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CPE for Government Auditors

New Uniform Guidance: Cost Principles for Nonprofits and Governments

CHAPTER 1:

General Principles & Basic Premises

Objectives:

  • Differentiate between principles applicable to state and local governments and non-profits
  • Define key government regulators and their acronyms
  • Sequence the four layers of rules governing grants

1-1 Introduction to Federal Cost Principles

Now you’ve done it. You’ve taken on a federal grant – either to administer one or to audit one!

Federal grants can be very tricky, with many strings attached. But luckily the federal government tends to be specific about their expectations regarding how the resources are to be used.

In general, governments strive to enhance accountability and transparency in their recordkeeping and reporting. The citizens have a right to know what happened to their tax money. And they have the right to know that the money was spent properly.

What this means for us, the professionals working with these grants, is that we have to dot every “i” and cross every “t.” Most grants undergo several layers of scrutiny, and grantees are constantly under threat of the “de-obligation” of federal grant funds (which means the feds ask for their money back) if they don’t follow the rules.

This course examines one significant aspect of the federal government’s expectations regarding the use of taxpayers’ dollars – the cost principles.

We will examine the federal cost principles applicable to state and local governments and Indian tribal governments and to non-profit organizations that receive federal grants. The cost principles apply to almost all federal grant programs, although some do have exceptions contained in their program regulations or individual grant terms and conditions. This text does not specifically address universities, hospitals, or for-profit entities.

When an entity receives federal grants, or expects to in the near future, it should ensure that one or more of its employees have a strong working knowledge of the federal cost principles.

1-1-1 Is That Allowable?

When you behave and spend resources within the federal guidelines, your expenditures are deemed ”allowable.”

As an administrator, you may need to answer confidently for the auditor and grantor questions similar to these:

  • Is it allowable to buy a truck to deliver meals to the elderly?
  • Is it allowable to purchase food for the annual holiday party with federal funds?
  • Is the salary for the receptionist for the whole agency chargeable to the grant?
  • Is the cost for defending our patent chargeable to the grant?

If you are unsure about the allowability of costs, the auditor and grantor will wonder whether you are competent. And when auditors or grantors start to doubt your credibility, they have a responsibility to dig a little deeper, and it is never pleasant to be on the receiving end of a dig.

On the other hand, if you are an auditor, you need to be able to detect when costs are not allowable and help the client come into compliance with grant regulations.

1-1-2 Acronyms, Definitions, and Relationships

Before we dig into the federal regulations, we’d better master a few key acronyms and relationships. The federal government is ripe with them.

Here are some acronyms you will see frequently in this text:

OMB: Office of Management and Budget – An agency in the executive branch of the federal government. OMB works with the president to help him direct all of the federal agencies at his command, such as the Department of Defense, the Department of Health and Human Services, Department of Housing and Urban Development, etc.

The OMB helps the president design the federal budget, and also issues directives from the executive branch called ”circulars.” These circulars convert law and executive directions into implementable actions and are to be used by the federal agencies in carrying out their missions. The circulars define terms and fill in the blanks with references that Congress may or may not fill in. They are usually fairly easy to read as the OMB does its best to speak in plain English, but they are often long and detailed.

The circulars cover a wide range of topics. Here is a partial list of the circulars regarding just financial management from the OMB’s website at http://www.whitehouse.gov/OMB/circulars/:

  • OMB Circular A-21 – Cost Principles for Educational Institutions, relocated to 2 CFR, Part 220 (30 pages)
  • OMB Circular A-50 – Audit Followup
  • OMB Circular A-87 – Cost Principles for State, Local, and Indian Tribal Governments, relocated to 2 CFR, Part 225
  • OMB Circular A-102 – Grants and Cooperative Agreements with State and Local Governments
  • OMB Circular A-110 – Uniform Administrative Requirements for Grants and Other Agreements with Institutions of Higher Education, Hospitals, and Other Non-profit Organizations, relocated to 2 CFR, Part 215
  • OMB Circular A-122 – Cost Principles for Non-Profit Organizations, relocated to 2 CFR, Part 230
  • OMB Circular A-123 – Management’s Responsibility for Internal Control (Effective beginning with Fiscal Year 2006) (Revised 12/21/2004)
  • OMB Circular A-127 – Policies and Standards for Financial Management Systems
  • OMB Circular A-133 – Audits of States, Local Governments, and Non-Profit Organizations (includes revisions published in Federal Register 06/27/03)
  • CFR: Code of Federal Regulations – The Code of Federal Regulations is authored by the federal agencies that administer the grants. So the Department of Defense and the Department of Health and Human Services write these regulations. Each of 50 broad titles can usually be associated with a particular federal agency. Each title is divided into parts that cover specific regulatory areas.

