Accountants’ Handbook Special Industries and Special Topics 10th Edition_11 pot

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Exhibit 34.1
Continued.
F
ORMAT
A—
C
ONSOLIDATED PRESENTATION
F
ORMAT
B—U
NCONSOLIDATED
(STANDALONE
)
PRESENTATION
Note C. Contingencies
Note C. Contingencies
In addition to the general liability and malpractice insurance
carried by the individual physicians, GoodDocs is insured with
respect to general liability and medical malpractice risks on a
claims-made basis. Management is not aware of any claims
against the company. In addition, GoodDocs has not accrued a
loss for unreported incidents or for losses in excess of insur
-
ance coverage, as the amount, if any, cannot be reasonably
estimated and the probability of an adverse outcome cannot be
determined at this time. It is the opinion of management that
the ultimate resolution of any unasserted claims will not have a
material adverse effect on GoodDocs’ financial position or re-
sults of operations.
No disclosures related to medical malpractice would be in-
cluded in the financial statements. The discussion of the busi-

ness contained in the Form 10-K filed by GoodDocs would
probably contain a statement similar to the following:
“The provision of medical services by the physician group with
which GoodDocs contracts entails an inherent risk of profes-
sional liability claims. GoodDocs does not control the practice
of medicine by physicians or the compliance with certain
regulatory and other requirements directly applicable to physi-
cians and physician groups.”
34
•
48
recently consummated, a signiﬁcant management agreement generally are not required in an IPO
ﬁling if the PPM does not consolidate the practice and does not guarantee any minimum practice
income, extend unusual credit terms, or fund operating losses.
However, if the PPM is expected to have a material dependence on the PC, separate ﬁnancial in-
formation about the practice would be material to investors. For example, if the management fee
from the practice is expected to generate more than 20% of the PPM’s revenues in the next 12
months, the SEC has requested audited ﬁnancial statements of the practice. However, the SEC has
accepted only unaudited summary ﬁnancial information about the practice for the three most recent
ﬁscal years if audited ﬁnancial statements are not readily available and its owners are not promoters
of the offering being registered.
Historical information about the practice for any period before its ownership by the current own-
ers would not be requested unless the PPM is of the view that a change in an owner does not funda-
mentally change the underlying business. If the owners of a practice generating 20% or more of the
PPM’s revenues own 10% or more of the PPM at the time of its IPO or are promoters of the offering,
audited ﬁnancial statements of that practice for at least its most recent ﬁscal year ordinarily would be
required, unless effects of providing the management services to the practice have been included in
the PPM’s audited ﬁnancial statements for at least nine months. If ﬁnancial information of a man-
aged practice is presented, care should be taken to avoid the impression that an investor is obtaining
an interest in the practice or that the historical results are indicative of future results under the altered

incentive structure and management afﬁliates established with the PPM.
Disclosure Issues. The SEC staff expects PPM registrants to clearly and accurately describe
their business and contractual relationships. Financial statement disclosures should address the
following:
W
HAT IS THE NATURE OF THE PPM’S BUSINESS?
•
Describe the contractual relationship among the PPM and the medical practices. Describe the
PPM’s rights and limitations under the contracts.
•
Disclose how the PPM’s fees are determined. If the fees are based on a percentage of certain
items, what are those percentages, or what is the range of the percentages? What items affect
the calculation?
•
Even if the PPM combines the operations of the medical practice group for ﬁnancial statement
purposes or has consolidated subsidiaries that provide the medical services, the PPM must
clearly distinguish the services it provides from the practice of medicine.
W
HAT IS THE PPM’S RELATIONSHIP WITH MANAGED CARE PROVIDERS?
•
Disclose whether the PPM (or an assignee) enters into direct contracts with managed
care
companies or whether the physician groups contract directly with the managed care compa-
nies.
•
Identify the party who assumes the risk under managed care contracts (i.e., the PPM or the
physician group). If the PPM assumes the contracts, are there any issues relating to medical li-
censing?
•
Who assumes the risk associated with capitated payment contracts? If the PPM assumes the

risk, does this subject it to regulation as an insurance company?
I
S THE PPM SUBJECT TO ANY STATE OR FEDERAL REGULATIONS?
•
Describe any state prohibitions on the corporate practice of medicine, and discuss the impact
upon the PPM.
•
Is the PPM subject to regulation as an insurer?
•
What is the effect of federal antikickback and self-referral restrictions?
34.4 SPECIAL ACCOUNTING PROBLEMS OF SPECIFIC TYPES OF PROVIDERS 34
•
49
34.5 FINANCIAL REPORTING PRACTICES
(a) USERS OF FINANCIAL STATEMENTS. The primary users of health care companies’ general
purpose ﬁnancial statements are providers of capital who make rating and investment decisions in
competitive capital markets (including investors in tax-exempt debt securities); suppliers of goods
and services to the industry with whom health care companies maintain credit relationships; stock-
holders and other owners; the Securities and Exchange Commission; and regulators such as state De-
partments of Insurance and other oversight groups.
(b) BASIC FINANCIAL STATEMENTS. Investor-owned and not-for-proﬁt health care pro-
viders generally prepare four ﬁnancial statements:
1. Balance sheet
2. Income statement/statement of operations
3. Statement of changes in stockholders’ equity/statement of changes in net assets
4. Statement of cash ﬂows
Not-for-proﬁt health care entities are required to follow the ﬁnancial reporting requirements con-
tained in FAS No. 117, Financial Statements of Not-for-Proﬁt Organizations, as modiﬁed by certain
requirements contained in Health Care Organizations. Generally speaking, FAS No. 117 provides
broad standards of ﬁnancial reporting with which all not-for-proﬁt organizations (including not-for-

proﬁt health care organizations) must comply. However, the FASB permitted the AICPA to provide
industry-speciﬁc implementing guidance for FAS No. 117 through its audit and accounting guides.
Although technically the guidance in Health Care Organizations stands lower in the GAAP hierar-
chy than does the FASB guidance, the FASB expects not-for-proﬁt health care organizations to apply
the requirements of FAS No. 117 in the manner speciﬁed by the Audit Guide. Generally speaking,
those modiﬁcations are intended to keep the ﬁnancial statements of not-for-proﬁt providers compa-
rable to those of investor-owned providers.
Governmental health care entities are required to follow the ﬁnancial reporting require-
ments prescribed by GASB No. 34, “Basic Financial Statements—and Management’s Discus-
sion and Analysis—for State and Local Governments.” (GASB No. 34’s phased-in effective
date is discussed at Section 32.11.)
For purposes of applying GASB No. 34, the governmental health care organizations included
within the scope of the AICPA audit and accounting guide Health Care Organizations are considered
“special purpose governments engagement in business-type activities.” Those entities should present
ﬁnancial statements required for enterprise funds, which consist of:
• Management’s Discussion and Analysis (as RSI)
• Statement of net assets (balance sheet)
• Statement of revenues, expenses, and changes in net assets
• Statement of cash ﬂows
• Notes to ﬁnancial statements
• RSI other than MD&A (if applicable)
Although GASB No. 34 establishes eight required elements of MD&A, many of those ele-
ments are not applicable to governmental health care entities. Consequently, MD&A discussion
should be limited to only the elements that are applicable.
Health Care Organizations provides illustrative ﬁnancial statements for investor-owned, tax-
exempt, and governmental health care organizations. Those statements illustrate the application
of the reporting practices contained in the Guide. Speciﬁc types of health care organizations are
presented, but only to illustrate a wide diversity of reporting practices. It is not intended that
these illustrations represent either the only types of disclosure nor the only statement formats that
would be appropriate. More or less detail should appear in the ﬁnancial statements or notes, de-

pending on the circumstances.
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50
PROVIDERS OF HEALTH CARE SERVICES
(c) BALANCE SHEET. All health care organizations must prepare classiﬁed balance sheets which
segregate assets and liabilities between current and noncurrent categories.
22
Special considerations
related to balance sheet reporting of not-for-proﬁt and governmental providers are discussed below.
(i) Not-for-Proﬁt Providers. Restricted assets and liabilities should not be carved out and pre-
sented separately in the balance sheet. Because donor restrictions generally relate to limitations on
the use of net assets rather than speciﬁc assets (i.e., the provider normally is not required to physi-
cally maintain restricted resources separately from unrestricted resources), “cash is cash” regardless
of whether it was received as a speciﬁc-purpose gift or generated through operations. As a result, the
provider’s obligation to use unexpended donor-restricted contributions in accordance with the
donor’s wishes is reﬂected by structuring the equity section of the balance sheet into three broad
classes: unrestricted net assets, temporarily restricted net assets, and permanently restricted net as-
sets. If the amount of unexpended donor-restricted contributions is material, the nature of restrictions
should be disclosed in the notes to the ﬁnancial statements. The accounting and reporting require-
ments for donor-restricted contributions is discussed at Subsection 34.3.
Limitations on the use of assets arising from sources other than donor restrictions are high-
lighted by using the balance sheet caption “assets whose use is limited.” These are discussed at
Subsection 34.3(b)(i).
(ii) Governmental Providers. A governmental provider’s balance sheet may be prepared using
either the traditional balance sheet format or a net assets format (assets less liabilities equal net as-
sets). The equity section of the balance sheet is structured into three broad classes of net assets: un-
restricted; invested in capital assets, net of related debt (i.e., capital assets reduced by accumulated
depreciation and by any outstanding debt incurred to acquire, construct or improve those assets); and
restricted (differentiated between expendable and nonexpendable). The provider’s obligations to use

