Business and regulatory opportunities and challenges for Government contractors NCMA Bostons March Workshop March 8 2017 Agenda Section 1 Introduction Section 2 FAR and DFARS Regulatory Considerations ID: 557627
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Organizational Changes and Restructuring: Business and regulatory opportunities and challenges for Government contractors
NCMA Boston’s March WorkshopMarch 8, 2017Slide2
AgendaSection 1 - Introduction
Section 2 - FAR and DFARS Regulatory ConsiderationsSection 3 - Mergers & Acquisitions (“M&A”) Considerations Over the Deals Life Cycle
Strategy
Pre-deal due diligence
Post-deal integrationSection 4 - Internal ReorganizationsSection 5 – Restructuring Proposal Format – IllustrationsSection 6 - Group Discussion Topics / Q&A
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2Slide3
Section 1Introduction
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Course ObjectivesIdentify organizational transformation initiatives and how those initiatives affect government contractors and contract cost accounting
Mergers and acquisitionsCost competitiveness
Operating synergies
Understand differences between external and internal restructuring activities and how those differences may affect transformation initiatives
Understand the approach for submitting restructuring proposals, securing an audit of the proposal, and obtaining an advance agreement on costs
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What is meant by organizational transformation?Defining an “organizational transformation”
Strategic change in business structure or end-to-end processes with the goal of improving performance by focusing on capabilities, effectiveness, and efficiency
Forms of organizational transformation
External M&A through acquisitions or carve-outs
Internal or intra-company realignments or cost improvementsCost allowability: organization costs vs. restructuring costs
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Section 2FAR and DFARS Regulatory Considerations
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Discussion - Organization Costs Cost Principle
FAR 31.205-27 Organization Costs makes unallowable expenditures associated withPlanning or executing the organization or reorganization of the corporate structure of a business, including mergers and acquisitionsResisting or planning to resist the reorganization of the corporate structure of a business or a change in the controlling interest in the ownership of a business
Raising capital (net worth plus long-term liabilities
)
Unallowable reorganization costs include the cost of any change in the contractor’s financial structure, excluding administrative cost of short-term borrowings for working capital, resulting in alterations in the rights and interests of security holders (i.e. “restructuring” costs) whether or not additional capital is raised
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Discussion - Organization Costs Cost Principle (cont’d)
FAR 31.205-27 Organization Costs examples of allowable costs include:Recurring costs associated with maintaining the business structure, including costs associated with changes in ownership of the contractor’s securities, are allowable under FAR 31.205-28 Other Business Expenses
Costs of providing contractor’s securities to employees for the primary purpose of compensation are allowable under FAR 31.205-6 Compensation for Personal Services
Costs of long-range management planning, including plans to make organizational change, are allowable under FAR 31.205-12 Economic Planning Costs and paragraph (b)(b) of FAR 31.205-38
Selling CostsAdministrative costs for arrangement of short-term borrowing that do not fall under FAR 31.205-20 Interest and Other Financial
Costs
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Discussion - Organization Costs Cost Principle (cont’d)
Costs of forming or changing the corporate structure of a business and raising capital have been unallowable since T.D. 5000 was published in 1940FAR 31.205-20 Interest and other Financial Costs and (f)(2) of FAR 31.205-47 Costs Related to Legal and Other Proceedings have the same restrictions
Rationale: costs have no relationship to the work of the existing business entity, and therefore provide little benefit to the contractor’s Government work
Disagreements between contractors and Government auditors when distinguishing between allowable organizational planning activity and unallowable organization costs
CAS 405-60(c) illustration uses this source of disagreement between organizational planning activity and organization costs as an example of the type of cost that need not be identified and excluded from contract cost until the contracting officer determines that such cost is unallowable
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Discussion - External Restructuring Costs10 U.S.C. 2325(a) Limitation on Payment
Secretary of Defense may not pay restructuring costs unless written determination that either:Savings exceed costs by at least 2:1; or
Savings exceed costs and preservation of critical capability would otherwise by lost to DoD
Secretary may not delegate the authority to make the determination, with respect to a
business combination, to an official of the Department of Defense -Below the level of an Assistant Secretary of Defense for cases in which the amount of restructuring costs is expected to exceed $25,000,000 over a 5-year period; orB