The OMB, in an effort to make it easier to find the information they need to manage grants, has relocated some of its circulars to the Code of Federal Regulations. Formerly, the cost principles were in three circulars, but now they reside in the CFR. This makes sense, as the circulars are directions for federal agencies, and grantees are used to looking for federal rules in the CFR.

This relocation is part of a broader initiative to make Title 2 of the CFR the single location where the public can find guidance for grants and agreements. The broader initiative provides a good foundation for streamlining and simplifying the policy framework for grants and agreements.

1-1-3 Four Types of Regulations Applicable to Each Grant

There are four layers of regulations usually applicable to each federal grant:

  1. Cross-cutting administrative rules;
  2. Cross-cutting cost principles (the subject of this text);
  3. Program rules; and
  4. Individual grant terms and conditions.

1-1-3a Layer 1: Cross-Cutting Administrative Rules

Cross-cutting administrative rules cover issues such as:

  • Budget revisions,
  • Procurement, and
  • Property standards.

For governmental units and non-profits, these rules, which differ by type of entity, are set out in:

  • OMB Circular A-102 – for all state and local governments, except for schools of postsecondary education (colleges and universities) and hospitals, and
  • 2 CFR 215, formerly Office of Management and Budget (OMB) Circular A‑110 – for non-profit organizations, schools of postsecondary education and hospitals.

OMB Circular A-102 applies to all state and local governments, except schools of postsecondary education and hospitals. This is one circular that hasn’t yet been moved to the CFR.

Schools of postsecondary education and hospitals, regardless of whether or not they are state or local governments, use the rules set forth in 2 CFR 215. Also, non-profits are bound by the rules contained in 2 CFR 215.

Each type of entity adopts the rules that apply to it, regardless of how the funds flow. For example, if the federal government makes an award to the state of Florida, the state uses the rules contained in OMB Circular A-102. If the state then makes a subaward to the University of Florida, the university follows the rules in 2 CFR 215. If the university then makes a subaward to the city of Miami, Miami follows the rules contained in OMB Circular A-102. As you will see, the same approach applies to the cross-cutting cost principles.

1-1-3b Layer 2: Cross-Cutting Cost Principles

Cross-cutting cost principles address the general rules on what makes a cost allowable and cover the rules on specific types of costs. These rules, which differ by type of entity, are set out in 2 CFR 225 and 2 CFR 230.

  • 2 CFR 225, Cost Principles for State, Local, and Indian Tribal Governments, (formerly OMB Circular A-87) applies to state and local governments, and to Indian tribal governments.
  • 2 CFR 230, Cost Principles for Non-Profit Organizations, (formerly OMB Circular A-122) applies to non-profit organizations.

Neither 2 CFR 225 (State and Local Governments) nor 2 CFR 230 (Non-Profits) applies to any university or hospital, regardless of whether the entity is organized as a governmental organization or as a private non-profit. Universities and hospitals, which are not the focus of this text, are covered under 2 CFR 220 and 45 CFR 74, Appendix E of the Department of Health and Human Services cost principles, respectively.

If you work with a for-profit entity (such as a defense contractor), the Federal Acquisition Regulations (known as FAR) apply.

The cost principles in 2 CFR 230 (Non-Profits) and 2 CFR 225 (State and Local Governments) apply to costs of work under grants, cooperative agreements, cost reimbursement contracts, and other contracts in which costs are used in pricing, administration, or settlement.

Entities use the cost principles that apply to them regardless of how the funds flow. In the example used above, the state of Florida would use the cost principles contained 2 CFR 225 (State and Local Governments); the University of Florida would use the cost principles contained in 2 CFR 220 (even though it is a state school); and the city of Miami would use the cost principles contained in 2 CFR 225 (State and Local Governments).

There is one exception. The federal government requires a small number of very large non-profit organizations to follow the FAR rather than 2 CFR 230 (Non-Profits). There is a list of these large non-profits in Appendix C to 2 CFR 230 (Non-Profits).

Did you catch all that? CFRs, circulars, and FAR. I hope the OMB keeps working on making things simpler and putting information all in one place, don’t you?

1-1-3c Layer 3: Program Rules

Program rules, which differ by federal program, are customarily cited in the grant award. They may conflict with, and override, cross-cutting administrative rules and the cost principles. That is totally within the rights of the granting agency and makes keeping up with more than one grant from more than one granting agency loads of fun.