certain resources for speciﬁc purposes is reﬂected in the balance sheet by (1) presenting those assets
separately and (2) reporting any difference between those assets and their related liabilities as “re-
stricted net assets.” The word “restricted” is not required to be used in labeling the assets themselves;
however, the descriptions used on the face of the balance sheet should make it clear that such assets
cannot be used to satisfy the organization’s current liabilities (other than any current liabilities that
are intended to be satisﬁed with the restricted assets). Under GASB No. 34, assets are reported as re-
stricted when limitations on their use is externally imposed (e.g., by creditors, grantors, contributors,
or the laws or regulations of other governments). Restricted assets should be presented separately in
the balance sheet.
Internally imposed limitations (such as speciﬁc-purpose designations imposed management
or the board) are included in unrestricted net assets.
(d) OPERATING STATEMENT. Appendix A of the Guide provides illustrative income state-
ments for investor-owned, not-for-proﬁt, and governmental health care organizations. These
statements are not intended to establish standards but merely to illustrate the reporting conven-
tions discussed in the Guide. Although income statement reporting requirements differ signiﬁ-
cantly based on whether a provider is investor owned, not-for-proﬁt, or governmental, all allow
ﬂexibility in the amount of detail that is provided. Some providers choose to present a great deal
of detail; others present statements that are highly condensed with details, if any, provided in the
notes. The Guide allows each provider to determine the level of detail that provides the most
meaningful disclosure within the broad parameters established by GAAP.
34.5 FINANCIAL REPORTING PRACTICES 34
•
51
22
For not-for-proﬁt providers, this is a modiﬁcation of the guidance provided in FAS No. 117, which requires in-
formation about liquidity of assets and liabilities be provided in “some fashion” (e.g., by sequential ranking)
within the balance sheet.
Signiﬁcant differences exist in the presentation of extraordinary items, discontinued operations, and
cumulative effect of changes in accounting principles depending on whether a provider is investor
owned, not-for-proﬁt, or governmental, as follows.

Presentation of
Type of Provider Extraordinary Items Discontinued Operations Cumulative Effect
Investor-owned Just before net income Just before net income Just before net income
Not-for-proﬁt Just before change in Just before change in Just before change in
unrestricted net assets, unrestricted net assets, unrestricted net assets,
with subtotal with subtotal with subtotal
Governmental Below nonoperating revenue See discussion Adjustment of
beginning fund balance
GASB No. 34 is silent on how discontinued operations should be reported. Based on informal dis-
cussions with GASB staff, the author believes that reporting of discontinued operations would be part of
the detail required by GASB No. 34 for the “Operating revenue” and “Operating expense” sections of
the statement of changes in revenues, expenses, and changes in net assets, because both continuing and
discontinued operations are part of a health care organizations operating activity. The “Operating rev-
enues” section would contain one or more lines identiﬁed as “revenue from discontinued operations,”
with a similar presentation of “expenses from discontinued operations” provided in the “Operating ex-
penses” section. Any gain or loss on disposal of an operation would be reﬂected as nonoperating revenue
or expense (similar to the treatment of other types of gains/losses under GASB No. 34).
(i) Requirements for Investor-Owned Providers. The income statement reporting requirements
for investor-owned health care providers are similar to those for other types of investor-owned ser-
vice providers. Providers that are SEC registrants sometimes will receive comment letters from the
SEC requesting that their income statements display operating expenses at a level of detail “consis-
tent with the AICPA audit guide for health care providers.” As stated previously, the sample ﬁnancial
statements included in the Guide are illustrative and are not intended to establish a practice that
would require a certain level of disclosure.
(ii) Requirements for Not-for-Proﬁt Providers. The income statement requirements for not-for-
proﬁt health care entities were established by FAS No. 117, as modiﬁed by certain requirements con-
tained in Health Care Organizations. Those modiﬁcations are as follows:
FAS No. 117 Requirement
Presentation of a “statement of activity” that
combines the information traditionally

presented in an income statement with the
information traditionally reported in the
statement of changes in net assets.
Reporting of results of operations (i.e., net
income) is permitted but not required.
Contributions of property, plant, and equipment
(or of funds expended to purchase such assets)
are reported as increases in unrestricted net
assets in the statement of activities.
Modiﬁcation provided in
Health Care Organizations
Subdivides “statement of activity” into two
required statements: a “statement of operations”
(i.e., income statement) and a “statement of
changes in net assets.”
Must provide “performance indicator”
subtotal
23
within the statement of operations.
Such contributions should be reported below
the “performance indicator” (i.e., excluded from
net income) in the statement of operations.
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PROVIDERS OF HEALTH CARE SERVICES
23
The FASB has objected to use of the term “net income” to refer to the results of operations of not-for-proﬁt
health care organizations. Therefore, Health Care Organizations uses the generic term “performance indicator”
to describe the operating measure.

Other requirements imposed on not-for-proﬁt providers that differ from those of investor-owned
and governmental providers are as follows:
•
Net assets released from restrictions (except those related to long-lived assets) are included in
net income.
•
All expenses must be reported in the “unrestricted net assets” classiﬁcation. No expenses may
be reported in the statement of changes in net assets for the temporarily or permanently re-
stricted classiﬁcations.
•
FAS No. 117 requires reporting of expenses by functional categories such as “program,”
“management,” and “fund raising.” Administrative allocations to the functional categories
should be based on full cost allocations. Normally, providers report expenses classiﬁed along
revenue/cost center lines (e.g., nursing services, other professional services, general services)
or “natural” lines (e.g., salaries and wages, employee beneﬁts, supplies, purchased services).
Health Care Organizations emphasizes the ﬂexibility allowed in FAS No. 117, which allows
reporting the functional information in the notes to the ﬁnancial statements. Similarly, ﬂexi-
bility is allowed in the degree to which details are presented with regard to functional infor-
mation. Some providers may choose to present only two categories: “health services” and
“general and administrative”; others may desire to report more detailed information.
• APB No. 30 items must be reported below the performance indicator (see Subsection 34.5(d)(iv).
The health care Guide does not require not-for-proﬁt providers to distinguish between operating
and nonoperating activities. If an “income from operations” subtotal is presented and its use is not
apparent from the details provided on the face of the statement, note disclosure should be made re-
garding the nature of the measure or the types of items excluded from that measure.
In June 2002, AcSEC issued an exposure draft of a proposed Statement of Position, “Accounting for
Derivative Instruments and Hedging Activities by Not-for-Proﬁt Health Care Organizations, and Clariﬁ-
cation of the Performance Indicator.” The proposed standard would amend the AICPA audit and ac-
counting guide Health Care Organizations to clarify that the performance indicator reported by
not-for-proﬁt health care organizations is analogous to income from continuing operations of a for-proﬁt

enterprise. (The analogy is made to a for-proﬁt enterprise’s income from continuing operations, rather
than net income, because FAS No. 117 requires “APB No. 30” type items—extraordinary items, cumu-
lative effect of accounting changes, and discontinued operations—to be reported separately from mea-
sures of operations such as the performance indicator. In order for the performance indicator to be
comparable to net income, APB No. 30 items would need to be included within the performance indica-
tor. See Subsection 34.5(d)(iv) for information on reporting APB No. 30 items.) This clariﬁcation also
provides not-for-proﬁt providers with a clearer concept of “other comprehensive income” reporting.
(Not-for-proﬁt organizations were excluded from the scope of FAS No. 130, “Reporting Comprehensive
Income,” because FAS No. 117 already required them to display the equivalent of total comprehensive
income in the Statement of Activities.) Gains and losses that FASB pronouncements classify as elements
of other comprehensive income should be excluded from the performance indicator.
(iii) Requirements for Governmental Providers. The operating statement prepared by govern-
mental health care organizations is the “Statement of revenues, expenses, and changes in net assets.”
The focus of this statement is “all-inclusive”—that is, it presents all changes in net assets, not just
those that affect net income. Therefore, it contains all transactions that would be reported in an in-
come statement plus a statement of changes in net assets, including changes in restricted resources.
The statement must be prepared using a speciﬁcally sequenced format that distinguishes op-
erating and nonoperating revenues and expenses, and provides an intermediate total for operat-
ing income or loss. The prescribed sequence is as follows:
• Operating revenues (detailed)
• Total operating revenues (required subtotal)
34.5 FINANCIAL REPORTING PRACTICES 34
•
53
• Operating expenses (detailed)
• Total operating expenses (required subtotal)
• Operating income/loss (required subtotal)
• Nonoperating revenues/expenses (detailed)
• Income before other revenues, expenses, gains, losses, and transfers
• Capital contributions

