B-224782.7, Feb 29, 1988

B-224782.7, Feb 29, 1988

DIGEST: In response to request for suggested changes to Federal Acquisition Regulation Parts 30 and 31 concerning the allowability of costs incident to mergers and other business combinations, General Accounting Office states its belief that as a general rule the book value of an asset subsequent to a business combination should be limited to the book value of the asset when first devoted to government contracting, less accumulated depreciation; revaluations of assets should be permitted on a case-by-case basis only where it can be shown that a combination will result in corresponding benefits to the government.

Ms. Margaret A. Willis:

This responds to your letter of November 19, 1987, requesting our comments concerning the allowability of costs incident to mergers and other business combinations. This is Federal Acquisition Regulation (FAR) case No. 87-43.

Generally accepted accounting principles (GAAP) and the Cost Accounting standards recognize two methods of accounting for the costs of tangible capital assets following a merger or other business combination: the purchase method and the pooling of interests method. Accounting Principles Board Opinion No. 16, August 1970; FAR Sec. 30.404-50(d), (e) (Federal Acquisition Circular No. 84-30, Sept. 30, 1987). Under the purchase method, a business combination is viewed as the acquisition of one company by another, and the acquiring company records the acquired assets at its cost. Under the pooling of interests method, on the other hand, the transaction is viewed as an exchange of equity securities that unites the ownership interests of two or more previously independent companies; the historical cost (acquisition cost less accumulated depreciation) of assets is carried forward from the constituent companies to the combined corporation. Under GAAP, the pooling of interests method should be used if specified conditions are met. Otherwise, the purchase method is used.

When the book value of an asset used in performing government contracts is increased, or "stepped up," under the purchase method of accounting in connection with a business combination, the total depreciation that may be charged with respect to that asset also is increased. Thus, having reimbursed one contractor for some or all of the cost of an asset through annual depreciation allowances, the government may be required to reimburse the acquiring company for the same asset through further depreciation allowances based on the stepped up value. In addition, a step-up in the value of assets increases the base for measuring the return on investment, or profit, of the acquiring company for purposes of future contract negotiations. In both cases, the incentive for the acquiring company to hold down acquisition costs is reduced. Moreover, both depreciation allowances and contractor profit may increase even though there may be no benefit to the government resulting from the business combination.

Although GAAP would require a stepped-up book value for financial accounting purposes, we believe that as a general rule the book value of an asset subsequent to a business combination should be limited to the book value of the asset when first devoted to government contracting, less accumulated depreciation. Revaluations of assets should be permitted on a case-by-case basis only where it can be shown that a business combination will result in increased benefits to the government, for example, lower unit costs.