elow the level of the Director of the Defense Contract Management Agency for all other cases
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Discussion - External Restructuring Costs (cont’d)DFARS 231.205-70(c) Cost Limitation
Restructuring costs are allowed if:Costs are allowable in accordance with FAR Part 31 and DFARS Part 231
An audit of costs and savings is performed and reviewed by the ACO
ACO negotiates and advance agreement
USD (AT&L) or Director DCMA, depending upon the amount of restructuring costs, determines audited savings exceed costs by a factor of 2:1 or preservation of critical capability would otherwise by lost to DoDOtherwise, costs are non-reimbursable as restructuring
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Discussion – External Restructuring Costs (cont’d)DFARS 231.205-70(b) Definitions
Business Combination: Assets or operations of companies not previously under common control are
combined
External
Restructuring Activities:Occur after business combination (i.e. common ownership or control)Direct outgrowth of business combinationNormally initiated within 3 years of business combination
Restructuring Costs:
Direct and indirect costs of restructuring activities in
excess of $2.5 million allocated to
DoD contracts
Costs must be allowable in accordance with FAR Part 31 and DFARS Part 31
Restructuring Savings:
Direct and indirect cost reductions resulting from restructuring activities
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Discussion – External Restructuring Costs (cont’d)DFARS 231.205-70(b) Definitions - Restructuring Activities
Include:Efforts that are:Nonroutine
Nonrecurring
Extraordinary
To combine:Facilities
Operations
Workforce
In
order to
:
Eliminate redundant capabilities
Improve future operations
Reduce overall costs
Do
not include:
Activities occurring after a business combination that affect the operations of only
one
of the companies not previously under common ownership or control
.
Routine or ongoing repositionings and redeployments of a contractor’s productive facilities or workforce (e.g., normal plant rearrangement or employee relocation).
Other routine or ordinary activities charged as indirect costs that would otherwise have been incurred (e.g., planning and analysis, contract administration and oversight, or recurring financial and administrative support).
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Discussion - Organization Costs vs. Restructuring CostsDCAA Audit Guidance on Restructuring and Organization Costs (PAD 730.45/95-23)
Terms organization and reorganization apply to transactions that involve a change in the capital and/or financial structure of the company“
What constitutes a change in the capital and/or financial structure
?”
The Cost Principles Subcommittee relied upon the definitions of reorganization contained in A Dictionary for Accountants (Third Edition) by Eric L. Kohler:“A major change in the financial structure of a corporation or group of associated corporations resulting in alterations in the rights and interest of security holders
(emphasis added); a recapitalization, merger, or consolidation.”
Restructuring costs result from changes to a contractor’s organization in
a effort to address a declining base or to enhance business
efficiencies
Internal changes – e.g., downsizing, cost improvement program/initiative
External changes – e.g., mergers, divestiture, or other form of business combination
Restructuring costs and the “but for” argument - ASBCA decisions indicate costs associated with subsequent events, that are not in and of themselves organizational changes, do not meet the definition of organization costs under FAR 31.205-27 and should generally not extend to restructuring activity costs
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Discussion – Organization Costs vs. Restructuring Costs (cont’d)
DFARS 231.205-70 External Restructuring Costs provides a procedural process for obtaining recovery of post merger integration costs when certain conditions are metCAS 406-61 provides an interpretation that the treatment of restructuring costs (external or internal) may
be accumulated as deferred
cost
and subsequently amortized over a period during which the benefits of restructuring are expected to accrueFAR Part 30.603-2(e) for unilateral and desirable changes and 9903.201-8 contract requirements for compliant changes due to external restructuring provide that:Requirements for contract price and cost adjustments do not apply to compliant cost accounting practices that are directly associated with external restructuring activities meeting requirements of 10 U.S.C. 2325
However, disclosure requirements shall be followed
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Section 3M&A Considerations Over the Deal L
ife CycleDraft - Subject to Change
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The deal life cycleDraft - Subject to Change
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StrategyIntent of how acquired entity will operate
Buy and hold separateIntegrate with other businesses
Silo government contracting requirements
and compliance and reputational risks
within the organizationEstimate for potential unallowable costs that may not be recoverableIdentify government contracting market opportunitiesAdditional sales channelsTypes of contract vehicles
Alignment with the organization’s strategic goals and objectives for growth
Design of future state organizational cost accounting
structure
Minimize indirect rate impacts