• Additions to term and permanent endowments
• “Special items”
• Extraordinary items
• Transfers
• Increase (decrease) in net assets
• Net assets—beginning of period
• Net assets—end of period
Because the focus of this statement is on the change in total net assets, rather than changes in
classes of net assets, no reclassiﬁcations from restricted to unrestricted funds are reported when
when restrictions are released. The use of restricted funds and expiration of time restrictions are
ﬁnancial statement “nonevents” under GASB No. 34. Balance sheet reclassiﬁcations from “re-
stricted” to “unrestricted” and vice versa are not reported anywhere in a governmental entity’s
ﬁnancial statements.
Revenues should be reported by major source, and entities are required to separately identify rev-
enues that provide security for revenue bonds. GASB No. 34 links the determination of
operating/nonoperating classiﬁcation to the classiﬁcation of transactions in the statement of cash
ﬂows under GASB No. 9. Transactions related to cash ﬂows that are classiﬁed as noncapital ﬁnanc-
ing, capital ﬁnancing, or investing in the statement of cash ﬂows typically are not classiﬁed as “op-
erating” in the statement of revenues, expenses, and changes in net assets. Examples of items that are
required to be classiﬁed as nonoperating using this approach are contributions received (ﬁnancing
activity), interest expense (ﬁnancing activity), and interest income (investing activity). Under the all-
inclusive format, restricted contributions (other than capital contributions) and restricted investment
income are included in nonoperating revenues together with unrestricted contributions and unre-
stricted investment income). Each organization must establish a policy that deﬁnes operating rev-
enues and expenses based on the above parameters and disclose that policy in the notes to the
ﬁnancial statements.
GASB No. 34 established a new category of transaction called “special items.” A special item is
a signiﬁcant transaction or other event that is within the control of management and that meets one
(but not both) of the APB No. 30 criteria for classiﬁcation as an extraordinary item. Similar transac-
tions that are beyond the control of management are not special items. Special items should be re-

ported separately below nonoperating revenues (expenses).
Although governmental health care entities generally are required to apply all FASB pro-
nouncements that apply to for-proﬁt enterprises, the all-inclusive reporting format required by
GASB No. 34 conﬂicts with FASB Statement No. 130, “Reporting Comprehensive Income.”
Therefore, governmental entities do not have a concept of “other comprehensive income.” Gains
and losses that FASB pronouncements classify as elements of other comprehensive income
should be reported no differently from other gains and losses in the statement of revenues, ex-
penses, and changes in net assets.
(e) STATEMENT OF CHANGES IN NET ASSETS/EQUITY. A Statement of Changes in Net As-
sets/Equity should report all changes that have occurred during the reporting period in all equity, net
asset, and fund balance accounts maintained by a not-for-proﬁt provider. Governmental providers
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PROVIDERS OF HEALTH CARE SERVICES
do not prepare this statement, due to the “all-inclusive” nature of their operating statement as
discussed at Subsection 34.5(d)(iii).
(f) STATEMENT OF CASH FLOWS. Standards for cash ﬂow reporting differ among investor-
owned, not-for-proﬁt, and governmental health care entities, as follows:
Source(s) of “Cash Flows from
Type of Provider Authoritative Guidance Operations” Reconciles To
Investor-owned FAS No. 95 Net income
Not-for-proﬁt FAS No. 117/FAS No. 95 Change in net assets
Governmental GAS No. 9 Income/loss from operations
(i) Considerations for Not-for-Proﬁt Providers. Unique considerations for not-for-proﬁt
providers include the following:
•
Because FAS No. 117 reconciles cash ﬂows from operations to change in total net assets, the
reconciliation will have to accommodate certain equity items that are not dealt with in cash
ﬂow statements prepared for investor-owned companies. These items include equity trans-

fers, contributions of long-lived assets, unrealized gains and losses on certain investments,
investment returns restricted by donor or law, and restricted contributions.
•
Unrealized gains and losses on investment other than trading securities and contributions of
long-lived assets will need to be adjusted out as noncash items.
•
Equity transfers, restricted investment income, and restricted contributions (including contri-
butions restricted for purchase of long-lived assets) will need to be “transferred” to the ﬁnanc-
ing category by adjusting them out of operating cash ﬂows and increasing (or decreasing, as
appropriate) the ﬁnancing category by that same amount.
•
Purchases, sales, and maturities of trading securities should be classiﬁed as cash ﬂows from op-
erating activities; cash ﬂows from purchases, sales, and maturities of other than trading securi-
ties should be classiﬁed as cash ﬂows from investing activities.
•
Cash and cash equivalents reported as “assets whose use is limited” should be excluded from
“cash and cash equivalents” reported in the cash ﬂow statement.
(ii) Considerations for Governmental Providers. Governmental providers follow the guidance
in GASB Statement No. 9, Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds
and Governmental Entities That Use Proprietary Fund Accounting, in preparing their statement of
cash ﬂows. That statement’s requirements differ from those of FASB Statement Nos. 95 and 117 in
the following ways:
• The direct method of presenting operating cash ﬂows must be used, with a reconciliation pro-
vided of operating cash ﬂows to operating income (loss).
•
The GASB cash ﬂow statement has four categories: operating, investing, capital ﬁnancing, and
noncapital ﬁnancing. The capital ﬁnancing category is used for acquiring and disposing of cap-
ital assets, borrowing money for acquiring capital assets, and repaying the amounts borrowed.
All other ﬁnancing is classiﬁed as noncapital.
•

Some items are classiﬁed differently by the GASB than they are by the FASB. For example,
ﬁxed assets are classiﬁed as capital ﬁnancing activities under GASB Statement No. 9, but are
considered to be investing activities under FASB Statement No. 95.
•
GAS No. 9, par. 8 provides that a statement of cash ﬂows should explain the change in all cash
and cash equivalents, regardless of any restrictions on their use.
• The total amount of cash and cash equivalents should be easily traceable to similarly titled line
items. If it is not, a reconciliation should be provided.
34.5 FINANCIAL REPORTING PRACTICES 34
•
55
34.6 STATUTORY/REGULATORY REPORTING ISSUES
(a) STATUTORY FINANCIAL STATEMENTS. Increasingly, HMOs and provider-sponsored net-
works are coming under regulation by state departments of insurance. Generally speaking, regulated
insurers are required by their state of domicile to submit annually a set of audited ﬁnancial state-
ments that are prepared using that state’s prescribed regulatory accounting principles (“statutory ﬁ-
nancial statements”).
In 1999, the NAIC completed a process to codify statutory accounting practices (SAP) for
managed care organizations, resulting in a revised Accounting Practices and Procedures Man-
ual. Nine of the Statements of Statutory Accounting Principles (SSAPs) included in the Manual
have been speciﬁcally modiﬁed or written to address issues related to managed care. These in-
clude SSAP No. 25, “Accounting for and Disclosures about Transactions with Afﬁliates and
Other Related Parties,” No. 35, “Guaranty Fund and Other Assessments,” No. 47, “Uninsured
Plans,” No. 50, “Classiﬁcations and Deﬁnitions of Insurance or Managed Care Contracts in
Force,” No. 54, “Individual and Group Accident and Health Contracts,” No. 55, “Unpaid
Claims, Losses and Loss Adjustment Expenses,” No. 66, “Retrospectively Rated Insurance
Contracts,” No. 73, “Health Care Delivery Assets—Supplies, Pharmaceuticals and Surgical
Supplies, Durable Medical Equipment, Furniture, Medical Equipment and Fixtures, and Lease-
hold Improvements in Health Care Facilities,” and No. 84, “Health Care Receivables.” All other
SSAPs should be considered that are applicable to the particular managed care entity.

The Manual is updated annually to reﬂect revisions or additions to SAP. It is expected that
most states will require insurers to comply with most, if not all, provisions of the Manual. States
may adopt the Manual in whole, or in part, as an element of prescribed SAP in those states. If,
however, the requirements of state laws, regulations, and administrative rules differ from guid-
ance provided in the Manual, those state laws, regulations, and administrative rules preempt the
guidance in the Manual.
(b) RISK-BASED CAPITAL FOR MANAGED CARE ORGANIZATIONS. State laws generally
require insurers to maintain minimum levels of capital or surplus. The NAIC has implemented a
“risk-based capital” (RBC) formula for managed care organizations under which affected managed
care organizations must calculate and report to regulators its capital requirement and total adjusted
capital. There are ﬁve principal elements to the RBC formula: afﬁliated investment risk, asset risk,
underwriting risk, credit risk, and general business risk. Four action levels (in order of increasingly
stringent level of regulatory response) are: company action level, regulatory action level, authorized
control level, and mandatory control level. At a minimum, the company action-level event requires
the ﬁling of an RBC plan that details conditions leading to the event and proposals of corrective ac-
tion with the state insurance commissioner.
(c) OMB CIRCULAR A-133. Health care organizations that receive ﬁnancial assistance from a
governmental agency may be subject to audit requirements in accordance with the Single Audit Act
of 1996 and Ofﬁce of Management and Budget (OMB) Circular A-133, Audits of Institutions of
Higher Education and Other Nonproﬁt Organizations. Financial assistance may take the form of
grants, contracts, loans, loan guarantees, property, cooperative agreements, interest subsidies, and in-
surance or direct appropriations.
34.7 SOURCES AND SUGGESTED REFERENCES
American Institute of Certiﬁed Public Accountants, “Health Care Organizations,” Industry Audit and Accounting
Guide. New York, 1996.
, “Checklists and Illustrative Financial Statements for Health Care Organizations,” 1996.
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PROVIDERS OF HEALTH CARE SERVICES

