GAB Decision 271
March 31, 1982 Illinois Department of Administrative Services; Docket
No. 81-59 Ford, Cecilia; Settle, Norval Garrett, Donald
The Illinois Department of Administrative Services appealed the
decision of William C. Moran, Hearing Officer, /1/ regarding computer
billing rates for services provided to State agencies by the Illinois
Data Processing Center during the period July 1, 1976 through June 30,
1979
For reasons discussed below, we sustain the Hearing Officer's
decision. In dispute is $5,228,647, which includes the following items:
(1) $2,507,496 accumulated in a retained earnings account of the
revolving fund used to pay for data processing servies; (2) $1,827,372
paid as interest costs under three lease-purchase agreements for
computer equipment; (3) $333,779 charged for development of a statewide
generalized accounting system; and (4) $560,000 representing
undercharges to users of new computer equipment (IBM 3800 Printer and
Mass Storage Unit) which were recovered by higher billings to users of
other equipment. Appellant did not appeal part of the determination
requiring the refund of $121,893 charged for bad debts. Each of these
items is discussed separately below.
This decision is based on the application for review as supplemented
by the parties' responses to a request by the Board for additional
information and the parties' responses to our Order to Show Cause. (2)
Background
The Agency's determination was based on an Agency review of the
Illinois Data Processing Center (IDPC) undertaken pursuant to 45 CFR
Part 74, Appendix C, Part I, Section J.4 (1979), which makes HHS, in
collaboration with the other federal agencies concerned, responsible for
negotiation, approval, and audit of state central service cost
allocation plans. The regulation requires the submission of a cost
allocation plan which identifies and distributes the cost of services
provided by support organizations to those departments in a state
government performing federal grants or contracts. A cost allocation
plan must be approved by the cognizant federal agency, in this instance,
HHS, in order for the costs allocated to a state agency pursuant to the
plan to be allowable for federal financial participation. The refund
required by respondent in this case would be made by IDPC to the State
user agencies to whom costs were allocated under the plan and who are
reimbursed under grants awarded by the consituent agencies of HHS.
Those agencies would then adjust their claims for federal funds
accordingly.
Discussion
I. Retained Earnings
Respondent found that as of June 30, 1979, there was $2,507,496 in a
retained earnings account of the Statistical Services Revolving Fund.
The Fund was one of several sources from which expenses of the Illinois
Data Processing Center were paid. Respondent found that this amount was
accumulated during the State's fiscal years beginning July 1, 1977 due
to charges to users which exceeded expenses. Respondent's position was
that the retained earings represented an unallowable profit within the
meaning of 45 CFR Part 74, Appendix C, Part I, Section A.1., which
states that the cost principles in Appendix C are "designed to provide
that federally assisted programs bear their fair share of costs . . .
," and further states that "(no) provision for profit or other increment
above cost is intended."
Appellant did not dispute that there were retained earnings in the
amount of $2,507,496 as of June 30, 1979. It argued, however, that that
amount did not represent "profits" within the meaning of Part 74 since
it was "not used or available for any purposes other than permissible
ones, namely the provision of data processing services to users."
(Letter dated April 17, 1981, p. 3) It pointed out that, in July 1980,
the funds in the retained earnings account were in fact used to cover
part of a $5,437,925 loss sustained in connection with an agreement to
sell old computer equipment and purchase new equipment. Appellant
argued that this loss indicated that the charges to users (3) which
resulted in the earlier accumulation of retained earnings were actually
too low rather than too high. It also argued that, in any event, there
was nothing which authorized the refund requested. Appellant also
claimed that if the retained earnings had not been available to offset
the loss of $5,437,925, it would have had to bill user agencies
separately for their prorated share of this loss. Appellant contended
that the higher rates wuhich resulted in the accumulation of the
retained earnings were preferable to billing users separately because
users were charged the same amount for each accounting period.
Respondent argued, however, that its request for a refund was
authorized by 45 CFR Part 74, Appendix C, Part I, Section C.3., which
requires that otherwise allowable expenditures be reduced by any
"applicable credits." It also noted that a sample central service
cost
allocation plan presented in "A Guide for State and Local Government
Agencies, Cost Principles and Procedures For Establishing Cost
Allocation Plans and Indirect Cost Rates for Grants and Contracts with
the Federal Government," December, 1976 (OASC-10) provided that
"(profits) or losses are carried forward and used to adjust price
schedules of ensuing quarterly billing rates." (OASC-10, p. 53)
Respondent also noted that appellant's own procedures for the
Statistical Services Revolving Fund submitted as part of a proposed
statewide cost allocation plan provided that "(in) years when revenue
exceeds expenditures, a pro-rata dividend is paid to user agencies . .
