the effective date of the Standard.

The procurement regulations for costs of deferred compensation awarded prior to the effective date of the Standard generally provide that such costs will be allocable in the period in which they are paid to recipients. The Standard being promulgated today would not disturb the contractual provisions applicable to such prior awards. The provisions of this Standard are applicable only to new awards of deferred compensation made on or after the date that the Standard becomes applicable to each contractor. The Board recognizes that there will be a minor budgetary increase required by the Government agencies until the prior deferred compensation awards are paid. However, for the majority of deferred compensation plans, the awards previously made will be paid out over a relatively short period of time, e.g., five years. Consequently, the Board believes that a transition provision is not necessary for the Standard being promulgated today.

Other Changes

The first illustration (415.60(a)) was changed to reflect the change in the provision regarding interest rates that are not fixed at the date of award. Other changes of a minor nature were made to various sections of the Standard for clarification.

Costs and Benefits

Section 719(g) of the Defense Production Act of 1950, as amended, provides “In promulgating such standard and major rules and regulations for the implementation of such standards, the Board shall take into account, and shall report to the Congress in the transmittal required by section 719(h)(3) hereof, the probable costs of implementation, including inflationary effects, if any, compared to the probable benefits, including advantages and improvements in the pricing, administration and settlement of contracts.”

Comments received in response to the Federal Register publication, as well as information obtained from contractors prior thereto, indicated that there would be minimal administrative costs entailed in complying with the Standard. One Government agency stated that additional administrative burden would be placed on the Government as a result of the conversion from a cash basis to the accrual method of accounting. The Board believes that any such additional administrative costs due to this conversion will be minimal. The Governmental agencies have always had the responsibility for reviewing the reasonableness of deferred compensation plans and evaluating the payments to assure that such payments coincide with the principal and interest provisions of the plan. The Board believes the main additional administrative cost involved is in reviewing the present value calculation and determining if the contract has incurred a valid obligation at the time the award is made.

Among the benefits which the Board believes will be derived from the use of this Standard is the assignment of the costs of deferred compensation to proper periods. Under the present regulations, the assignment of much of these costs is essentially on a cash basis. As a consequence, deferred compensation costs may have been incurred in much earlier periods than the periods in which they were recognized as incurred costs; in many cases, several years after the service has been rendered by the employee. Giving full consideration to all the relevant factors discussed herein, the Board believes the benefits to be derived from this Standard clearly outweigh any costs of implementation.

As required by section 719(g), the Board has evaluated the potential inflationary effect of this Standard. The Standard requires the use of present value techniques for the assignment of cost and incorporates a forfeiture provision with interest. The use of these techniques recognizes the time cost of money. In the long run, the cost to the Government should be essentially the same as that which would be incurred under a cash basis of accounting. For a majority of deferred compensation plans, moreover, the awards previously made will be paid out over a relatively short period of time, e.g., five years. The Board has concluded that there will be only a minor budgetary increase on the Government agencies until the prior deferred compensation awards are paid. Overall, however, any inflationary effect of this Standard will be minimal.

The Board expects that this Standard will become effective January 1, 1977.

There is also being published today an Amendment to Part 400, Definitions, to incorporate in that part terms defined in 415.30 of this Cost Accounting Standard.

Preamble B

Preamble to Revision of Section, 7-30-76 and 1-8-78

The following is the preamble to the revision of 415.80, published at 42 FR 18857, Apr. 11, 1977 and correctly reprinted at 43 FR 24821, June 8, 1978.

On July 30, 1976, a Cost Accounting Standard entitled Accounting for the Cost of Deferred Compensation was published in the Federal Register (41 FR 31797 et seq.). The effective date of the Standard was reserved in the July 30 publication. This final rule establishes the effective date.