, “Providers of Health Care Services (Section 6400).” Technical Practice Aids, 1997.
Healthcare Financial Management Association, (P&P Board Statements and Issue Analyses are available from
HFMA at 1-800-252-4362, ext. 420.) “Accounting and Reporting for Agency Relationships,” Principles and
Practices Board Statement No. 5. Westchester, IL, 1983.
, “Accounting and Reporting by Institutional Health Care Providers for Risk Contracts,” Principles and
Practices Board Statement No. 11, 1989.
, “Valuation and Financial Statement Presentation of Charity Service and Bad Debts by Institutional
Health Care Providers.” Principles and Practices Board Statement No. 15, 1993.
, “Classifying, Valuing, and Analyzing Accounts Receivable Related to Patient Services.” Principles and
Practices Board Statement No. 16, 1993.
, “Assessments and Arrangements Similar to Taxes on Tax-Exempt Institutional Health Care Providers,”
Principles and Practices Board Statement No. 17, 1994.
, “Public Disclosure of Financial and Operating Information by Health Care Providers,” Principles and
Practices Board Statement No. 18, 1994.
, “Transactions Among Afﬁliated Entities Comprising an Integrated Delivery System,” Principles and
Practices Board Statement No. 19, 1995.
, “Healthcare Mergers, Acquisitions, and Collaborations,” Principles and Practices Board Statement No.
20, 1997.
, “Acquisitions of Physician Practices,” Principles and Practices Board Issue Analysis No. 95-1, 1995.
,
“Assessing Managed Care Contracting Risk,” Principles and Practices Board Issue Analysis No. 97-
1, 1997.
Financial Accounting Standards Board, “Application of FASB Statement No. 94, Consolidation of All Majority-
Owned Subsidiaries, and APB Opinion No. 16, Business Combinations, to Physician Practice Management
Entities and Certain Other Entities with Contractual Management Arrangements,” EITF Issue No. 97-2. Nor-
walk, CT, 1997.
, “Accounting for Contributions Received and Contributions Made,” Statement of Financial Accounting
Standards No. 116, 1993.
, “Financial Statements of Not-for-Proﬁt Organizations,” Statement of Financial Accounting Standards
No. 117, 1993.

, “Accounting for Certain Investments Held by Not-for-Proﬁt Organizations,” Statement of Financial Ac-
counting Standards No. 124, 1995.
34.7 SOURCES AND SUGGESTED REFERENCES 34
•
57
CHAPTER
35
ACCOUNTING FOR
GOVERNMENT CONTRACTS
Margaret M. Worthington, CPA
35.1 UNIQUE ACCOUNTING
REQUIREMENTS FOR FEDERAL
CONTRACTORS 1
35.2 MANAGEMENT INFORMATION
SYSTEM REQUIREMENTS 2
(a) Cost Accounting Systems 2
(b) Cost Estimating Systems 4
(c) Material Management and
Accounting Systems 5
(d) Project Management
Systems 7
(e) Billing Systems 8
(i) Cost-Reimbursement
Contracts 8
(ii) Fixed-Price Contracts 9
(f) Record-Retention
Requirements 9
35.3 SPECIFIC ACCOUNTING
REQUIREMENTS 10

(a) Effects on Contractors 10
(b) Cost Principles 10
(i) Advance Agreements on
Particular Cost Items
(FAR 31.109) 11
(ii) Composition of Total
Allowable Costs 12
(iii) Factors Affecting
Allowability (FAR 31.201) 12
(c) Cost Accounting Standards 13
(i) Contract Coverage 15
(ii) Price Adjustments 17
(iii) Disclosure Statements 18
(iv) The Standards 20
(d) Contract Changes and
Terminations 26
(i) Contract Changes 26
(ii) Contract Terminations 27
35
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1
35.1 UNIQUE ACCOUNTING REQUIREMENTS FOR
FEDERAL CONTRACTORS
The federal government operates within a formalized statutory and regulatory framework when
it acquires products and services. That process was signiﬁcantly streamlined and simpliﬁed in
the 1990s for acquisitions of commercial products and services or awards that are competed
among qualiﬁed suppliers. For contracts awarded in these circumstances, negotiations are
based on prices submitted by offerors in response to government solicitation notices. However,
when products or services are custom made and/or awards are not competed, the estimated or
actual cost of performance becomes a dominant factor in setting prices. Consequently, systems

used by federal contractors in this latter environment must not only maintain information that is
necessary to effectively price contracts and control contract incurred costs but also must com-
ply with special cost estimating, cost accounting, billing and project management requirements.
This chapter is designed to provide a practical discussion of those unique federal contracting re-
quirements, which include:
• Cost Principles. Federal cost principles contained in Part 31 of the Federal Acquisition Regula-
tion (FAR) provide speciﬁc criteria as to the costs that may be included in contract proposals,
claims and billings submitted to the government.
• Cost Accounting Standards. Nineteen cost accounting standards (CAS) and disclosure state-
ment ﬁling requirements address disclosure of cost accounting practices and measurement and
assignment and allocation of costs.
• Defective Pricing. The Truth in Negotiations Act is designed to ensure that the government has
the opportunity to review all signiﬁcant and relevant cost or pricing data available to the con-
tractor when contract prices are being negotiated on the basis of estimated costs of perfor-
mance. If, after the negotiation, it is determined that current, complete, and accurate data were
not submitted, the contract price is subject to downward adjustment for any price increase re-
sulting from the failure to disclose the relevant data.
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS
To compete effectively in any market, management must have the information necessary to plan
and control its business. In the complex federal acquisition environment, companies must have
systems and controls that provide adequate accounting, estimating, and project management in-
formation. The planning phase begins when a contract proposal is prepared. During that
process, contract performance is broken down into meaningful work packages with cost esti-
mates, performance schedules, and performance responsibility assigned to appropriate cost cen-
ters. When the contract is awarded, such data should be used to establish the performance and
cost baseline for monitoring actual performance. During performance, comparisons of actual
and budgeted costs and schedule permit a contractor to take prompt corrective action as unfa-
vorable variances occur.
(a) COST ACCOUNTING SYSTEMS. Most negotiated federal contracts contain the FAR
52.215-2 clause, “Audit and Records—Negotiation,” which provides that “the Contractor shall

maintain . . . records and other evidence sufﬁcient to reﬂect properly all costs claimed to have been
incurred or anticipated to be incurred directly or indirectly in performance of this contract.” Con-
tractors performing contracts for which cost or pricing data were submitted before contract award
must have cost accounting systems that comply with FAR (and perhaps CAS) requirements. Allow-
able costs form the basis for requests for reimbursement of costs incurred under cost-reimbursement
contract billings and ﬁxed-price contract progress payments. For ﬁrm-ﬁxed-price contracts requiring
submission of cost or pricing data prior to contract award, an adequate cost accounting system is re-
quired even though costs incurred on the contract do not affect the remuneration ultimately paid to
the contractor upon contract completion. Rather, the cost accounting system is critical for providing
data for follow-on contract cost pricing, providing a basis for tracking contract performance and sup-
porting cost-based progress payment requests. To price follow-on contracts, information on the rate
of improvement in performing repetitive tasks on subsequent production (i.e., learning curves) is im-
portant. Well-designed cost accounting systems can enable estimators to identify the costs or hours
incurred on prior contracts or production lots. The ability to segregate nonrecurring costs from re-
curring costs is also critical for follow-on pricing. Clearly, the design of the accounting system is all-
important in providing valuable input for the estimating or planning process for contract costs.
The regulations do not specify that the contractor maintain any speciﬁc type of accounting
system. Rather, FAR 31.201-1 states that “any generally accepted method of determining or es-
timating costs that is equitable and is consistently applied may be used, including standard
costs properly adjusted for applicable variances.” Cost ledgers can be designed in a variety of
35
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2
ACCOUNTING FOR GOVERNMENT CONTRACTS
ways to permit efﬁcient accumulation of costs for billing purposes. In practice, these records
vary considerably, based on the individual company’s need for information and the complexity
of the contract requirements. A key requirement is the existence of adequate audit trails. An ac-
counting system provides satisfactory audit trails if: (1) every transaction is traceable from its
origin to its ﬁnal posting in the books of account; (2) every posting to accounts is susceptible
to breakdown into identiﬁable transactions; and (3) adequate documentation (e.g., time cards

