DEPARTMENTAL APPEALS BOARD
Department of Health and Human Services
SUBJECT: Oregon State System of DATE: June 8, 1989 Higher
Education Docket No. 88-145 Audit
Control No. A-10-87-00006 Decision No. 1058
DECISION
The Oregon State System of Higher Education (OSSHE or appellant)
appealed a determination by the Regional Director of Region X (Agency)
of this Department disallowing an estimated $1,000,000 in federal
funding received by the appellant under various federally supported
projects. The disallowed amount represented the federal share of the
$9.9 million surplus found to exist in the appellant's Internal Service
Funds (ISFs) as of June 30, 1984. These Funds are set up to cover the
costs of operation, both direct and indirect, of diverse activities
required by the colleges and universities within OSSHE, such as computer
centers, service stores, printing shops and motor pools. Most of these
activities provide services or materials to federally supported projects
within the colleges and universities and are reimbursed through charges
to those projects. The Agency found that the surplus resulted because
charges were in excess of the actual costs of the activities and OSSHE
had failed to make appropriate adjustments in its charges to reflect the
surplus.
Based on an audit performed by the Region X Office of Audit, the
Regional Director concluded that the surplus in appellant's ISFs was not
authorized by the provisions of the applicable cost principles, Office
of Management and Budget (OMB) Circular A-21. On appeal, the appellant
argued that part or all of the surplus was authorized under the cost
principles either as working capital or as a reserve for equipment
replacement. The appellant also disputed whether the Agency had
correctly computed the amount of the surplus. Finally, the appellant
argued that, in any event, the surplus would be depleted by June 30,
1991 since, in recent years, the appellant had been incurring costs in
excess of charges.
Based on the following analysis, we conclude that the surplus was not
authorized by the cost principles. We also find that, under the
circumstances here, the Agency had a reasonable basis for calculating
the amount of the surplus, and that a disallowance for the period ended
June 30, 1984 was justified regardless of whether, under projections by
OSSHE, the surplus will be depleted by June 30, 1991.
Accordingly, we uphold the disallowance in full.
Background
This Department has been selected by OMB to act as the cognizant agency
responsible for Oregon's statewide cost allocation plan under OMB
Circular A-87, Oregon's statewide single audits under OMB Circular
A-128, and indirect cost rates, audit, and audit follow-up at Oregon's
colleges and universities under OMB Circular A-88. Agency Br., p. 2.
As part of these responsibilities, the HHS Office of Inspector General
performed an audit of the Internal Service Funds' surpluses reported on
the State's combined financial statements for the year ended June 30,
1984. In that audit the cost principles contained in OMB Circular A-87
(Cost Principles for State and Local Governments) were applied. Id. In
a draft audit report issued November 5, 1985, the auditors found that
the State had accumulated surpluses of $73.8 million in various accounts
and recommended that the surpluses be eliminated through a systematic
reduction in the State's rates. In response to the draft report, the
Director, Executive Department, State of Oregon, noted:
We are generally in agreement with your auditor's
findings and will strive to implement your
recommendations.
Id. at 3.
After the final audit report was issued, the HHS Director, Division of
Cost Allocation (DCA), asked the State to submit an action plan setting
forth the steps it would take to comply with the recommendations
contained in the final audit. In its response, the State asked that any
requests for adjustments of rates to reduce the $25.2 million surplus
contained in the ISFs controlled by OSSHE be referred to OSSHE since its
activities are not covered by the Statewide Cost Allocation Plan. The
Department, without objection of OSSHE, apparently decided at this point
that since these activities were not covered by the statewide plan,
issues relating to the surplus would be subject to the cost principles
contained in OMB Circular A-21, Cost Principles for Educational
Institutions, rather than Circular A-87. Id. (We should note, however,
that there is no indication in the record of this appeal that the
treatment of the specific issues raised would have been any different if
the Agency had continued to apply Circular A-87.)
