Northrup Grumman's PRB Cost Accounting Caused Disallowed Costs

Northrop Grumman Corporation's (Northrop) accounting of costs for providing post-retirement benefits (PRB) are in dispute. PRBs are benefits available to employees once they retire and may include health care, life insurance, disability, and welfare benefits. The Federal Acquisition Regulation (FAR) allows contractors to obtain reimbursement for PRB from the federal government.

Northrop's Accounting Methods

In 1991, the FAR was amended and required PRB costs assigned to a given year to be funded by that year’s tax return deadline to be able to be reimbursed from the government. The amendment allowed did not require any specific accounting standard to be used. The FAR was amended again in 1995 requiring the use of accounting standards established in the Statement of Financial Accounting Standards 106 (FAS 106) to determine allowable PRB costs in government contracts. That same year, Northrop used an accounting method for its PRB costs by using an accounting method that conformed to the requirements of the Deficit Reduction Act of 1984 (DEFRA). DEFRA and FAS 106 require the use of accrual accounting methods, but DEFRA calculates PRB costs based on current medical costs, while FAS 106 calculates PRB costs based on future interests of medical costs. Northrop continued to use the DEFRA accounting method after the 1995 amendment had taken effect, even though that method was no longer in compliance with FAR.

Mistakes Overlooked For Decades

For over ten years, Northrop filed disclosure statements with the U.S. government, disclosing its continued use of DEFRA. The government was aware of Northrop  not being in compliance with the correct accounting method but chose not to object because Northrop’s continued use of DEFRA, the incorrect method, resulted in lower reimbursed costs to the government. Northrop’s mistake allowed the government to save $253 million from 1995 to 2006. Further evidence the U.S. government approved of Northrop’s accounting methods is demonstrated by an audit conducted by both the Defense Contract Management Agency (DCMA) and the Defense Contract Audit Agency (DCAA) showing “no instances of noncompliance with applicable Cost Accounting Standards.” This “negative plan amendment” reduced Northrop’s cost obligations by $307 million.

PRB Disallowed Costs 

In 2006, Northrop switched accounting methods from DEFRA to FAS 106. In doing so, Northrop amended its PRB plans, capping the annual amount it contributed to PRB plans independent of future healthcare cost increase, and limiting the benefits available to its employees under those plans. In 2007, DCMA issued a notice of its intent to disallow costs. DCMA argued Northrop’s transition obligation was unavailable in future accounting periods because Northrop did not use the same method between 1995 and 2006 and failed to timely assign the unfunded difference between FAS 106 and the lower DEFRA amount during that period. DCMA issued a Final Determination in 2008 disallowing $253 million of Northrop’s PRB costs from its reimbursement submissions. Northrop responded by submitting a certified claim for these funds in 2010 to which it was denied by DCMA in 2011. Northrop deducted the $253 million in disallowed costs by the DCMA from its annual PRB cost reimbursement submissions since 2007, amortized over a 20-year period. Northrop appealed to the Armed Services Board of Contract Appeals (ASBCA).

Armed Services Board of Contract Appeals Conclusion

The ASBCA determined Northrop’s use of the DEFRA accounting method was out of compliance. It found that Northrop did not timely fund its PRB obligations because it used the FAS 106 method. This caused Northrop’s $235 million transition obligation  to be unallowable. The Board concluded that it could not resolve Northrop’s argument that the government’s unallowance was improper. It stated there was inconsistent testimony as to whether unallowable costs in its reimbursement submissions were included.

The United States Court of Appeals reviewed the Board’s legal conclusions de novo. The court noted that the Board’s findings were supported by testimony of Northrop’s independent actuary expert. The expert stated that the government “will never pay for the $253 million of unfunded costs because the costs have been eliminated.” The expert testimony provide evidence supporting the Board’s conclusion that it would have been impossible for Northrop to include the $253 million in its post-2006 PRB cost calculations, making the government’s disallowance of the costs improper. The U.S. Court of Appeals concluded the Board’s finding that Northrop’s negative amendment to its PRB plans eliminated the $253 million in disputed PRB costs. The Court of Appeals also disagreed with the Secretary’s argument Northrop underfunded its PRB costs because the costs were “unallowable”, and the government is required to disallow this amount from Northrop’s future reimbursement claims. The Court concluded Northrop never submitted any unallowable costs for reimbursement, and the U.S. government had no basis to disallow this amount from Northrop’s reimbursement submissions.

Secretary of Defense’s Argument

The Secretary argued Northrop’s negative plan amendment was a separate event from its FAS 106 method. The Secretary argued the amendment could not offset the disputed $253 million in PRB costs. The Court however disagreed. It instead held both events occurred simultaneously, and Northrop’s negative plan amendment had a direct effect on FAS 106 method. The amendment lowered the accumulate value of Northrop’s PRB plans, eliminating Northrop’s transition obligation. The Court of Appeals also disagreed with the Secretary’s assertion that the government is entitled to the full benefit of Northrop’s negative plan amendment. The Court argued the government already benefitted from saving $253 million between 1995 and 2006 and would benefit twice from Northrop’s noncompliance with FAS 106.

Holding

The U.S. Court of Appeals concluded there was substantial evidence that Northrop’s negative PRB plan amendment eliminated Northrop’s transition obligation. It affirmed the Board’s decision that the U.S. government’s disallowance of the $253 million of Northrop’s PRB costs was improper and dismissed Northrop’s cross-appeal. If you would like more information on this case contact Whitcomb Selinsky PC at (303) 534-1958 or complete an online contact form.