or vendors’ invoices) is available and accessible to support the accuracy and validity of indi-
vidual transactions.
In a job-order costing system, costs are collected using a work-order process. Contractors,
particularly in a production environment, are not required by the regulations to account for costs
by contract (e.g., maintain a job-order cost accounting system). A cost accounting system in a
production environment is generally driven by the contractor’s products and/or production
processes. The cost accounting system should be deemed adequate if production costs are ap-
propriately, equitably, and consistently allocated to all ﬁnal cost objectives. The obvious neces-
sity is to capture and accumulate costs in a manner that reﬂects the cost of performance in
individual government contracts. To do this, certain costs that can be identiﬁed speciﬁcally with
contracts and/or products are treated as direct costs and are charged in that manner. Typically,
direct costs include material, subcontracts, and labor, but they are by no means limited to these.
FAR 31.201-4 requires that costs charged directly to contracts be allocated “on a basis of the
relative beneﬁts received or other equitable relationship.”
Indirect costs, or other costs that beneﬁt more than one contract, must be pooled and allo-
cated to contracts on some equitable basis. According to FAR 31.203(b), the general criteria for
establishing indirect cost pools are:
Indirect costs shall be accumulated by logical cost groupings with due consideration of the reasons
for incurring such costs. Each grouping should be determined so as to permit the distribution of the
grouping on the basis of the beneﬁts accruing to the several cost objectives. Commonly, manufac-
turing overhead, selling expenses, and general and administrative (G&A) expenses are separately
grouped. Similarly, the particular case may require subdivision of these groupings, e.g., building
occupancy costs might be separable from those of personnel administration within the manufactur-
ing overhead group When substantially the same results can be achieved through less precise
methods, the number and composition of cost groupings should be governed by practical consider-
ations and should not unduly complicate the allocation.
FAR 31.203(b) and (c) similarly provide ﬂexibility in determining what allocation base to
use in distributing costs from the indirect cost pools to contracts:
This necessitates selecting a distribution base common to all cost objectives to which the grouping
is to be allocated. The base should be selected so as to permit allocation of the grouping on the basis

of the beneﬁts accruing to the several cost objectives
Once an appropriate base for distributing indirect costs has been accepted, it shall not be frag-
mented by the removal of individual elements. All items properly includable in an indirect cost base
should bear a pro-rata share of indirect costs irrespective of their acceptance as Government con-
tract costs. For example, when a cost input base is used for the distribution of general and adminis-
trative (G&A) costs, all items that would properly be part of the cost input base, whether allowable
or unallowable, shall be included in the base and bear their pro-rata share of G&A costs.
Accounting for indirect costs presents a challenge to those uninitiated in government contracting.
The government has promulgated speciﬁc rules in FAR Part 31 and CAS governing the allocability
of indirect costs. However, these rules still permit considerable ﬂexibility in the number and types of
pools that can be selected and the methods used for allocating indirect costs.
The allocation of indirect costs in a highly automated environment presents an even greater
challenge, since typical overhead allocation bases, such as direct labor, may represent only a
minor component of total factory costs. In this environment, the need for multiple cost pools al-
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35
•
3
located over nonlabor bases, such as machine usage, may be required. This requirement is evi-
dent in activity-based costing or advanced cost management systems that have been imple-
mented by some government contractors. In an automated environment, requirements for audit
trails still exist; however, additional controls over input to the system and program logic are es-
sential to validate the accuracy of such systems.
For cost-reimbursement, time-and-material, and ﬁxed-price incentive contracts, accurate
labor charging by contract is imperative. To make sure of the reliability of recorded labor hours
and costs, a contractor must have an adequate internal control system for collecting and distrib-
uting labor costs. Accurate labor charging also encompasses accounting for all hours worked. If
salaried employees work a signiﬁcant number of hours in excess of 40 hours per week, a risk of
labor mischarging to the government may be asserted if all hours worked are not accounted for.
Although no speciﬁc regulatory provisions mandate the use of total time accounting, govern-
ment auditors have long asserted that accounting for all hours worked is a basic requirement of

FAR 31.201-4 and CAS 418, which provide that costs should be charged to contracts on the
basis of relative beneﬁts received. Proposals for professional or technical services that are ac-
quired on the basis of the number of hours to be provided must identify both uncompensated
hours and the uncompensated overtime rate (described in FAR 52.237-10) for direct charge ex-
empt personnel included in the proposal. The accounting practices used to estimate uncompen-
sated overtime must be consistent with the cost accounting practices used to accumulate and
report uncompensated overtime hours.
(b) COST ESTIMATING SYSTEMS. Pursuant to the requirements of FAR Subpart 15.4, cost or
pricing data generally must be submitted prior to award of a contract of $550,000 or more unless:
• The prices agreed upon are based on adequate price competition.
• The prices agreed upon are based on prices set by law or regulation.
• Commercial item are being acquired or a contract for commercial items is being modiﬁed.
• A waiver has been granted.
In estimating the costs to be incurred on government contracts, contractors’ cost estimating systems
must incorporate large amounts of data generated from a myriad of sources and departments. These
data often include historical data, vendor quotations, projections based on changes in production
methods, changes in technology, volume changes, management decisions, and estimates of future
costs. FAR 15.407-5 addresses the beneﬁts to both the government and the contractor of using an ac-
ceptable estimating system for proposal preparation. The Department of Defense (DOD) FAR Sup-
plement (DFARS), 215-407-5-70(d), applicable to defense contracts and subcontracts, outlines the
following characteristics of an acceptable estimating system:
• Clear responsibilities for preparation, review, and approval of cost estimates
• Written description of the organization and duties of personnel responsible for preparing, re-
viewing, and approving cost estimates
• Sufﬁcient personnel training, experience, and guidance to perform estimating tasks in accor-
dance with established procedures
• Identiﬁcation of the sources of data, estimating methods, and rationale used in developing
cost estimates
• Appropriate supervision throughout the estimating process
• Consistent application of estimating techniques

• Detection and timely correction of errors
• Protection against cost duplication and omissions
• Use of historical experience, where appropriate
35
•
4
ACCOUNTING FOR GOVERNMENT CONTRACTS
• Use of appropriate analytical methods
• Integration of information available from other management systems, where appropriate
• Management review, including review of company estimating policies, procedures, and
practices
• Internal review of and accountability for the acceptability of the estimating system, including
comparisons of projected and actual results and analyses of variances
• Procedures for timely updates of cost estimates throughout the negotiation process
• Responsibility for review and analysis of the reasonableness of subcontractor prices
The accuracy of the contractor’s cost estimating system is critical, since estimating mistakes
can only harm the contractor. If the estimate understates costs, the contractor may end up with a
loss on the contract. If the proposed costs are overstated, the company may be vulnerable to a
downward price adjustment as a result of defective pricing.
Cost proposals must be compatible with the cost accounting system that will be use to mea-
sure and accumulate costs during contract performance. To comply with government require-
ments for most contracts, the cost accounting system must be able to produce information on the
speciﬁc cost elements and in the same detail as proposed. FAR 15.408 Table 15-2, “Instructions
for Submitting Cost/Price Proposals When Cost or Pricing Data Are Required,” outlines the doc-
umentation needed to support the proposed costs by cost element and contract line item. Table
15-2, Section I—General Instructions, includes a discussion of the requirement for submission of
current, complete, and accurate cost or pricing data. Table 15-2, Section II—Cost Elements, iden-
tiﬁes speciﬁc requirements for presenting and supporting the following elements of cost:
• Materials and services
• Direct labor

• Indirect costs
• Other costs
• Royalties
• Facilities’ capital cost of money
Relevant information that becomes available after submitting the proposal must be provided
to the contracting ofﬁcer before ﬁnal contract negotiation. Contractors should maintain a record
of all data provided, the date and to whom provided, and, if feasible, copies of all data provided
to the contracting ofﬁcer and/or the auditor.
(c) MATERIAL MANAGEMENT AND ACCOUNTING SYSTEMS. While no speciﬁc cost
accounting requirements relating to material costs are contained in FAR, DFARS clause
252.242-7004, “Material Management and Accounting Systems” (MMAS), addresses “systems
for planning, controlling, and accounting for the acquisition, use, issuing, and disposition of
material.” The clause is included in all defense contracts and subcontracts over $100,00 that are
not for the acquisition of commercial items. The clause contains 10 standards that are used in
determining whether systems are adequate:
• Adequate system description including policies, procedures, and operating instructions
• Costs of purchased and fabricated material charged or allocated to a contract based on valid time
phased requirements as impacted by minimum/economic order quantity restrictions (desired ac-
curacy levels of 98% for the bill of material and 95% for the master production schedule)
• Mechanism to identify, report and resolve system control weaknesses and manual overrides
and identify operational exceptions such as excess/residual inventory as soon as known
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35
•
5
• Audit trails and records (maintained for the prescribed record retention periods) necessary
to evaluate system logic and to verify through transaction testing that the system is operat-
ing as desired
• Adequate levels of record accuracy (desired accuracy level of 95%); reconciliation of
recorded inventory quantities to physical inventory by part number on a periodic basis; and
detailed descriptions of circumstances that will result in manual or system generated trans-

