*This is Part 2 of a 2-part blog. Part 1 of this blog addressed (i) the basic fundamental requirements at CAS 404-40(a), 404-(b)(1), and 404-(b)(2); and (ii) the techniques for application at CAS 404-50(a), as well as the fundamental requirements that relate to those techniques. This Part 2 of the blog addresses the techniques for application at CAS 404-50(b) thru (f).
Background: As noted in Part 1 of this blog, this standard is primarily concerned with the measurement of costs, and the assignment of those costs to accounting periods. When a contractor purchases an item, CAS 404 provides the criteria for determining whether or not to assign the entire amount of the asset cost in the year of purchase (expense the asset), or to spread the cost over two or more years (capitalize the asset). Under the CAS definition, a tangible asset for which the cost is spread over two or more years is termed a “tangible capital asset”. CAS 404 also provides criteria for determining the cost of the tangible capital asset. Note that CAS 409, which will be the subject of a future Practical CAS blog, provides criteria for depreciating capital assets, i.e., the acceptable methods for spreading the costs of tangible capital assets over multiple years.
Fundamental Requirement at CAS 404-50(b) thru (f):
- CAS 404-50(b) addresses tangible capital assets constructed or fabricated by the contractor for its own use. Under this CAS provision, tangible capital assets constructed or fabricated by the contractor for its own use must be capitalized at amounts which include all allocable indirect costs.
EXAMPLE: A contractor that is in the business of constructing tooling machines constructs a tooling machine for its own use. Direct labor costs for the tooling machine are $50,000 and material costs are $25,000. The contractor has a single indirect cost pool that is allocated on the basis of total cost incurred. The rate for the year in which the tooling machine was constructed is 10%. The capitalized amount under CAS 404 is computed as follows:
Direct Labor $50,000
Indirect Costs $ 7,500 (10% x $75,000)
Capitalized Amount $82,500
- CAS 404-50(b) also requires that when a material amount of the cost of the tangible capital asset constructed or fabricated by the contractor is incurred by personnel whose salaries are regularly charged to an indirect expense pool, such costs must be included as direct labor in computing the cost of the asset.
EXAMPLE: A contractor that is not in the business of constructing lathes or similar machines constructs a lathe for its own use. The planning and supervision of the lathe is performed by personnel that normally charge their salaries to the G&A pool. This planning and supervision totaled $23,000. CAS 404 requires that the $23,000 be included in the direct labor costs for purposes of computing the capitalized amount.
- CAS 404-50(c) addresses the acquisition of a tangible capital asset that is not an arms-length transaction. When the acquisition is not an arms-length transaction, this CAS provision requires that the acquisition cost be the capitalized cost of the asset to the owner who last acquired the asset through an arms-length transaction, reduced for any depreciation charges from the date of that acquisition to the date of gift or sale.
EXAMPLE: A contractor pays $70,000 cash for a truck. The truck is purchased from a related party. The fair value of the truck at the time of the purchase is $50,000. The related party purchased the truck three years before for $100,000 from a non-related party. The net book value of the truck on the related party owner’s books at the time of the related party transaction is $40,000. To comply with CAS 404, the truck must be capitalized at $40,000, which is the net book value of the truck on the related owner’s books. That net book value represents the purchase price of $100,000 less depreciation charges for the three years since it was purchased from the non-related party.
- CAS 404-50(d) and (e) include requirements for accounting for tangible capital assets acquired in a business combination. A business combination is an event that occurs when a corporation and one or more separate business entities are brought together under common control. At the time CAS 404 was written, for financial accounting purposes, there were two methods of accounting for such business combinations, the “pooling of interest method“ and the “purchase method”. Thus, CAS 404 states that the amount the contractor is required to record for purposes of capitalization under CAS 404 depends upon which financial accounting method is used. However, on January 23, 2001, the Financial Accounting Standards Board (“FASB”), the independent board responsible for establishing and interpreting generally accepted accounting principles, determined that for financial accounting purposes all business combinations shall be accounted for using the “purchase method” of accounting. Therefore, for CAS purposes, all business combinations must follow the CAS requirements that apply to the “purchase method” of accounting. Since the pooling of interest method is no longer permitted, this blog does not address the requirements at CAS 404-50(e), which addressed the pooling of interest method.