. . " (Decision of Hearing Officer dated March 18, 1981, p. 3)
Respondent further took the position that the accumulated retained
earnings as of June 30, 1979, could not be offset by the loss incurred
in July 1980. The loss was sustained as part of an agreement to lease
purchase new data processing equipment. Respondent's position was based
in part on the requirement in OASC-10 for submission of a separate
central service cost allocation plan for each fiscal year for which
costs were claimed, discussed further below. Respondent also relied on
the requirement for prior approval of the acquisition of data processing
equipment.
Prior written approval of the federal grantor agencies was not
obtained for the acquisition of the equipment involved as required by 45
CFR Part 74, Appendix C, Part II, Dc. 1, and 45 CFR 95.611 /2/
Respondent (4) contended that there could be no offset of the retained
earnings in the absence of prior approval of the purchase of the new
equipment which the State acquired in the transaction which resulted in
the loss. Respondent further contended that the offset was precluded
since the State did not obtain prior approval when it initially
purchased the old equipment which was sold in the 1980 transaction.
Appellant did not deny that it had not received prior approval for the
purchase of the equipment. Furthermore, respondent asserted, and the
State has not argued to the contrary, that the State had not submitted
documentation which would support retroactive approval of the purchase
of the old equipment.
(4) Respondent's determination that the retained earnings as of June 30,
1979 should be refunded to the State agencies is supported by the
applicable regulations. Respondent's argument that each fiscal year
should be treated separately for the pupose of determining if computer
billing rates were too high is particularly persuasive. Unless that
approach is taken, appellant could set rates which exceeded expenses and
accumulate the excess revenues in its retained earnings account
indefinitely until some event not otherwise budgeted for arose. This
would mean that the reteined earnings account in effect constituted a
contingency fund. Section D.2. of 45 CFR Part 74, Appendix C, Part II,
provides that "(contributions) to a contingency reserve or any similar
provision for unforeseen events are unallowable." Thus, even if the
purchase of the equipment which produced the loss in 1980 had been
approved, we find that the loss could not be offset against the amount
previously accumulated in retained earnings.
We also agree with respondent's argument that the failure to obtain
prior approval of the purchase of the equipment precludes the State from
offsetting the loss against retained earnings. It is a specific
condition for federal financial participation under Subpart F of 45 CFR
Part 95 that a state must obtain prior written approval for the
acquisition of automatic data processing (ADP) equipment or services
when the cost exceeds $25,000 (as it did in this case). (45 CFR 95.601
and 95.611(a)) This Board has previously held that, under these
regulations, the Agency's approval of the acquisition of ADP equipment
or services is mandatory in order to receieve federal matching funds.
New York Department of Social Services, Decision No. 238, December 10,
1981. Since, lacking prior approval, the State was not entitled to
receive federal financial participation in the first instance, it cannot
now charge costs associated with the equpment to the federal government.
Appellant argued that, regardless of the balance in the retained
earnings account, there was no authority for requiring a refund to the
State agencies which used data processing services. This argument, (5)
however, does not provide a basis for reversing the determination here.
The retained earnings as of June 30, 1979 represented the difference
between payments by users and the actual cost of computer services
provided. The retained earnings thus constitute "applicable credits,"
defined in 45 CFR Part 74, Appendix C, Part I, Section C.3. as those
"transactions which offset or reduce expense items allocable to grants
as direct or indirect costs . . . (such as) adjustments of overpayments
or erroneous charges." Section D.1. further provides that "(the) total
cost of a grant program is comprised of the allowable direct cost
incident to its performance, plus its allocable portion of allowable
indirect costs, less applicable credits." In this case, the payments
made by State agencies for computer services were ultimately charged to
their federal grants and contracts (to the extent allocable). As noted
by the Agency, moreover, appellant's own statewide cost allocation plan
contemplated refunds under these circumstances. Thus, it is appropriate
that the overpayments be refunded to the State agencies in order that
they might in turn reduce the amount charged to grants and contracts in
accordance with Section D.1.
II. Interest Costs
Respondent determined that charges to users of data processing
services included interest costs totalling $1,827,372 paid under several
lease - purchase agreements in State fiscal years 1977, 1978 and 1979.
