Materiality Defined
Materiality is a concept that is widely applied in accounting and financial reporting, including accounting for government contracts. In government contracting, materiality comes into play in different contexts such as a price reduction for defective certified cost or pricing data, accounting for a direct cost as an indirect cost, and a Cost Accounting Standards (CAS) non-compliance.
Despite its significance in government contracting, materiality is not defined in the Federal Acquisition Regulation (FAR) or CAS rules. In this regard, while the CAS rules do not define “materiality,” they do provide guidance on factors that should be considered when determining materiality. This article will discuss materiality in the context of the CAS and discusses two common scenarios that typically impact government contractors.
Cost Accounting Standards Board Rules
In accordance with 41 U.S.C. §1502, “[t]he Cost Accounting Standards Board has exclusive authority to prescribe, amend, and rescind cost accounting standards, and interpretations of the standards.” Pursuant to this authority, the CASB has promulgated rules concerning the CAS which are found in 48 CFR 99. As a part of these rules, the CASB has promulgated contract provisions and clauses that are to be used in solicitations and contracts that are subject to the CAS. These provisions and clauses have been adopted by the FAR Councils and are found at FAR 52.230-1 through -6. For these purposes, all contracts are subject to the CAS unless they are exempt from such coverage by the CASB’s rules.
Pursuant to FAR 52.230-2, a contractor must agree to a price adjustment if it makes a change to a cost accounting practice to comply with a changed Cost Accounting Standard or if the contractor makes a voluntary cost accounting practice change. In addition, the government is entitled to a price adjustment if the contractor fails to comply with an applicable Standard or the contractor’s established accounting practices and such failure causes an increase in costs to the government. It should be noted that FAR 52.230-2 does not condition the right to these adjustments on the cost impact being material. Similarly, FAR 52.230-6, Administration of Cost Accounting Standards, contains guidance on how to compute the cost impact resulting from any of these actions. However, it does not require the cost impact to be material. Thus, the CASB has not imposed any requirement that the cost impact of an accounting practice change or non-compliance must be material before a price adjustment is in order.
FAR Council Guidance
Although the CASB has not issued any guidance on what role, if any, materiality plays in administration of the CAS, the FAR Councils have attempted to fill this void. FAR 30.601 provides that the cognizant Federal agency official (CFAO) shall make all CAS-related required determinations and findings for all CAS-covered contracts and subcontracts, including whether a change in cost accounting practice or noncompliance has occurred and how any resulting cost impacts are resolved. FAR 30.602 goes on to provide guidance on materiality and how it plays in administering the CAS.
For these purposes, the FAR states that in determining materiality, the CFAO shall use the criteria in 48 CFR 9903.305. Those criteria provide that
In determining whether amounts of cost are material or immaterial, the following criteria shall be considered where appropriate; no one criterion is necessarily determinative:
- The absolute dollar amount involved. The larger the dollar amount, the more likely that it will be material.
- The amount of contract cost compared with the amount under consideration. The larger the proportion of the amount under consideration to contract cost, the more likely it is to be material.
- The relationship between a cost item and a cost objective. Direct cost items, especially if the amounts are themselves part of a base for allocation of indirect costs, will normally have more impact than the same amount of indirect costs.
- The impact on Government funding. Changes in accounting treatment will have more impact if they influence the distribution of costs between Government and non-Government cost objectives than if all cost objectives have Government financial support.
- The cumulative impact of individually immaterial items.
It is appropriate to consider whether such impacts:
- Tend to offset one another, or
- Tend to be in the same direction and hence to accumulate into a material amount.
- The cost of administrative processing of the price adjustment modification shall be considered. If the cost to process exceeds the amount to be recovered, it is less likely the amount will be material.
Obviously, this gives the CFAO a great deal of discretion in determining what criteria will be applied in a given case and the weight to be accorded the various factors. However, FAR 30.602 requires that a determination of materiality is to be based on adequate documentation. Similarly, if a determination of immateriality is made, the CFAO is to document the rationale for such determination. In addition, if a cost impact is determined to be immaterial, the CFAO will make no contract adjustments and in the case of noncompliance issues, inform the contractor that the noncompliance should be corrected; and if the noncompliance is not corrected, the government reserves the right to make appropriate contract adjustments should the cost impact become material in the future.
On the other hand, if the cost impact is determined to be material, the CFAO is to follow the procedures described in FAR 30.603 through .606 as appropriate, and make the required changes to the contract price.
Although the CFAO is afforded discretion in how they apply the 9903.305 materiality criteria, the appeal of Raytheon Company, Space & Airborne Systems in ASBCA No. 58068 provides a valuable illustration of the CFAO’s requirement to consider each of them. In this instance, the Board found that the CFAO (divisional administrative contracting officer in this case) essentially determined that the cost impact of a Raytheon accounting practice change was material simply because it resulted in increased costs to the government without due consideration of the other criteria. Further, it highlighted the point that although “no one criterion is necessarily determinative”, if a CFAO has considered all of the criteria, it is possible that one significantly outweighs all others.
How Can Government Contractors Leverage the Requirements for Determining Materiality?
Recognize that the CFAO is required to document their consideration of the 9903.305 criteria and basis for determining whether the amounts of costs are material or immaterial. Although all of the six criteria may not apply to every cost matter, the CFAO should also be able to demonstrate why they found one or more was not applicable.
When a contractor is preparing their cost impact submission, they should utilize the 9903.305 criteria as a checklist to evaluate which are applicable and then address each one. For instance, following 9903.305(b), a $200k cost impact might be considered material on its own, but in proportion to $100M of contract cost it may not appear as significant.
By performing analysis on the factors the CFAO is required to consider, contractors can better develop and defend their position on materiality.
Although we’ve discussed the criteria for determining materiality in the context of CAS, other common scenarios where contractors should remember to consider it include among others, Defense Contract Audit Agency (DCAA) audits of incurred cost and accounting systems. If for instance, costs are questioned as unreasonable, contractors can evaluate whether the amounts would actually move the indirect rates and utilize that information to help determine how they respond to the finding or negotiate.
Considering materiality also helps to remind contractors to look at issues through a wider lens. Perhaps a particular cost is considered immaterial, but could it grow to a material amount in a subsequent year? If a process in the accounting system draws attention, but is essentially compliant, contractors may be able to make a case for it being immaterial versus making a wholesale change to the system. Assessing materiality should be a standard step when evaluating issues and engaging with the Government.
Guiding You Forward
If you have questions concerning materiality or other contracting matters, do not hesitate to contact us for advice and assistance.