- CAS 404-50(d) addresses business combinations accounted for under the purchase method of accounting. For CAS purposes, under the “purchase method” of accounting, the value established for the tangible capital assets depends on whether the capitalized asset of the acquired company generated depreciation expenses and/or cost of money during the most recent accounting period that were allocated to Government contracts negotiated on the basis of cost.
- Under CAS 404(d)(1), when the tangible capital assets of the acquired company generated depreciation expenses and/or cost of money during the most recent accounting period that were allocated to Government contracts negotiated on the basis of cost, the amount capitalized is the net book value of the assets as reported by the seller at the time of the business combination.
EXAMPLE: On January 1, 2012, Company A and Company B are brought together in a business combination. The surviving company is Company A. Company B has three tangible capital assets, as shown in the table below:
|Asset||Net Book Value on Company B’s Books||Fair Value||Depreciation/Cost of Money Charged During Last Year|
|Machine||$ 50,000||$ 30,000||$ 16,000|
|Truck||$ 20,000||$ 25,000||$ 4,000|
The depreciation expense and the cost of money of the machine, building, and truck were included in overhead pools and allocated to some Government contracts negotiated on the basis of cost in the most recent accounting period. CAS 404 requires that these assets be capitalized at their net book value of $50,000 for the machine, $600,000 for the building, and $20,000 for the truck. Note that the assets are capitalized using the net book value regardless of whether that value is greater than or less than the fair value of the asset.
- Under CAS 404-50(d)(2), when the tangible capital assets of the acquired company did not generate either depreciation expense or cost of money that were allocated to Government contracts negotiated on the basis of cost in the most recent accounting period, the capitalized amount is the fair value of the assets as of the date of the acquisition. However, if the fair value of the acquired assets, less liabilities assumed, exceed the purchase price of the acquired company, the tangible capital assets shall be reduced by a proportionate part of the excess.
EXAMPLE: Company C acquired Company D in a business combination for $900,000 cash. Company D had no cash and no liabilities, but consisted solely of the following assets:
|Asset||Net Book Value on Company D’s Books||Fair Value||Depreciation/Cost of Money Charged During Last Year|
|Fabrication Machine||$ 60,000||$ 75,000||$10,000|
|Assembly Machine||$ 90,000||$ 50,000||$15,000|
|Finishing Machine||$ 30,000||$ 25,000||$ 5,000|
There were no Government contracts negotiated on the basis of cost that had depreciation expense or cost of money allocated to them in the most recent accounting period. Since the purchase price of $900,000 for Company D exceeds the $800,000 total fair values of the assets, each of the assets is recorded at their fair value, which is $650,000 for the building, $75,000 for the fabrication machine, $50,000 for the assembly machine, and $25,000 for the finishing machine.
EXAMPLE: Assume the same example as above, except that Company C acquires Company D for $600,000 cash. In this case, the fair value of the acquired assets of $800,000 exceeds the $600,000 purchase price of Company D. Thus, CAS 404 requires that the tangible capital assets be reduced by a proportionate part of the excess as shown below:
|Asset||Fair Value||Proportional Percentage ($600,000/800,000)||Fair Value to be Recorded on Company C’s Books|
|Fabrication Machine||$ 75,000||75%||$ 56,250|
|Assembly Machine||$ 50,000||75%||$ 37,500|
|Finishing Machine||$ 25,000||75%||$ 18,750|
Therefore, the assets would be capitalized on Company C’s books at $487,500 for the building, $56,250 for the fabrication machine, $37,500 for the assembly machine, and $18,750 for the finishing machine.
- Under CAS 404-50(f), asset accountability units must be identified and separately capitalized at the time the assets are acquired and removed from the asset accounts when disposed of or replaced. If replaced, the replacement unit must be capitalized.
EXAMPLE: Contractor P has printing presses that include specialized rollers that have an acquisition cost of $36,000 each. The printing presses have useful lives of fifteen years, while the rollers have useful lives of five years. The contractor’s accounting practices state that the rollers are asset accountability units. On January 1, 2004, the contractor purchases a roller for Machine X. The contractor must separately capitalize the roller. On January 1, 2009, the contractor replaces the roller with a new one. The contractor must remove the roller purchased in 2004 from the asset accounts, and begin depreciating the roller purchased in 2009.