(Draft ADP Cost Determination Report, pp. 8 - 9) It concluded that a
refund of that amount was required under 45 CFR Part 74, Appendix C,
Part II, Section D.7., which provides that "(interest) on borrowings
(however represented), . . .(is) unallowable except when authorized by
Federal legislation." Respondent noted that the lease - purchase
agreements specifically identified "the Interest component in each of
the periodic payments made or to be made under the terms of the
agreement." (Decision dated March 18, 1981, p. 4)
Appellant argued that the payments in question were termed interest
in the lease - purchase agreements merely to provide tax benefits to the
lessor - seller, and did not thereby become interest within the meaning
of Part 74. It contended that the intent of Part 74 is to prohibit
additional costs usually associated with time purchases from being
charged to the federal government, and that that intent was not defeated
since the State's total payments under the lease - purchase agreements
were less than they would have been under a regular lease so that "no
true additional cost is being passed on to users." (Letter dated August
12, 1981, p. 1) It also argued that requiring it to refund the costs in
question would be inconsistent with the policy guides for the
application of the cost principles expressed in Appendix C (6) which
state that "State and local governments are responsible for the
efficient and effective administration of grant and contract programs
through the application of sound management practices." 45 CFR Part 74,
Appendix C, Part I, Section A.2.a. In response to the Board's Order,
appellant contended that it was its understanding from the Federal
Register, Volume 45, Number 246, dated December 19, 1980, that Federal
Management Circular (FMC) 74 - 4 would be adjusted to allow interest
under lease - purchase arrangements.
Appellant's argument is essentially a policy argument. We agree with
appellant that the mere fact that a lessor may choose to denominate part
of the monthly rental payment as interest is not determinative that it
is an unallowable interest expense (although we do not understand how
merely denominating a part of the payment as interest would give the
lessor a tax benefit). An examination of the agreements in question,
however, shows that the total payments required to be made by the State
under the agreements exceeded the net purchase price, excluding payments
for insurance, by the amount denominated as interest. The lease -
purchase agreements entered into by the State have the atrributes of
installment sales agreements other than the fact that title remains in
the lessor until such time as the lessee exercises its option to pay or
the lease term ends. Under the agreements, the lessor exercised litlle
control over the equipment subject to the lease. Appellant was required
to maintain and repair the equipment as well as provide insurance. The
lease - purchase agreements stated that the parties agreed that payments
under the lease consisted of amortization of the purchase cost of the
leased equipment, as well as interest. Also, appellant did exercise its
option to purchase the equipment subject to one of the lease - purchase
agreements. The State cannot disguise the purchase of computer
equipment by a lease - purchase agreement in order to claim interest
costs from the federal government. We find, therefore, that the State
purchased the equipment and that there was "interest" within the meaning
of Part 74 in the amount of $1,827,372.
Moreover, appellant's reliance on the cited Federal Register
publication, which proposed revisions of FMC 74-4, is misplaced. OMB
Circular A-87, which supersedes FMC 74-4 and which was published January
28, 1981 (46 Fed. Reg. 9548), was not amended to allow interest under
lease - purchase agreements. Accordingly, respondent's determination in
this matter must be sustained.
III. Statewide Generalized Accounting System
Respondent found that the State charged $333,779 for the development
of an automated accounting system as overhead costs which were then
distributed to all users of data processing services. Respondent found
(7) that the system was not related to the provision of data processing
services, and concluded that, in basing charges for development of the
system on the amount of data processing services used, appellant
violated 45 CFR Part 74, Appendix C, Part I, Section C.2.a. That
section provides that "(a) cost is allocable to a particular cost
objective to the extent of benefits received by that objective."
Respondent noted specifically that there was no advance commitment by
State agencies using data processing services to use the accounting
system once it became available, and further, that two major federally -
funded State agencies did not in fact use the system once it became
available. Appellant argued, however, that since the system was
available to all users, the development costs were properly chargeable
to all users. It contended that "(this) is the only practical and
equitable way of recovering the development costs of system." (Letter
dated April 17, 1981, p. 5)
The applicable regulations permit the assignment of costs to a
particular cost objective only in accordance with benefits received.