1-1-3d Layer 4: Individual Grant Terms and Conditions

The federal grantor can go one step farther than allowing or restricting behavior in the program rules. They can write specific terms and conditions for a grant going to a particular entity.

For instance, if a grantee has a history of violating grant rules, the federal grantor may consider the grantee ”high risk.” As a result, the grantor can spell out terms for the grantee that other recipients are not required to meet. Of course, if there are any objections, the grantee does not have to sign the agreement or take the money. But once the agreement is signed, the grantee is locked into the terms negotiated with the grantor.

 

1-2 Overview of General Principles & Basic Premises

Below are the basic structures of the Cost Principles for State, Local, and Indian Tribal Governments, 2 CFR 225, and the Cost Principles for Non-Profits, 2 CFR 230. The full text of both of these regulations appears as an attachment to this course.

2 CFR 225 is organized as follows:

Part 225 Cost Principles for State, Local, and Indian Tribal Governments (previously OMB Circular A-87).

§225.5 Purpose.
§225.10 Authority.
§225.15 Background.
§225.20 Policy.
§225.25 Definitions.
§225.30 OMB responsibilities.
§225.35 Federal agency responsibilities.
§225.40 Effective date of changes.
§225.45 Relationship to previous issuance.
§225.50 Policy review date.
§225.55 Information contact.
Appendix Appendix A—General Principles for Determining Allowable Costs
Appendix B—Selected Items of Cost
Appendix C—State/Local-Wide Central Service Cost Allocation Plans
Appendix D—Public Assistance Cost Allocation Plans
Appendix E—State and Local Indirect Cost Rate Proposals

This is how 2 CFR 230 is organized:

Part 230 Cost Principles for Non-Profit Organizations (previously OMB Circular A-122).

§230.5 Purpose.
§230.10 Scope.
§230.15 Policy.
§230.20

Applicability.

§230.25

Definitions.

§230.30

OMB responsibilities.

§230.35 Federal agency responsibilities.
§230.40 Effective date of changes.
§230.45 Relationship to previous issuance.
§230.50 Information contact.
Appendix Appendix A—General Principles
Appendix B—Selected Items of Cost
Appendix C—Non-Profit Organizations Not Subject to This Part

Section 225.20 provides that the general cost standards are intended to “…promote effective program delivery, efficiency, and better relationships between governmental units and the Federal government.” While not specifically stated in the rules regarding non-profit organizations, it would be reasonable to conclude that these entities have similar goals for the federal awards administered by them. Such awards can include:

  • Grants,
  • Cost reimbursement contracts, and
  • Other agreements with the federal government.

The cost principles are designed to assure that federal award recipients bear their fair share of costs, except where prohibited or restricted by law. For example, as a condition to receiving the federal award, some grants require that the grantee contribute a share, either in funds (real money) or “in–kind” contributions (goods and services), to total award expenditures. Generally, this type of requirement is intended to provide assistance while assuring community or governmental unit support for the project.

Appendix A to Title 2, Part 225 (State and Local Governments)

A. Purpose and Scope

1 Objectives. This Appendix establishes principles for determining the allowable costs incurred by State, local, and federally-recognized Indian tribal governments (governmental units) under grants, cost reimbursement contracts, and other agreements with the Federal Government (collectively referred to in this appendix and other appendices to 2 CFR part 225 (State and Local Governments) as “Federal awards”). The principles are for the purpose of cost determination and are not intended to identify the circumstances or dictate the extent of Federal or governmental unit participation in the financing of a particular program or project. The principles are designed to provide that Federal awards bear their fair share of cost recognized under these principles except where restricted or prohibited by law. Provision for profit or other increment above cost is outside the scope of 2 CFR part 225 (State and Local Governments).

2 CFR 230 (Non-Profits)

§230.10 Scope

b) The principles deal with the subject of cost determination, and make no attempt to identify the circumstances or dictate the extent of agency and non-profit organization participation in the financing of a particular project. Provision for profit or other increment above cost is outside the scope of this part.

§230.20 Applicability

(a) These principles shall be used by all Federal agencies in determining the costs of work performed by non-profit organizations under grants, cooperative agreements, cost reimbursement contracts, and other contracts in which costs are used in pricing, administration, or settlement.

In the first few chapters of this text, we will discuss Appendix A – the General Principles – for both state and local governments and non-profits. In later chapters, we will cover specific items of cost and their allowability (in other words, we will focus on Appendix B).