Pursuant to the State's request, the Office of Audit, DCA, entered into
discussions with OSSHE concerning the surplus in its ISFs and decided,
after several exchanges, that an additional audit of the OSSHE surplus
would be necessary. The audit report of the accumulated surplus in the
ISFs of OSSHE, issued on October 8, 1987, concluded that the surplus
amount as of June 30, 1984 was $9.7 million instead of $25.2 million and
requested that OSSHE make the financial adjustment necessary to
eliminate the accumulated surplus. That audit report became the basis
for this disallowance. The Regional Director concluded that the federal
share of the OSSHE surplus should be disallowed because OMB Circular
A-21 did not permit OSSHE to retain any surplus in its ISFs. During the
pendency of OSSHE's appeal before this Board, the surplus amount has
been further refined by the Agency to be $9.9 million and the federal
share has been estimated to be $1 million.
OSSHE's position
OSSHE made the following arguments in support of its appeal of the
disallowance. OSSHE argued that part or all of the surplus was
authorized under OMB Circular A-21 either as working capital or as an
equipment replacement reserve. In addition, OSSHE questioned, on
several grounds, the Agency's calculation of the amount of the surplus.
Finally, OSSHE argued that, on the basis of its analysis of the status
of the ISFs as of July 1988, expenditures on equipment and other outlays
incurred by June 30, 1991 would not only deplete the existing surplus
balance but also create a shortfall totaling approximately $5 million.
OSSHE implied that, in view of this projection of the status of the ISFs
for the near future, a disallowance at this time would not be justified.
We address each of these arguments below.
Analysis
I. The surplus here was not authorized by OMB Circular A-21.
A. Working Capital
OSSHE argued that part or all of the surplus could justifiably be
retained as working capital. During the telephone conference held in
this appeal, OSSHE summarized its position on working capital as
follows:
The question posed . . . is under what authority may the
State retain a surplus as working capital?
Now, Circular A-21 does not have . . . explicit language
that refers to working capital; however, it is inherent
or intrinsic to the nature of a self sustaining
enterprise, which is what the Internal Service Funds
are, . . . that they will have enough funds on hand in
terms of cash flow to meet ongoing expenditures, whether
they be payroll expenditures, or other kinds of
expenditures, that may go beyond the cash that is
flowing in as a result of sales of goods or services
that they provide.
If they did not have some amount of working capital to
take care of these needs that were not met by existing
cash flow, they would have to go out and borrow money.
As to whether there is any limit on the amount that can
be retained, that limit is established by the experience
of a particular operation, and the nature of that
operation and its cash flow, and it may vary from time
to time, but what they have to do is constantly examine
their experience and keep on hand that which is
necessary to cover their cash flow needs.
Conference Transcript (Tr.), pp. 18-19.
The primary response to these arguments, which OSSHE itself acknowledged
at the outset of this statement, is that there is simply no authority in
Circular A-21 for working capital as an allowable cost. Indeed, the
applicable provisions of Circular A-21 limit federal reimbursement to
actual costs and preclude charges in excess of costs. Thus, section D.2
of the Circular states:
The cost of materials supplied from stock or services
rendered by specialized facilities or other
institutional service operations may be included as
direct costs of sponsored agreements, provided such
items are . . . charged under a recognized method of
computing actual costs . . . .
(Emphasis supplied.)
Aside from lack of authority in Circular A-21, there are other factors
which strongly undercut OSSHE's position on working capital. OSSHE's
arguments appear to be an effort to rationalize whatever amount may have
been determined by the Agency to be part of the surplus for its ISFs for
the period in question. OSSHE conceded that it had no policy as to how
much working capital was necessary for any particular ISF. Tr., p. 20.
Indeed, OSSHE did not even attempt to demonstrate that any part of the
amount in question here was actually retained by its ISFs as working
capital and that such retention of working capital was necessitated by a
reasonable and coherent policy adopted to meet operational needs and
that the same needs could not be met through alternative methods. (At a
minimum, OSSHE could have explained why the ISFs were unable to modify
their system of charging funding sources to avoid the need for
substantial amounts of working capital.) Finally, as the Agency argued,
even if OSSHE could demonstrate the necessity for the retention of a
prescribed amount of working capital in its ISFs, that capital could be
funded from non-federal sources (here providing 90% of the funding for
the ISFs) in view of the lack of authority for working capital in the
applicable cost principles and the prohibition on charging in excess of
actual costs.
