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Uncommon Sense | The fallacy of accounting, legal entity alignment

From time to time, we deal with matters concerning cost accounting structures as they may (or may not) relate to legal entity structures. On one end of the spectrum, we see contractors create complex and cumbersome cost accounting structures in an attempt to preserve accounting and legal entity alignment. On the other end of the spectrum, we see government auditors take issue with logical cost accounting structures because they don’t align neatly with legal entities.

We suspect such situations arise because the government’s cost accounting rules don’t directly address the issue of accounting versus legal entity alignment. Although the Cost Accounting Standards definition of “segment” includes government-owned, contractor-operated (GOCO) facilities and certain joint ventures and subsidiaries (i.e., separate legal entities), it does not require them to be unique segments. The rules aren’t black and white (we believe intentionally so), but both contractors and government auditors gravitate toward interpreting them that way. After all, who doesn’t like the perceived safety of certainty? However, as is often the case, overly-narrow interpretations can create perverse results.

In essence, the government’s rules require that a contractor’s cost accounting structure aligns with how it operates and manages its business. For some contractors, operations and legal entities align neatly. For others, operational units may include more than one legal entity. For still others, legal entities may align with more than one operational unit.

Other than some unique cost allowability requirements concerning socioeconomic and political matters, the government’s rules generally require contractors to do good cost accounting. Contractors incur costs to perform contracts, manage their operations and run the business. This operating structure may or may not have anything to do with legal entities. Operating structures, as opposed to legal entities, have a direct bearing on business activities, on the costs incurred as a consequence of those activities and, thus, the causal/beneficial relationship between the activities and their related costs.

Separately and distinctly, contractors may establish legal entity structures for reasons unrelated to how they manage the business operationally and financially. Depending on the nature of a contractor’s operations, geographic locations, composition of its workforce, etc., distinct legal entities may be necessary to manage legal liability, meet local incorporation requirements or comply with state/country tax obligations. Contractors necessarily create complex legal entity structures when they operate in multiple foreign countries, engage in business activity that includes significant risks or employ unionized workforces. Contractors that have grown through acquisition also often have complex legal structures.

In essence, the government’s rules require that a contractor’s cost accounting structure aligns with how it operates and manages its business. For some contractors, operations and legal entities align neatly. For others, operational units may include more than one legal entity. For still others, legal entities may align with more than one operational unit.

Untethering cost accounting from legal entities may seem like an unsettling step, but it could help certain contractors streamline operations and achieve functional support efficiencies – a positive outcome for both the contractor and the government.

Brent Calhoon
Partner, CPA
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