2022-001 Internal Control and Compliance Finding Related to 48 CFR 9904.404, Capitalization of Tangible Assets, and 48 CFR 9904.409, Depreciation of Tangible Capital Assets, Noncompliances a. Condition Our review of compliance and internal control testing in accordance with OMB 2022 Compliance Supplement for Part A. Activities Allowed or Unallowed: Part B. Allowable Cost/Cost Principles and Part H. Period of Performance identified a noncompliance related to the capitalization and depreciation of tangible assets as reported in DCAA Audit Report No. 03441-2022S19404001, dated January 23, 2023. SRC is claiming depreciation expenses in excess of what should be allocated to this FY. Our review of SRC's depreciable cost identified the following noncompliance with specific requirements of 48 CFR 9904.404. In addition, our review of SRC's depreciation costs identified the following noncompliance with specific requirements of 48 CFR 9904.409 and FAR 31.205-11, Depreciation. - SRC does not document their analysis of historical asset service life in support of its estimated useful lives utilized as part of its depreciation calculation, which is in noncompliance with 48 CFR 9904.409-50(e)(1) and 48 CFR 9904.409-50(e)(2). SRC does not maintain records to support useful lives on its useful life matrix. The actual lives are longer than the estimated useful lives utilized, resulting in understated useful lives and overstated depreciation expense in the estimated useful life years. - SRC does not estimate residual values, therefore residual value in excess of ten percent is not considered in calculating the depreciable costs, which is in noncompliance with 48 CFR 9904.409-50(a)(1), 48 CFR 9904.409-50(h), FAR 31.205-11 and the contractor?s written capital asset policy. The system automatically sets up residual value at zero percentage. This results in overstated depreciation expense. - The building purchase price includes the cost of the land and SRC depreciated land, which is in noncompliance with 48 CFR 9904.404-40(a) and the contractor's written capital asset policy. The policy was not consistently applied by the employee recording the cost of buildings in the books and records. Land costs were depreciated resulting in overstated depreciation expense. - SRC?s Disclosure Statements regarding the self-constructed assets is not in compliance with its actual practice, which is noncompliance with 48 CFR 9904.404-40(a). The disclosure statement does not explain the application of the overhead and G&A rates for similar and non-similar products. Incorrectly calculated depreciable costs could result in additional depreciation expense charged to indirect pools, resulting in increased indirect costs charged to Government contracts. - Assets are not all tagged by SRC, which is in noncompliance with the contractor?s written capital asset policy. The policy is not consistently followed as assets did not have tags and some assets had virtual tags, not covered in the policy. The lack of asset tab results in issues with identifying assets. Since the costs reviewed were for FY 2022 and the contractor has not had time to implement any corrective action, no additional testing was performed in our current audit. The resolution of the CAS noncompliance is being handled through the resolution process specified in FAR 30.605, Processing Noncompliances. On January 31, 2023, the Administrative Contracting Officer issued an initial determination of noncompliance with 48 CFR 9904.404 and 48 CFR 9904.409. Therefore, we have not qualified our audit results or questioned any indirect costs. This noncompliance pertains to all Federal Contracts under SRC's R&D cluster. b. Criteria We examined 48 CFR 9904.404-40(a) which states: The acquisition cost of tangible capital assets shall be capitalized. Capitalization shall be based upon a written policy that is reasonable and consistently applied. We examined 48 CFR 9904.409-50(a)(1) which states: The depreciable cost of a tangible capital asset shall be its capitalized cost less its estimated residual value. We examined 48 CFR 9904.409-50(e)(1) and (e)(2) which states: (1) The expected actual periods of usefulness shall be those periods which are supported by records of either past retirements or, where available, withdrawals from active use (and retention for standby or incidental use) for like assets (or groups of assets) used in similar circumstances appropriately modified for specifically identified factors expected to influence future lives. (2) Supporting records shall be maintained which are adequate to show the age at retirement or if the contractor so chooses, at withdrawal from active use (and retention for standby or incidental use) for a sample of assets for each significant category. Whether assets are accounted for individually or by groups, the basis for estimating service lives shall be predicated on supporting records of experienced lives for either individual assets or any reasonable grouping of assets as long as that basis is consistently used. We examined 48 CFR 9904.409-50(h) which states: Estimated residual values shall be determined for all tangible capital assets (or groups of assets). For tangible personal property, only estimated residual values which exceed ten percent of the capitalized cost of the asset (or group of assets) need to be used in establishing depreciable costs. Where either the declining balance method of depreciation or the class life asset depreciation range system is used consistent with the provisions of this Standard, the residual value need not be deducted from capitalized costs to determine depreciable costs. No depreciation cost shall be charged which would significantly reduce book value of a tangible capital asset (or group of assets) below its residual value. In addition, we examined FAR 31.205-11(a) which states: a) Depreciation on a contractor?s plant, equipment, and other capital facilities is an allowable contract cost, subject to the limitations contained in this cost principle. For tangible personal property, only estimated residual values that exceed 10 percent of the capitalized cost of the asset need be used in establishing depreciable costs. Where either the declining balance method of depreciation or the class life asset depreciation range system is used, the residual value need not be deducted from capitalized cost to determine depreciable costs. Depreciation cost that would significantly reduce the book value of a tangible capital asset below its residual value is unallowable. We also examined SRC's Capital Asset Policy which states in part: Salvage (Residual) Value - Assets placed in service will follow FAR 31.205-11 whereby residual value will be used ONLY when it exceeds 10% of the capitalized cost of the asset. Otherwise, no salvage (residual) value will be assumed. Land: Capitalized at original cost including readying the land for use. All assets (except Land) will be depreciated monthly on the straight line basis over the appropriate useful life. The Facilities/Property department is responsible for ensuring all capital assets are properly identified and tagged. The Company shall take all reasonable precautions to ensure that capital assets are properly maintained and kept in good, safe working order, are kept physically secure, and properly identified with a Company tag. We examined Item 4.5.0(d), Application of Overhead and G&A rates to specified Transactions or Costs-Self-constructed depreciable assets, of SRC's Disclosure Statement, Revision 22, effective October 1, 2021 which states in part: Other: Residual Value Code ?Y? - New assets placed in service after July 01, 2004 and beginning depreciation October 1, 2004, will follow FAR 31.205-11 whereby residual value will only be used when the residual value exceeds 10% of the capitalized cost of the asset. Assets placed in service prior to July 1, 2004 and currently being depreciated as of October 1, 2004 will continue to be depreciated using an estimated 5% salvage value. c. Recommendation SRC should comply with 48 CFR 9904.404 and its written policies regarding depreciable costs and self-constructed assets. In addition, SRC should comply with 48 CFR 9904.409 and FAR 31.205-11 regarding useful lives and residual value. The written capital asset policy should be followed regarding asset tags, and revised for virtual tags. Training should be provided to responsible employees to ensure compliance with 48 CFR 9904.404, 48 CFR 9904.409 and FAR 31.205-11. For full details, see recommendations included in DCAA Audit Report No. 03441-2022S19404001. d. Contractor Response SRC concurs to our findings. SRC?s complete response is included in the Corrective Action Plan for Current Year Findings in Appendix 3.