In both 2 CFR 225 and 2 CFR 230, Appendix A establishes the general principles and standards for a uniform approach in determining allowable costs incurred by governmental units and non-profit organizations, respectively, under federal awards. Although the wording may vary slightly, the general principles are essentially the same for these entities.

To be allowable, a cost must be both meet the cost principles and permissible. The general cost principles require that costs must be necessary and reasonable, allocable, treated consistently, adequately documented, etc. These criteria are crucial to the overall allowability of award costs.

While specific items of cost (e.g., salary, travel costs, indirect costs) may be permissible under federal rules, they may fail to meet one of the essential general cost principles. When this occurs, the costs are unallowable. On the whole, far more costs are determined to be unallowable because they fail the general standards than because they fail the specific requirements. Therefore, this section of the course may be of the greatest importance to those administering federal awards.

Metaphorically, the cost principles could be likened to a well-defined property line in that it is necessary to know the boundary (rules) before erecting a building (incurring award costs).

1-3 Application of the General Principles

The rules regarding the allowability of costs apply to the total composition of cost, which includes both direct costs and indirect costs. We will discuss direct costs and indirect costs in more depth later in this course. However, at this point, let us give you a brief definition of each.

Direct Costs: Direct costs are those costs that can be identified with a specific activity or function.

Indirect Costs: In general, indirect costs are those costs incurred by the grantee organization for a common or joint purpose benefiting more than one project.

Appendix A to Title 2, Part 225 (State and Local Governments)

D. Composition of Cost

1 Total cost. The total cost of Federal awards is comprised of the allowable direct cost of the program, plus its allocable portion of allowable indirect costs, less applicable credits.

E. Direct Costs

1 General. Direct costs are those that can be identified specifically with a particular cost objective.

F. Indirect Costs

1 General. Indirect costs are those: Incurred for a common or joint purpose benefiting more than one cost objective, and not readily assignable to the cost objectives specifically benefited, without effort disproportionate to the results achieved.

 

Appendix A to Title 2, Part 230 (Non-Profits)

B. Direct Costs

1 Direct costs are those that can be identified specifically with a particular final cost objective, i.e., a particular award, project, service, or other direct activity of an organization.

C. Indirect Costs

1 Indirect costs are those that have been incurred for common or joint objectives and cannot readily identified with a particular final cost objective. Direct cost of minor amounts may be treated as indirect costs, …

For example, if you provide school lunches to low income children, you incur a variety of costs; some costs are easily traceable to the program and some are not. Being “direct” indicates that a cost was incurred specifically for this program. Indirect costs are a little more fuzzy, or difficult to trace to a program.

For the school lunch program, the costs of food and the labor involved in cooking and serving the food are considered direct costs. Let’s say that the cost of food is 40 cents, the cost of labor to cook it is 20 cents, and the cost to serve is 24 cents. This totals 84 cents of direct costs.

The school district incurs a litany of other costs to make the program work. Many people call these fuzzier costs “overhead” costs. With the school lunch program, the administrative staff has to do the paperwork to ensure that the students are qualified to receive the lunches. The accounting department has to compile cost reimbursement paperwork to send in to the grantor. The janitor has to clean the lunchroom and kitchen. The electricity bill has to be paid. The lunchroom monitors must be compensated. The program has to be marketed or communicated to parents who are eligible for the program. We could go on and on and on!

If the school district asked the federal grantor to reimburse the district for only 84 cents per lunch per student, the district would be in the hole on this program, which isn’t very fair. In addition to spending the 84 cents for direct costs per school lunch, the district might spend another 49 cents on indirect costs. If the federal government mandates the program, they often (but not always!) pay for the whole program. Instead of paying only 84 cents, the federal grantor pays the district $1.33 per lunch.

1-3-1 Complexities Involved with Indirect Costs

Management accountants spend much of their careers trying to figure out how to allocate costs to a particular product or service. The proper way to allocate indirect costs to a product or service often is a bone of contention with these professionals. Some are fans of an intense cost allocation technique called “Activity Based Costing”[1] and others prefer to use a simple method to spread the costs in the pool among services and programs.

In the example above, how do you treat the salary of the chief accountant of the school district? Is he directly involved with the school lunch program? No. But does his administrative work in some way contribute to the program operating. Sure. So what is fair to charge the grantor and what is not?

The cost principles described in later chapters go into great detail about permissible indirect costs.