B. Equipment Replacement
OSSHE argued that it was entitled to retain at least part of the surplus
(totaling $2.7 million) as a reserve for equipment replacement. OSSHE
summarized its argument as follows:
A "surplus" may also arise from a deliberate policy.
Reserves are normally accumulated over time to fund
equipment purchases and other extraordinary
expenditures. Circular A-21 embodies generally accepted
accounting principles when it allows for the cost of an
asset to be depreciated over its useful life. This
practice means, as an example, that an item of equipment
costing $1,000,000, with a projected life of 10 years,
will have $100,000 of its cost included in the cost of
operations and the resulting prices for each of the ten
years. The recovery of this cost will be set aside each
year and used at the end of the ten year period in the
funding of a new item of equipment as a replacement for
the retired asset. OSSHE has followed this type of
depreciation policy since 1978; this policy has resulted
in the accumulation of cash in an equipment replacement
account totaling $2.7 million as of June 30, 1984.
OSSHE Reply Br., p. 3.
The Agency in response to OSSHE's argument agreed that OSSHE is entitled
to apply a reasonable amount of its retained earnings toward a
depreciation expense for the replacement of equipment. The Agency
stated that, as a result of the audit and subsequent review of OSSHE's
surplus for the period in question, it allowed OSSHE a reserve from
retained earnings of $7.3 million for depreciation on existing
equipment. Tr., p. 34; see also Agency Br., pp. 11-13. The Agency
noted that this particular amount had been proposed by OSSHE and was
accepted by the Agency. Id. at 34-35. The Agency then concluded that
since the $7.3 million reserve was intended to provide OSSHE with the
full amount needed for its depreciation reserve for the period in
question, OSSHE should not be entitled to retain in effect an additional
depreciation reserve in the form of a $2.7 million equipment replacement
account. The $2.7 million equipment replacement account was comprised
of funds transferred from retained earnings of ISFs to a separate
account designed to provide funds for ISF equipment replacement based on
OSSHE's stated 10-year replacement policy. Under the Agency's position
this account was considered to be part of the surplus of the ISFs, even
though technically no longer within the ISFs, since the funds were in
fact generated from the retained earnings of the ISFs and since the
funds were to be used for equipment replacement of the ISFs based on
depreciation of existing equipment.
We agree with the Agency that the $2.7 million equipment replacement
account must be viewed as part of the unauthorized surplus of the ISFs.
OSSHE repeatedly argued that the Circular A-21 cost principles authorize
a reserve for equipment replacement, citing section J.38. But that
argument is simply unresponsive to the issue before us. The Agency
conceded that OSSHE is entitled to a reserve for equipment replacement
based on depreciation of existing equipment. Its sole objection is that
OSSHE is not entitled to the equipment replacement account on top of the
depreciation reserve since the depreciation reserve was designed to
recognize fully the equipment replacement needs of the ISFs. As the
Agency stated:
That [depreciation reserve] adjustment gave [OSSHE] full
credit for all allowable depreciation expense, and as a
matter of fact, they have reviewed that computation and
agreed to the propriety of that number.
We cannot then allow [OSSHE] to claim an additional $2.7
million of depreciation expense. If we do, they will
have, in effect, claimed depreciation twice.
Tr., p. 34.
OSSHE never attempted to refute this position other than to allege that
the $2.7 million fund did not result in the overcharging of its ISF
users. But, as the Agency responded, if the users funded an excessive
amount for depreciation, then they were in fact overcharged. Section
J.38.c. of Circular A-21, which was cited by OSSHE, limits charges for
the use of specialized facilities to the aggregate cost of the services.
Thus, on the basis of the foregoing, we find that the $2.7 million
equipment replacement fund must be viewed as part of the unauthorized
surplus retained by the ISFs.
II. The Agency had a reasonable basis for calculating the amount of the
surplus.