fers of parts
• Consistent, equitable, and unbiased logic for costing of material transactions. With regard allo-
cations from common inventory accounts, controls to ensure that: (i) reallocations and credits
due are processed no less frequently than the routine billing cycle; (ii) inventories retained for
requirements that are not under contract are not allocated to contracts; (iii) algorithms are
maintained based on valid and current data
• Adequate controls to ensure that physically commingled inventories that may include material
for which costs are charged or allocated to ﬁxed-price, cost-reimbursement, and commercial
contracts do not compromise requirements of any of the above standards
• Periodic internal audits to ensure compliance with established policies and procedures
The accuracy requirements of 98% for the bill of materials and 95% for the master produc-
tion schedule are intended to ensure that the right materials are assigned to contracts based on
the time-phased requirements. Difﬁculties arise when the bill of materials and/or production
schedule are not updated, thus raising doubt as to whether the materials being procured are ac-
tually required and are only procured when they are needed for current production. The 95% ac-
curacy standard for physical inventory is intended to ensure that the number of parts reported in
the system for government contracts actually is in inventory and that the inventories allocated to
defense contracts and included in requests for progress payments have actually been used on
those contracts. However, accuracy levels for physical inventories may be difﬁcult to achieve
using the gross numbers of items in the inventory. During these periodic counts of physical in-
ventories, defense contractors can stratify inventories based on the value of the items and estab-
lish differing accuracy levels for various strata. For example, a high-cost, specialized electronic
component may be put in a stratum that requires 100% accuracy, whereas an inexpensive bolt
may be in a stratum that requires 60% accuracy. A potential result of using multiple strata is that
inaccuracy in one strata may cause the accuracy of the entire inventory to fall below the 95%
level; however, using multiple strata may make it easier to demonstrate that DOD has not been
harmed due to the lower accuracy in low-value parts. If systems have an accuracy level below
95%, the contractor must demonstrate that (1) there is no material harm to the government due
to lower accuracy level, and/or (2) the cost to meet the accuracy goal is excessive in relation to
the impact on the government.

Because transfers of parts between contracts transfers can affect billings based on cost, trans-
fers must be well documented, consistently applied, and use appropriate and equitable pricing
methodologies. Contractors must maintain and disclose a written policy describing the transfer
methodologies. The costing methodology may be standard or actual cost, or any of the inventory
costing methods permitted under CAS 411, which is discussed in Section 35.3(c)(iv). Consis-
tency must be maintained across all contract and customer types and from accounting period to
accounting period for initial charging and transfer charging. Loan/payback systems use the prin-
ciple that contracts that receive transfers of parts due to changed requirements should bear the
cost of the parts purchased to replace the items transferred; such systems are permitted only
when the loan and the payback are accomplished in the same billing period or, with govern-
ments approval, when billings are adjusted to mitigate any overbilling. Where it may not be ap-
propriate to transfer parts and associated costs within the same billing period, use of a
“loan/payback” technique must be approved by the administrative contracting ofﬁcer (ACO).
Controls must be in place to ensure that parts are paid back expeditiously; procedures and con-
trols are in place to correct any overbilling that might occur; at a minimum, the borrowing con-
35
•
6
ACCOUNTING FOR GOVERNMENT CONTRACTS
tract and the date the part was borrowed are identiﬁed monthly; and the cost of the replacement
part is charged to the borrowing contract.
System programming and records must be maintained in machine-readable form for the record
retention period outlined in Section 35.2(f). This requirement goes beyond the scope of normal
record retention provisions, which require manual or “hard” copies to be retained. This require-
ment also points out the government’s changing view of what constitutes an adequate audit trail.
(d) PROJECT MANAGEMENT SYSTEMS. The ability to monitor and project costs on gov-
ernment contracts is critical. The government is particularly concerned about overpaying cost-
based progress payments and not being forewarned about potential cost overruns.
The preparation of a comprehensive estimate of contract costs at completion is key to as-
sessing progress and determining if problems exist. These estimates should be prepared at least

quarterly to ensure the reliability of interim ﬁnancial statements and to avoid surprises that
come too late for effective corrective action. Management must be informed promptly and peri-
odically of the key facts concerning contract performance. Inherent in such systems is a conﬁg-
uration management function that tracks changes to the technical “baseline” of a product. The
project management system needs to timely provide information needed, which includes:
• Actual cost to date
• Budgeted cost for work scheduled
• Budgeted cost for work performed
• Estimated cost to complete
• Estimated cost at completion
• Contract amount (including changes)
• Projected overrun or underrun
• Contract scheduled completion date
• Expected completion date
• Projected slippage
To ensure effective monitoring of a contractor’s progress on major procurements, DOD in-
serts the “Earned Value Management System” (EVMS) clause (DFARS 252.234-7001) into cer-
tain large contracts requiring compliance with the criteria provided in DOD 5000.2-R,
“Mandatory Procedures for Major Defense Acquisitions Programs and Major Automatic Infor-
mation System Acquisition Programs. Basically, an EVMS or other type of cost/schedule con-
trol system breaks down the contract into work packages, identiﬁes organizations and managers
responsible, develops a schedule, and budgets the costs by those work packages.
The “Limitation of Cost” clause (FAR 52.232-20), inserted in fully funded cost-reimburse-
ment contracts, and the “Limitation of Funds” clause (FAR 52.232-22), inserted in incremen-
tally funded cost-reimbursement contracts, obligate the contractor to notify the government
when the contractor has reason to believe that within the next 60 days the cumulative cost in-
curred to date in performing the contract will exceed 75% of the estimated cost of, or funds al-
lotted to, the contract. The contractor must also notify the government anytime the total contract
cost is expected to be substantially more or less than the estimated cost or allotted funds. The
government is not obligated to reimburse the contractor for any cost in excess of the contract es-

timated cost or funds allotted to the contract. Nor is the contractor obligated to continue perfor-
mance or incur any costs in excess of the contract estimated costs or funds allotted. The
limitation of cost or funds clauses are designed to give the government an opportunity to decide
whether it can and will provide additional funds necessary to complete the work. Because of the
reporting requirements of these clauses, companies contracting with the government must have
an adequate project management system to allow for timely notiﬁcation of potential cost over-
runs. Boards of contract appeals and the courts have ruled in numerous instances that inadequate
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35
•
7
accounting or project management systems are not valid excuses for not providing the notice
required by the clauses.
(e) BILLING SYSTEMS
(i) Cost-Reimbursement Contracts. The “Allowable Cost and Payment” clause (FAR 52.216-7)
provides for reimbursement costs incurred in contract performance that are deemed “allowable” by
the contracting ofﬁcer, in accordance with procurement regulation cost principles and contract terms.
The clause provides cost reimbursement of allowable, recorded incurred costs for:
• Items or services purchased directly for the contract and associated ﬁnancing payments to sub-
contractors, provided payments are made on a timely basis
• Materials issued from the contractor’s stored inventory
• Direct labor
• Direct travel
• Other direct in-house costs
• Properly allocable and allowable indirect costs, except that pension plan contributions must be
funded no less frequently that on a quarterly basis
When pension plan contributions are funded less frequently than quarterly, the accrued cost
must be excluded from claimed indirect expenses until actually paid. The contractor’s cost ac-
counting system is used to determine properly allocable costs. As discussed in Section 35.3(c)
the allocation of costs to a government contract may be subject to some or all of the provisions
of the CASB’s rules, regulations, and standards.

In establishing the allowable indirect costs under a contract, indirect cost rates are ap-
plied to allowable contract base costs. Since indirect cost rates can be definitively deter-
mined only at the completion of a contractor’s fiscal year, estimated rates are required to
reimburse contractors on an interim basis. These rates, referred to as billing rates, are based
on the anticipated final annual rates. To prevent substantial overpayment or underpayment,
the billing rates should be adjusted as needed during the year. The contractor must determine
the continued appropriateness of previously established billing rates given the passage of
time and experience. The ACO or auditor responsible for determining the final indirect cost
rates is usually responsible for establishing the billing rates to be used. Final indirect cost
rates, which are generally determined after the contractor’s fiscal period ends, are used to
determine indirect expenses applicable to cost reimbursement–type contracts, as well as
fixed-price redeterminable and incentive-type contracts. The contractor is required to submit
an adequate final indirect cost rate proposal to the ACO and auditor within six months after
expiration of the fiscal year. For guidance on what constitutes an adequate proposal, FAR
42.705-1(b)(1) refers contractors to the Model Indirect Cost Proposal contained in Chapter 5
of the Defense Contract Audit Agency Pamphlet (DCAAP) No. 7641.90, “Information for
Contractors.”
1
FAR 42.703-2 and “Certiﬁcation of Final Indirect Costs” clause (FAR 52.242-4) require ex-
ecution of the following certiﬁcation when ﬁnal indirect cost rate proposals are submitted:
This is to certify that I have reviewed this proposal to establish ﬁnal indirect cost rates and to the
best of my knowledge and belief:
1. All costs included in this proposal (identify proposal and date) to establish ﬁnal indirect cost
rates for (identify period covered by rate) are allowable in accordance with the cost principles of
35
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8
ACCOUNTING FOR GOVERNMENT CONTRACTS
1
Defense Contract Audit Agency Pamphlet No. 7641.90 can be obtained by contacting Internet ad-