Here is what the cost principles do not do. Neither the Cost Principles for State, Local, and Indian Tribal Governments nor the Cost Principles for Non-Profit Organizations:

  • Identify who is going to pay for what or that the federal government is mandated to fund a particular program. The extent of federal and organizational participation in financing the award is part of the grant agreement, not the cost principles; or
  • Allow the grantee to build profit into their cost estimates or reimbursement requests. The grantee should not endeavor to generate profits to support other programs or activities by charging the federal grantor in excess of allowable costs.

1-4 Basic Premises

Because the federal grantor is the ultimate steward of the public’s resources, funds cannot be sent to entities that can’t handle them properly.

The rules for governmental units specifically state, “…governmental units are responsible for the efficient and effective administration of Federal awards through the application of sound management practices.”[2]

Thus, the grantee must manage the grant so that the program accomplishes its goals. The federal government expects the grantee to:

  • Manage efficiently,
  • Administer federal funds in accordance with the following:

– Applicable underlying agreements,
– The specific award agreement, and
– The program’s objectives, and

  • Establish its own organizational structure.

Super High Airfare!

A few years ago, while teaching a class on the cost principles to employees of a U.S. territory, a student raised a question about grant-related travel costs associated with their grant.

This student explained that flights to the U.S. had to be reserved four to six weeks in advance. But, because of the island’s cumbersome administrative process, the tickets might be purchased only a few days before the flight. Since the tickets were purchased so late, their cost often was more than double the reservation price.

A federal grant representative had warned the employees of the grantee that she might no longer accept the higher flight prices. The student was troubled by that possibility.

Now, if I were the grant representative, I would have questioned the excessive cost sooner. While it wasn’t the student’s (or his classmates’) fault, and the problem related to the administrative unit within the territory, the grant was not made to the student(s), but to the island itself. In my opinion, the grant representative acted appropriately since the territory had not complied with the basic requirement for “efficient and effective administration.” As a result, the unreasonable travel costs would be unallowable.

1-4-1 Entity Type Determines Rules

The type of entity of the grantee organization determines which rules the entity must follow. For example, in addition to the program-specific rules cited in the award documents and any specific award terms and conditions, governmental units must follow:

  • Rules governing the specific federal program,
  • The terms and conditions of the grant,
  • The cost principles in 2 CFR, Part 225 (State and Local Governments) (A-87),
  • The administrative requirements in A-102, as adapted by the awarding agency[3], and
  • The audit requirements in A-133.

Non-profit grantees must also follow:

  • Rules governing the specific federal program,
  • The terms and conditions of the grant,
  • The cost principles in 2 CFR, Part 230 (Non-Profits) (A-122),
  • The administrative requirements in 2 CFR, Part 215 (A-110), as adapted by the awarding agency, and
  • The audit requirements in A-133.

Appendix A to Title 2, Part 225 (State and Local Governments)

2. Policy guides.

a. The application of these principles is based on the fundamental premises that

(1) Governmental units are responsible for the efficient and effective administration of Federal awards through the application of sound management practices.
(2) Governmental units assume responsibility for administering Federal funds in a manner consistent with underlying agreements, program objectives, and the terms and conditions of the Federal award.
(3) Each governmental unit, in recognition of its own unique combination of staff, facilities, and experience, will have the primary responsibility for employing whatever form of organization and management techniques may be necessary to assure proper and efficient administration of Federal awards.

b. Federal agencies should work with States or localities which wish to test alternative mechanisms for paying costs for administering Federal programs.

****

This approach also should increase incentives for administrative efficiencies and improve outcomes.

There is no similar language found in Title 2 CFR, Part 230 (Non-Profits).

Chapter 1 Summary

The federal government endeavors to be specific and purposeful when they spend precious taxpayer dollars. Grantees are expected to follow a series of rules and guidelines issued by the federal government in spending grant monies. This text focuses on the cost principles, which are embodied in 2 CFR, Part 225 (State and Local Governments) (A-87) and 2 CFR, Part 230 (Non-Profits) (A-122).

 


[1] Activity Based Costing (ABC) incorporates simple methods of allocating overall costs, such as accounting.

[2] See A.2.(a)(1) of General Principles for Determining Allowable Costs of Appendix A to Title 2, part 225 (State and Local Governments).

[3] Federal agencies were required to adopt a “Common Rule” for administering grants with governmental units. However, there are minor variations in the regulations issued by the different federal agencies. Therefore, it is important for a grantee to review the regulations of the specific federal awarding agency. OMB maintains a chart, which includes the locations of the agencies requirements at http://www.whitehouse.gov/omb/grants_chart/.

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