OSSHE questioned the Agency's calculation of the amount of the surplus
on two separate grounds. OSSHE asserted that the Agency overstated the
ISF supplies inventories (and thus the surplus amount) by approximately
$1 million. OSSHE also argued that a part of the alleged surplus
actually represented contributed capital that would not be subject to a
disallowance since it did not involve any federal funding. The Agency
argued in response that in each instance it had made its calculation on
the basis of the best available documentary evidence. We address both
of these issues below and conclude that the Agency had a reasonable
basis for its calculation of the surplus amount.
A. ISF Supplies Inventories
In the case of the ISF supplies inventories, the Agency's calculation
($1,844,405) was based on the June 30, 1984 State's combining financial
statements, which accompanied the annual financial report prepared by
the State's accounting division. OSSHE asserted that the amount
reported in the statements was in error and that OSSHE was the best
source for accurate data. OSSHE asserted that its figure of $795,531
for the supplies inventory amount was substantiated by source
documentation, verified by formalized closing of the books procedures
and included in OSSHE's financial statements published in the OSSHE
Controller's Report for the year ended June 30, 1984. Although the
Agency acknowledged that the State Auditor's opinion was limited to the
State's combined balance sheet, it argued that in the process of
reviewing the reasonableness of the reported combined totals, the State
Auditor tested various components of those totals. Agency Br., pp.
13-14. The Agency noted:
As part of a prior HHS review (Audit Control No.
60455-10, dated February 28, 1986), the working papers,
prepared in support of the June 30, 1984 combining
financial statements by the State Division of Audits,
were reviewed and discussed with the Assistant Director
in charge of the audit area. It was found that the
reported inventory amount of $1,844,405 was based upon
an adjusting journal entry that was included in the
working papers prepared by the Division of Audits.
The Agency submitted a copy of the adjusting journal entry prepared by
the Oregon State Division of Audits in response to a request from OSSHE
in its reply brief. Agency Submission of January 25, 1989. The Agency
also pointed out that the reported inventory amount of $1,844,405 was
supported by the supplemental information provided by OSSHE in response
to the HHS draft audit report concerning the OSSHE ISF surplus.
Finally, the Agency noted that the closing of the books report relied
upon by OSSHE undoubtedly was available to the Division of Audits during
its review of the June 30, 1984 financial statements and to OSSHE when
it prepared the supplemental information and response to the HHS draft
audit report. The Agency concluded that it simply could not "accept
replacing an audited amount, which had previously been supported by
OSSHE, with a new lower amount based upon . . . the Closing of the Books
Report."
Based on the factors cited by the Agency in its brief, we find that the
Agency reasonably concluded that OSSHE inventories totaled $1,844,405
rather than $795,531. Here, the Agency relied upon an amount reported
in a statewide financial statement that was subjected to testing and
verification and which was not initially contested by OSSHE when the
amount was adopted in the Agency audit report that led to this
disallowance. Moreover, while OSSHE asserts that the closing of the
books report supports a lower amount, that report does not include a
formal finding concerning total supplies inventories for the ISFs as of
June 30, 1984. Instead, the report contains a listing of the organized
storerooms for individual schools from which OSSHE has pieced together
an amount for ISF supplies inventories for purposes of this appeal.
This selective reliance by OSSHE on the report does not, in our view,
provide conclusive evidence concerning the supplies inventories, nor
does it begin to explain why there was a discrepancy of over $1 million
from the combining financial statement. This Board has consistently
held, based on applicable regulations, such as 45 C.F.R. 74.61(g), that
the burden to document claimed costs rests with the grantee. Grantees
must document that charges to federal grants for the types of service
activities funded by the ISFs are based on actual costs of those
activities, and in so doing, must document the amount of supplies
inventories kept as part of an ISF. We find that in this instance OSSHE
has not met that burden and that the Agency's reliance on the combining
financial statement was reasonable.
B. Contributed Capital Accounts
OSSHE argued that the surplus calculated by the Agency should be reduced
by an amount of $660,689 held in Contributed Capital Accounts. The
Agency took the position that OSSHE has been unable to document that
equipment purchased for certain ISFs had been purchased with contributed
capital, i.e., capital that did not involve any federal participation.