dress www.dtic.mil/dcaa/chap5.html.
the Federal Acquisition Regulation (FAR) and its supplements applicable to the contracts to
which the ﬁnal indirect cost rates will apply; and
2. This proposal does not include any costs which are expressly unallowable under applicable cost
principles of the FAR or its supplements.
The certiﬁcation must be signed by a senior management ofﬁcial at a level no lower than vice
president or chief ﬁnancial ofﬁcer. The certiﬁcation requirements should not be taken lightly.
Contractors should ensure that effective internal controls exist to properly screen unallowable
costs from indirect expense proposals.
Including expressly unallowable costs in ﬁnal indirect cost rate proposals subjects the con-
tractor to certain monetary penalties prescribed in FAR 42.709-1 and the “Penalties for Unal-
lowable Costs” clause (FAR 52.242-3).
(ii) Fixed-Price Contracts. Pursuant to the “Progress Payments” clause (FAR 52.232-16),
ﬁxed-price contracts requiring the use of signiﬁcant contractor working capital for extended pe-
riods generally provide for progress payments if the contractor is reliable, is in satisfactory ﬁnan-
cial condition, and has an adequate accounting and control system. Payments are made as work
progresses, as measured by eligible costs incurred, except for construction-type contracts or ship-
building, conversion, alteration, or repair contracts, which are based on percentage of completion
or other measure of the speciﬁc stages of physical completion. Progress payments based on eligi-
ble costs incurred provide reimbursement of a speciﬁed percentage of total allowable costs in-
curred in performance of the contract, provided that payments for supplies and services
purchased directly for the contract are paid on a timely basis. Accrued costs of allowable pension
plan contributions must be funded on a quarterly basis.
(f) RECORD-RETENTION REQUIREMENTS. The audit-negotiation clause (FAR 52.215-
2), inserted in negotiated contracts, and the audit-sealed bidding clause (FAR 52.214-26), in-
serted in contracts awarded under sealed bidding, form the basis of the government’s access to
contractor records, and require contractors to provide the contracting ofﬁcer, or a representa-
tive of the contracting ofﬁcer who is a government employee, with access to certain records
whenever: cost or pricing data is required; a cost reimbursement or ﬂexibly priced contract is
used; or cost, funding, or performance reports are required by the contract. The audit clauses

must be ﬂowed down to all the subcontracts over $10,000. In these situations, contractors must
make available, in their original form, relevant books, records, documents, and other data or
evidence, and accounting procedures and practices. The data must be maintained for three
years after ﬁnal payment, except where shorter retention periods are prescribed in FAR 4.705
for certain speciﬁed types of data, as summarized below:
T
WO-YEAR RETENTION REQUIREMENT
• Labor cost distribution cards or equivalent documents
• Petty cash records
• Time and attendance cards
• Payroll checks
• Material and supply requisitions
F
OUR-YEAR RETENTION REQUIREMENT
• Accounts receivable invoices and supporting data
• Material, work order, or service order ﬁles
• Cash advance recapitulations
• Paid, canceled, and voided checks other than payroll checks
• Maintenance work orders
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35
•
9
• Equipment property records
• Expendable property records
• Receiving and inspections report records
• Purchase order ﬁles for supplies, equipment, materials, or services used in performance of a
contract
• Production records of quality control, reliability, and inspection
R
EQUIRED RETENTION OF THREE YEARS AFTER CONTRACT COMPLETION

• Payroll sheets, registers, or their equivalent, of salaries and wages paid to individual employees
for each payroll period and tax withholding statements
Records must be maintained for longer than the periods speciﬁed in FAR 4.705 if a longer re-
tention period is contractually speciﬁed or if the contractor, for its own purposes, retains the
records for a longer period.
35.3 SPECIFIC ACCOUNTING REQUIREMENTS
(a) EFFECTS ON CONTRACTORS. The FAR Part 31 cost principles and CAS affect many
companies doing business with the federal government and have significantly affected many
accounting systems. In addition to the records needed for financial reporting and tax return
preparation, contractors must often maintain records to comply with these requirements.
Some contractors tailor their cost accounting practices used for financial reporting purposes
to conform with FAR Part 31 and CAS, if such costing techniques are responsive to opera-
tional requirements. Other contractors choose to maintain separate memorandum records to
establish the cost accounting practices used for government contract costing purposes. The
Preamble to CAS 401, discussed in Section 35.3(c)(iv), addresses the use of memorandum
records as follows:
Commentators stated that the purpose of the standards would require each contractor to revise his
formal system of accounts in order to maintain them on a basis used for estimating Government
contracts. The Board did not intend that requirement. The standard does not contain any require-
ment that a contractor must revise his formal system of accounts. Cost accounting records are sup-
plemental to, and generally subsidiary to a contractor’s ﬁnancial records. However, it is necessary
that the cost accounting records be reconcilable to the contractor’s general ﬁnancial records.
FAR Part 31 and CAS requirements can affect companies’ proﬁts and resulting capital accu-
mulation and, if such effect is adverse, can discourage companies from pursuing government
work and thus weaken the base of suppliers available to satisfy the government’s needs. Indus-
try has continued to express concern that FAR Part 31 and CAS are too detailed and rigid, favor
the government, and give little attention to alternatives and that cost/beneﬁt analysis prior to
adoption of new requirements is inadequate. Compliance with FAR Part 31 and CAS should not
be taken lightly. Failure to comply can result in adverse adjustments of costs and proﬁts.
Positive effects from CAS include: more objective allocation techniques; greater compara-

bility and consistency through limitations on alternative accounting procedures; a more struc-
tured framework for effecting changes in cost accounting practices, and a disclosure statement
that is useful for gaining a mutual understanding of the practices to be used in costing govern-
ment contracts.
(b) COST PRINCIPLES. Cost principles contained in FAR Part 31 and departmental FAR
supplement cost principles apply to the pricing of contracts and subcontracts whenever cost
analysis is performed and the determination, negotiation, or allowance of costs when required
by a contract clause (e.g., “Allowable Cost and Payment” clause – FAR 52.216-7. While con-
35
•
10
ACCOUNTING FOR GOVERNMENT CONTRACTS
certed efforts over the years have enhanced the uniformity in determining what costs are ac-
ceptable, agency differences still exist. Contractors should be aware of such differences so that
any proposals, claims, and billings submitted to a particular agency conform to that organiza-
tion’s unique cost principles.
(i) Advance Agreements on Particular Cost Items (FAR 31.109). Because the cost principles
apply broadly to many accounting systems in varying contract situations, the reasonableness and al-
locability of certain cost items to a given contract may be difﬁcult to determine, particularly when
ﬁrms or organizational divisions within ﬁrms may not be subject to effective competitive restraints.
To avoid possible disallowance or dispute based on unreasonableness or nonallocability, contractors
are encouraged to seek advance agreement with the government on the treatment to be accorded spe-
cial or unusual costs. Advance agreements should be negotiated before the cost covered by the agree-
ment is incurred. Agreements must be in writing, executed by both contracting parties, and
incorporated in the applicable contracts. Contracting ofﬁcers are not authorized to enter into advance
agreements for the treatment of cost inconsistent with the other provisions of the cost principles.
Restructuring that results from business combinations often causes the incurrence of signiﬁ-
cant nonrecurring costs (e.g., severance payments, early retirement incentives, idle facilities and
idle capacity) and cost accounting practice changes. Increased overhead costs that are not the re-
sult of cost accounting practice changes are not recoverable under existing ﬁrm-ﬁxed-price con-

tracts since the prices for these contracts have already been established. Since restructuring
decisions beneﬁt future operations, contractors should attempt to negotiate advance agreements
to recover such costs over future periods. By amortizing the costs over future years, contractors
can recover a portion of such costs in pricing new ﬁrm-ﬁxed-price contracts. Advance agree-
ments are required for recovery of restructuring costs on defense contracts; in addition, restruc-
turing costs generally be recoverable only if the Undersecretary of Defense (Acquisition,
Technology, and Logistics) or the Principal Deputy determines that the audited projected sav-
ings for DOD resulting from restructuring exceeds the restructuring costs by a factor of at lest
two to one.
In addition to the requirement for advance agreements relating to external restructuring
costs applicable to DOD contracts, costs for which advance agreements may be particularly
important include:
• Compensation for personal services
• Use charges for fully depreciated assets
• Deferred maintenance costs
• Precontract costs
• Independent research and development and bid and proposal costs
• Royalties and other costs for use of patents
• Selling and distribution costs
• Travel and relocation costs, as related to: special or mass personnel movements; travel via con-
tractor-owned, -leased, or -chartered aircraft; or maximum per diem rates
• Costs of idle facilities and idle capacity
• Severance pay to employees on support service contracts
• Plant reconversion
• Professional services (e.g., legal, accounting, and engineering)
• General and administrative costs, particularly with regard to construction, job-site, architect-
engineer, facilities, and government-owned contractor operated (GOCO) plant contracts
• Costs of construction plant and equipment
• Costs of public relations and advertising
• Training and education costs