on current contract base
Maintain indirect rate competitiveness for the
future
Align cost accounting periods and estimating practices
Disclosure of
changes in
cost accounting practices
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Pre-deal Due DiligenceIdentify and diagnose key compliance risks/issues by analyzing:
Acquisition target’s government contracts portfolioCustomers, contract mix, procurement regulation requirements
Open audits or unsettled
contract costs and compliance issues
Pipeline/backlogGrowth and earnings potential based on contract types and government customerErosion of small business set-aside opportunities
Balance sheet reserves for existing and future contract cost settlement risks
Contractor business systems approvals
Desired level of system integration –
plan to adopt currently
approved processes and controls
Deficiencies could impact cash flow
via billing
withholds and
affect qualifications to pursue and receive
contracts
Contract novation requirements could lead to delays
in
customer acceptance and billing collections
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Post-deal External RestructuringDFARS 231.205-70(c) - Cost Limitation
Restructuring costs are allowed if:Costs are allowable in accordance with FAR Part 31 and DFARS Part 231
An audit of costs and savings is performed
Administrative Contracting Officer (“ACO”)
negotiates an advance agreementAudited savings exceed costs by factor of at least 2:1 or preservation of critical capability otherwise lost to DoDOtherwise, costs are non-reimbursable
as restructuring
External restructuring activities are a direct outgrowth occurring after a business combination; normally initiated within 3 years
External Restructuring Benefits:
Cost Impact
Exemption - FAR 30.602(e) and
9903.201-8
The
contract price and cost adjustment requirements
are
not applicable to compliant cost accounting practice changes directly associated with external restructuring activities that are subject to and meet the requirements of 10 U.S.C.
2325; disclosure of the practice changes still required
Assignment Period – CAS 406-61
Restructuring costs may be accumulated as a deferred cost, and subsequently amortized, over a period during which the benefits of restructuring are expected to accrue, but not to exceed 5 years
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External Restructuring CostsRestructuring
costs include:Personnel costs (e.g., relocations, severance, retraining, early retirement incentives)Facility
and asset costs (e.g., relocations, rearrangements,
dispositions)
Project management (e.g., incremental costs for labor, travel, consultants)Business process changes and related costsIncremental costs for information technology
Restructuring costs
do not
include routine management actions designed to improve operational efficiency
Evaluate allowability and reasonableness under FAR Part 31 and DFARS 231
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Consideration: 1) one-time, nonrecurring, nonroutine activity,
and
2) would otherwise not have been incurredSlide22
External Restructuring SavingsDirect and indirect cost reductions resulting from restructuring activities, such as:
Facilities savings (vacate, closure, downsize, etc.): rent, operating expensesFTE reductions: salary, fringe, bonuses
Reasonable expectation of
increased future
contract costs had the restructuring not occurredReassignments of cost to future periods are not restructuring savingsOverall costs and savings are to be realized:
Over a period not to exceed 5-years
Discounted to current year dollars
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DFARS 231.205-70(d)/PGI 231.205-70(d) – ACO Procedures
Execute contract novation agreement, if necessaryIn accordance with FAR 42.12 and DFARS 242.12 and include the provision at DFARS 242.1204(e)
Direct contractor to:
Segregate restructuring costs
Suspend them from billing and settlements until DoD makes determination of projected restructure savingsRequire contractor plan showing net present value of costs and savings
Adequately supported proposal to establish reasonableness of costs and projections
Breakout by year by cost element with basis of estimate rationale for accumulation, amortization, and methods of allocation
DoD participation rate or “share” of projected costs and savings
Separately identify from internal restructuring costs, if any
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DFARS 231.205-70(d)/PGI 231.2015-70(d) – ACO Procedures (cont’d)
Notify major buying activities of:Contractor’s restructuring actions
Impacts on major weapons
programs
Adjust FPRs to reflect the impact of projected restructuring costs and savingsUpon receipt of the contractor’s proposal, request an audit review Negotiate an advance agreement with the contractor setting a cumulative cost ceiling and cost amortization schedule (when necessary)
Recommend for certification, or determination, or both, to Under Secretary of Defense (Acquisition, Technology, and Logistics) who determines in writing that the audited restructuring
savings will exceed
costs by a factor of at least 2:1
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DFARS 231.205-70(e) – Information NeedsNovation Agreement, if required
Contractor’s Restructuring ProposalProposed Advance AgreementAudit ReportAny other pertinent informationACO recommendation for certification, or determination, or both
Savings based on audited data and result in overall reduced costs to DoD