The availability of the accounting system to all users of data
processing services cannot be considered tantamount to the receipt of a
benefit. Even if all users of data processing services ultimately
elected to use the accounting system, development costs should have been
charged in accordance with the extent to which the accounting system was
used rather than based on the use of completely unrelated data
processing services. Therefore, we sustain respondent's determination.
IV. IBM 3800 Printer and Mass Storage Unit
Respondent found that in fiscal year 1979, the cost of two new pieces
of computer equipment exceeded revenues by $560,000, and that this loss
was covered by excess revenues from other computer equipment. It
concluded that this situation violated the provision in 45 CFR Part 74,
Appendix C, Part I, Section C.2.a. quoted in section III above, since
users of the other computer equipment were in effect being billed for
services from which they did not benefit. Respondent further found that
losses on the new equipment also occurred in fiscal year 1980 and were
expected in fiscal year 1981, and stated that utilization records
examined by it showed that the capacities made available by the new
equipment were not required. It noted further that prior approval for
the purchase of the new equipment had not been obtained, as required by
45 CFR Part 95, Subpart F, and that appellant had not submitted the
documentation necessary to support retroactive approval of the
purchase.(8) Appellant did not deny that there were losses on the new
equipment. It contended, however, that it deliberately undercharged
users of the new equipment in order to make the use of that equipment
affordable until additonal users could be recruited. It asserted that
"(if) new equipment must immediately pay for itself in user charges, no
new equipment, no matter how more economical it might be, could be
substituted for old equipment. No single user could afford to be billed
the total cost of new equipment pending recruitment of other users so no
user could 'go first'." (Letter dated April 17, 1981, p. 6) Appellant
further argued that the "start-up" period for the new equipment "was
reasonably more than a fraction of, or even an, entire single fiscal
year." (Ibid.) Appellant also argued that its actions in this instance
were consistent with 45 CFR Part 74, Appendix C, Part I, Section A.2.c.,
which vests in state governments primary responsibility for employing
whatever form of organization and management techniques may be necessary
to assure efficient and effective administration of grant and contract
programs. (Ibid.)
Section 95.611 of 45 CFR (1978) provides that as a specific condition
for federal financial participation a state must obtain prior written
approval for the acquisition of ADP equipment or services when the
acquisition cost exceeds $25,000. The Board held in New York Department
of Social Services, cited supra, that, under the regulations, Agency
prior approval for the acquisition of ADP equipment or services is
mandatory in order to receive federal matching funds. Since appellant
did not receive prior written approval for this equipment, we find that
cost of the new equipment could not be passed on to the federal
government, either directly or through the use of revenues from other
equipment.
Moreover, although appellant gave a plausible reason for not charging
users the full cost of the new equipment during the start-up period, it
did not adequately address the question whether revenues from other
eqipment could properly be applied to the cost of the new equipment.
Appellant was asked to submit in its response to the Board's Order any
evidence that the new equipment was intended eventually to replace the
other equipment. Appellant did not provide any such evidence. Without
evidence to the contrary, we find that the new equipment was not meant
as a replacement for the other equipment. Thus, the application of the
excess revenues from the other equipment to the cost of the new
equipment was unjustified. Therefore, even if approval had been given
for the acquisition of the equipment, that would not alter the fact that
costs were not allocated in acccordance with benefits received.
(9) Conclusion
For the reasons state above, we uphold the Hearing Officer's
determination. /1/ The Hearing Officer was designated by the Acting
Deputy Under Secretary of HHS to review appellant's appeal
pursuant to 45 CFR Part 75 from the determination of the Director,
Division of Cost Allocation, Region V. Section 75.6 (d) of Title 45 CFR
provides for review by the Regional Director or his delegate; however,
the Hearing Officer was designated due to the vacancy in the office of
the Regional Director (formerly the Principal Regional Official). When
we refer to the "respondent" or "Agency" in this decision,
we mean any
of the following: the Regional Director of Region V, the Director,
Division of Cost Allocation, or the Hearing Officer. /2/ Part 95
was effective December 28, 1978, or earlier at state option. (43 FR
44853, September 29, 1978) Even if the State did not elect to implement
Part 95 earlier than December 28, 1978, the requirements for prior
approval contained in 45 CFR 95.611 were applicable to the earlier
periods involved in this case since Part 95 consolidated and codified
existing provisions of 45 CFR Part 74, Appendix C, Part II, C.1. 43 FR
448.51. Appellant, however, did not dispute that the prior approval
requirement of 45 CFR Part 95 was applicable.
OCTOBER 22, 1983