The four items that make up the disputed amount in the Accounts are:
Farm Equipment Pool ($324,987), Funds originating prior to date ISF
established ($70,154), Equipment Charged Prior to 7/78 ($254,934), and
Equipment purchased with other funds ($10,614). OSSHE questioned
whether these items had been federally funded since complete
documentation relating to the source of the items was no longer
available and because the equipment at least in part had been acquired
prior to the establishment of ISFs. The Agency argued that OSSHE was
unable to document that any of the four items was funded from sources
other than federally funded projects and that the equipment was similar
in nature to equipment that traditionally had been federally funded.
Finally, the Agency argued that there is no basis to conclude that the
equipment was not federally funded simply because it was acquired before
particular ISFs had been established.
We find that the Agency reasonably included the $660,689 disputed amount
as part of the federally funded surplus. OSSHE conceded that complete
documentation related to the contributed capital accounts is no longer
available. OSSHE Br., p. 9. Moreover, OSSHE did not dispute that the
types of equipment involved were similar or identical to equipment whose
costs had traditionally been charged to federally funded projects. In
view of these factors, we find that the Agency's inclusion of the
disputed amount as federally funded surplus was reasonable even though
some or all of the equipment may have been acquired before particular
ISFs had been established.
III. The Agency's disallowance for the surplus as of the year ended
June 30, 1984 is justified.
OSSHE took the position that even if the surplus was not authorized
under the cost principles, a disallowance would be inappropriate where
projections for a future period yet to come indicate that the surplus
would be liquidated. OSSHE stated:
Our analysis projects as of July 1, 1988, that by June
30, 1991, non recurring expenditures on equipment items
and other major outlays each costing $500 or more will
not only deplete existing surplus balances but will
create a shortfall totaling $4,998,200. [OSSHE Br., pp.
20-22.] This means that sound pricing practices require
that some prices be increased. If such increases were
not allowed, and if, in fact, price reductions were
required to eliminate the surplus that existed as of
June 30, 1988, OSSHE would be forced to borrow and incur
significant interest charges to fund the cost of the non
recurring expenditures. This would lead to significant
price increases. We do not believe that the Board would
condone such a result.
OSSHE Reply Br., p. 3.
We find that a disallowance for an unauthorized surplus as of June 30,
1984 would clearly be justified regardless of projections showing
possible depletions in the surplus for future years. The basic issue
presented here is whether OSSHE was entitled to retain a surplus for the
year ended June 30, 1984. This was the period considered in the
original statewide audit considered by the HHS Office of Inspector
General, and has remained the period in issue following the audit
specifically focusing on OSSHE that led to this disallowance. As we
concluded above, OMB Circular A-21 authorizes reimbursement based on the
cost of the services and does not authorize charges for surpluses to be
retained in excess of costs. Since we find that OSSHE retained an
unauthorized surplus in its ISFs for the year in question, we find that
the Agency may appropriately disallow the federally-funded part of the
surplus and need not look at the status of the surplus for future years.
As the Agency argued, if OSSHE needs to increase rates to recover higher
costs incurred by its ISFs in future years, it may do so in the years in
which the costs are incurred. Tr., pp. 77-78. The retention of
surpluses in anticipation of increased costs is not authorized by the
Circular A-21.
Moreover, the Agency noted that, from a practical perspective, it has
taken over four years to determine how much of a surplus existed as of
1984. If the Agency were required to delay resolution of this surplus
until it had been able to resolve the amount of the surplus as of 1991,
any resulting disallowance would be unreasonably delayed, and the
appellant would have retained an unauthorized surplus in the interim.
The Agency also disputed whether the record demonstrates that the
surplus had in fact been decreasing and asserted that in the six or
seven years that it had been examining the question, the surplus had not
decreased. Tr., p. 77. However, the essential point is that,
regardless of what OSSHE may or may not be able to demonstrate by
projections for years into the future, the Agency is entitled to proceed
on its disallowance for the prior closed period under consideration
here.
Conclusion
On the basis of the foregoing analysis, we uphold the disallowance in
full.
Judith A. Ballard
Norval D. (John) Settle
Donald F. Garrett Presiding Board