35.3 SPECIFIC ACCOUNTING REQUIREMENTS 35
•
11
Given the potentially controversial nature of many of the costs listed in FAR 31.109, it is readily
understandable why they are suggested as items for which advance agreements may be appropriate.
(ii) Composition of Total Allowable Costs. The cost principles of commercial organizations de-
ﬁne the “total cost of a contract” as the sum of the allowable direct and indirect costs allocable to the
contract, less allocable credits, plus any allocable cost of money. Credits are deﬁned as the applica-
ble portion of income, rebates, allowances, and other credits that relate to allowable costs. Credits
can be given to the government as either cost reductions or cash refunds.
The distinction between direct and indirect costs is a signiﬁcant concept in the cost principles. A
direct cost is identiﬁable with a speciﬁc ﬁnal cost objective (e.g., the contract), whereas indirect costs
are incurred for more than one cost objective. However, direct costs of insigniﬁcant amounts may be
treated as indirect costs for administrative convenience. Consistent application of criteria for identi-
fying costs as either direct or indirect is emphasized. Once a cost is identiﬁed as a direct cost to a par-
ticular contract, the same type of cost, incurred in similar circumstances, may not be included in any
indirect expense pool allocated to that contract or any other contract. The cost principles do not pre-
scribe which costs should be charged as direct as opposed to indirect. The criteria for charging direct
versus indirect should be based on an analysis of the nature of the particular contractor’s business
and contracts. The criteria should be codiﬁed into a written statement of accounting principles and
practices for classifying costs and for allocating indirect costs to contracts.
(iii) Factors Affecting Allowability (FAR 31.201). Costs are not allowable merely because they
were determined by application of the company’s established accounting system. Factors considered
in determining the allowability of individual cost items include: (1) reasonableness; (2) allocability;
(3) cost accounting standards, if applicable, or generally accepted accounting principles and prac-
tices appropriate in the particular circumstances; (4) terms of the contract; and (5) limitations speci-
ﬁed in the cost; principles. A company should succeed in obtaining reimbursement for incurred costs
if the contracting ofﬁcer believes that all these criteria have been met.
Reasonableness. Reasonableness has been one of the more difﬁcult concepts in the regulations,
and understandably so in view of the substantially subjective nature of the concept. The cost princi-

ples consider a cost to be reasonable if, in its nature and amount, it does not exceed that which would
be incurred by a prudent person in the conduct of competitive business. The cost principles recognize
that reasonableness must often be determined on a case-by-case basis, considering the speciﬁc cir-
cumstances, nature, and amount of the cost in question. Reasonableness determinations depend on a
variety of considerations and circumstances, including whether:
• The cost is generally recognized as ordinary and necessary for conducting business or per-
forming the contract.
• The cost reﬂects sound business practices, arm’s length bargaining, and the requirements of
federal and state laws and regulations.
• A prudent businessperson would take similar action, considering his or her responsibilities to
the business owners, employees, customers, the government, and the public.
• Signiﬁcant deviations from established contractor practices inordinately increased contract costs.
Allocability. Although the concept is not complicated, its application can become extremely difﬁ-
cult and frequently controversial. The cost principles consider a cost to be allocable if it is assignable
or chargeable to one or more cost objectives in accordance with the relative beneﬁts received or other
equitable relationship. Subject to the foregoing, a cost is allocable to a government contract if it:
• Is incurred speciﬁcally for the contract
• Beneﬁts both the contract and other work, or both government work and other work, and can be
distributed to them in reasonable proportion to the beneﬁts received
35
•
12
ACCOUNTING FOR GOVERNMENT CONTRACTS
• Is necessary to the overall operation of the business, although a direct relationship to any par-
ticular cost objective cannot be shown
If the cost is direct, it is recoverable against a speciﬁc contract; if indirect, only an appropri-
ate portion of the expense can be recovered on a given contract. Disagreements often focus on
the extent of “beneﬁt” to the government. There is no requirement that beneﬁt to the govern-
ment be capable of precise measurement.
Cost Accounting Standards or Generally Accepted Accounting Principles. Certain cost ac-

counting standards have been speciﬁcally incorporated into the cost principles. A practice incon-
sistent with those standards is subject to disallowance under the cost principles as well as a
ﬁnding of noncompliance with the standards. If cost accounting standards are not applicable,
generally accepted accounting principles (GAAP) may be an authoritative reference for deter-
mining appropriate accounting treatment. Although GAAP have been deﬁned for a variety of ﬁ-
nancial reporting practices, cost accounting standards address the allocability of costs to speciﬁc
ﬁnal cost objectives (e.g., contracts). Consequently, the courts and boards of contract appeals
have generally given considerable weight to GAAP only when more deﬁnitive accounting treat-
ment is not prescribed in the acquisition regulations or the contract itself. The boards and courts
have cautioned against relying on GAAP to determine the allocability of costs to government
contracts by noting that “such principles have been developed for asset valuation and income
measurement and ‘are not cost accounting principles’ as such, although ‘cost accounting con-
cepts . . . may evolve out of them.’ ”
2
When the cost accounting treatment permitted by GAAP is
contrary to the criteria provided in the cost accounting standards, cost principles, or the contract,
these latter criteria generally prevail.
Selected Costs. The cost principles are revised on occasion to reﬂect public policy considerations,
administrative convenience, and congressional interest. The acquisition regulations require that ex-
pressly unallowable costs, plus all directly associated costs, be identiﬁed and excluded from propos-
als, billings, and claims submitted to the government. A “directly associated cost” is a cost that is
generated solely as a result of incurring another cost and would not have been incurred had the other
cost not been incurred. Salary costs of employees who engage in activities that generate unallowable
costs generally are treated as directly associated costs to the extent of the time spent on the pro-
scribed activity. Directly associated costs are only unallowable to the extent that they are material in
amount, except where the allowance of cost costs is considered contrary to public policy. The cost
principles do not address each cost that may be incurred. In the absence of a cost principle for a par-
ticular cost item, the determination of allowability is to be based on the principles and standards of
FAR Subpart 31.2 and the treatment of similar or related selected items in FAR 31.205. Cost items
described in the cost principles are listed in Exhibit 35.1, with a brief summary as to whether or not

the cost is allowable.
(c) COST ACCOUNTING STANDARDS. The original Cost Accounting Standards Board
(CASB) was established in 1970 as an agent of Congress. During its turbulent life from 1970 to
1980, CASB promulgated accounting practice disclosure requirements and 19 cost accounting
standards, which have the full force and effect of law. In 1988, a ﬁve-member CASB was reestab-
lished within the executive branch (Ofﬁce of Federal Procurement Policy—OFPP), and chaired
by the OFPP Administrator. The other four members consist of a DOD member, a General Ser-
vices Administration (GSA) member, an industry member, and a private-sector member knowl-
edgeable in cost accounting matters. The current board, like its predecessor, is authorized by
statute to:
35.3 SPECIFIC ACCOUNTING REQUIREMENTS 35
•
13
2
Celesco Industries, ASBCA No. 22401, January 31, 1980, Contract No. 80-1 BCA 14,271.
35
•
14
ACCOUNTING FOR GOVERNMENT CONTRACTS
FAR 31.205 Allowability Status
Public relations & advertising costs -1 Substantially unallowable
Bad debts -3 Unallowable
Bonding costs -4 Generally allowable
Compensation for personal services -6 Allowable with restrictions
Contingencies -7 Unallowable, with regard to
conditions that cannot be
measured with reasonable
accuracy
Contribution and donations -8 Unallowable
Cost of money -10 Allowable

Depreciation -11 Allowable (but see 31.205-52)
Economic planning costs -12 Allowable
Employee morale, health, welfare, food service, -13 Allowable with restrictions
and dormitory costs and credits
Entertainment costs -14 Unallowable
Fines and penalties and mischarging costs -15 Unallowable
Gains and losses on disposition of depreciable -16 Allowable (gains limited to
property or other capital assets depreciation taken)
Idle facilities and idle capacity costs -17 Allowable with restrictions
Independent research and development and bid -18 Allowable
and proposal costs
Insurance -19 Allowable with restrictions
Interest and other ﬁnancial costs -20 Unallowable
Labor relations costs -21 Allowable with restrictions
Lobbying and political activity costs -22 Unallowable
Losses on other contracts -23 Unallowable
Maintenance and repair costs -24 Allowable
Manufacturing and production engineering costs -25 Allowable
Material costs -26 Allowable, with restrictions
Organization costs -27 Unallowable
Other business expenses -28 Allowable
Plant protection costs -29 Allowable
Patent costs -30 Allowable with restrictions
Plant reconversion costs -31 Substantially unallowable
Precontract costs -32 Allowable with restrictions
Professional and consultant service costs -33 Allowable with restrictions
Recruitment costs -34 Allowable with restrictions
Relocation costs -35 Allowable with restrictions
Rental costs -36 Allowable with restrictions
Royalties and other costs for use of patents -37 Allowable with restrictions

Selling costs -38 Generally allowable
Service and warranty costs -39 Allowable
Special tooling and special test equipment costs -40 Allowable
Taxes -41 Allowable with restrictions
Termination costs -42 Generally allowable
Trade, business, technical, and professional -43 Allowable
activity costs
Training and educational costs -44 Allowable with restrictions
Transportation costs -45 Allowable
Travel costs -46 Allowable with restrictions
Costs related to legal and other proceedings -47 Substantially unallowable
Deferred research and development costs -48 Generally unallowable
Goodwill -49 Unallowable
Cost of alcoholic beverages -51 Unallowable
Asset valuations resulting from business combinations -52 Unallowable
Exhibit 35.1 FAR 31.205 selected costs.

Accountants’ Handbook Special Industries and Special Topics 10th Edition_11 pot

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