Audited savings for DoD exceed costs by 2:1
Preservation of critical capability/savings exceed costsDraft - Subject to Change
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DFARS 231.205-70(f) – CO Responsibilities, in consultation with the cognizant ACO
Consider including a repricing clause in noncompetitive fixed-price contractsDecision to use repricing clause depends upon the particular circumstances:
When restructuring will take place
When savings will be realized
Contract performance periodReasonableness of impact estimate on the contractSize of potential dollar impact on contract
If repricing clause used, provide for downward-only adjustment
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External Restructuring Proposal ConsiderationsDetermine Restructuring Activities and Objectives
Identify Restructuring Projects and Tasks
Establish Anticipated Period of Performance
Develop Cost and Savings Summary – NPV / DoD Share
Determine Cost Accounting Structure / Practice ChangesDraft - Subject to Change
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Section 4Internal Reorganizations
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Internal ReorganizationsDefinition: the act of reorganizing the legal, ownership, operational, or other structures of a company for purposes of making it more profitable.
Internal reorganizational drivers:Legal entity consolidation
Streamline
operations and systems (people, processes, and technology)
Ability to create cost synergies through segment consolidation or establishing services centersLimit exposure within organization to government contracting requirementsAbility to share commercial/government labor resources across segmentsConsolidation of financial and ERP systems to a standard platform
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Internal ReorganizationsPlanning & Execution:
Define goals and cost synergies to formulate a plan on restructuring activitiesAssess the allowability of costs in accordance with FAR
Part 31
requirements
Consider following the DFARS external restructuring process to address:Determine if the audited savings exceed costs by factor of at least 2:1 Communicate plan with the ACOPrepare a proposal outlining internal restructuring savings and costs
Seek benefits of cost impact exemption and an extended restructuring cost assignment period
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Section 5Restructuring Proposal Format - Illustrations
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Summary – Savings and CostsDraft - Subject to Change
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Summary – Savings by Initiative by YearDraft - Subject to Change
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Summary – Costs by Initiative by YearDraft - Subject to Change
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Example – Basis of Estimate TemplateDraft - Subject to Change
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Section 6Group Discussion Topics / Q&A
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Group Discussion QuestionsWhat are some reasons the DoD initially encouraged defense contractors to restructure?
What are the threshold requirements for the DFARS external restructuring procedures? How is the threshold calculated in practice utilizing the rate structure?
Does the external restructuring cost principle make organization costs allowable? Why?
What are some positive benefits the external restructuring process provides for the government and for the contractor?
What are some negative consequences that may occur?Are internal reorganizations treated different than external as it relates to cost allowability?What business functions are involved internal/external restructuring activities? When should those functions be engaged in the process?
Once a deal is announced, what requirements are placed upon the Administrative Contracting Officer? What actions may be required of the Procuring Contracting Officer?
A deal is publicly announced in mid-February and closes in late May.
What kind of activities might occur during this time period and how
would you
treat those activities
?
When should planning related to a deal or internal reorganization be communicated to their Administrative Contracting Officer?
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Group Discussion Questions
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How
would you determine which DoD contracts would participate in the savings from the business combination and contribute to cost recovery of the restructuring costs
restructuring?
Can an external restructuring process be initiated more than 3 years after a transaction closes?
Does the external restructuring process change any financial reporting measures under GAAP?
Are DoD and non-DoD contracts similarly affected by external restructurings? Why?
How are internal restructurings similar to and different from external restructurings? Should internal restructurings follow the external restructuring process?
How long does the external restructuring process take? What are some “leading practices”?
What records must be maintained to demonstrate the total restructuring savings and restructuring cost?Slide39
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Questions?
Gregg
Pilotte
Mark Dostal
Director
Director
gregg.s.pilotte@pwc.com
mark.s.dostal@pwc.com
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- 4514
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