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Reasonable and Necessary

April 20, 2010

The following is an excerpt from the new self-study course on Cost Principles written by Sefton Boyars and Bill Allen:

Reasonable people may have different concepts of what is a necessary cost. My spouse thinks 200+ DVDs of every Disney movie ever made is necessary to entertain our children; I don’t. I think staying in a Motel 6 is unacceptable; my spouse thinks it is more than fine.

While not specifically stated, the cost principles recognize this conundrum and set out some basic criteria related to determining the reasonableness of costs incurred in the performance of federal projects.

Basketball Tickets

In the 1970s, we conducted many audits of the U.S. Department of Education’s Title I program. This program is designed to help children who are functioning below average to perform at their grade level.

During these audits, we found numerous instances of schools conducting activities, particularly field trips, which did not seem designed to improve educational achievement. Schools had taken kids to Disneyland, to Knott’s Berry Farm, and to roller rinks under the Title I program. One school district even paid for the junior high prom dinner with Title I funds. Another district took about 30 children to a professional basketball game and charged the tickets to the Title I program. They classified the activity as part of the reading program. I wondered if they were teaching the children to read defenses.

As a side note, after we reported on a number of these abusive practices, the audit reports became public. The districts were severely criticized in the newspapers (for you younger folks, newspapers were the predecessors to blogs). After the publicity, those charges reduced significantly.

The Prudent Person Rule

Appendix A of both 2 CFR 225 and 2 CFR 230 clarifies that to be reasonable, a cost may not be more than a "prudent person" would spend in its nature and amount at the time of the decision.

Appendix A to Title 2, Part 225 (State and Local Governments)
2 Reasonable costs. A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person under the circumstances prevailing at the time the decision was made to incur the cost. …

Appendix A to Title 2, Part 230 (Non-Profits)
3 Reasonable costs. A cost is reasonable if, in its nature or amount, it does not exceed that which would be incurred by a prudent person under the circumstances prevailing at the time the decision was made to incur the costs….

The prudent person rule is also used in the Government Auditing Standards (also known as the Yellow Book) to define abuse. Under GAGAS 4.12,  "Abuse involves behavior that is deficient or improper when compared with behavior that a prudent person would consider reasonable and necessary business practice given the facts and circumstances."

Then, to determine whether a cost is reasonable in a given situation, we must consider whether each cost would have been expended by a "prudent person."  Who is this prudent person? I don’t personally know one, and the determination of what is reasonable is quite subjective. The cost principles fail to define this vague term, but they do the best possible job defining what is OK and what is not OK to charge to the program.

Subfactors Used to Determine Reasonableness

The determination of whether a cost is reasonable requires the application of the following sub-criteria:

1. The cost generally would be recognized as ordinary and necessary for the operation of the governmental unit or the performance of the federal award.
2. The cost conforms to:
   • Sound business practices,
   • Arm’s length bargaining,
   • Laws and regulations, and
   • Terms and conditions of the federal award.
3. The cost was incurred using the organization’s established practices. (Significant deviations from established organizational practices of the governmental unit may unjustifiably increase the federal award’s cost.)

Appendix A to Title 2, Part 225 (State and Local Governments)
2 Reasonable costs. … The question of reasonableness is particularly important when governmental units or components are predominately federally-funded. In determining reasonableness of a given cost, consideration shall be given to:
a. Whether the cost is of a type generally recognized as ordinary and necessary for the operation of the governmental unit or the performance of the Federal award.
b. The restraints or requirements imposed by such factors as: Sound business practices; arm’s length bargaining; Federal, State and other laws and regulations; and, terms and conditions of the Federal award.
c. Market prices for comparable goods or services.
d. Whether the individuals concerned acted with prudence in the circumstances considering their responsibilities to the governmental unit, its employees, the public at large, and the Federal Government.
e. Significant deviations from the established practices of the governmental unit which may unjustifiably increase the Federal award’s cost.

Appendix A to Title 2, Part 230 (Non-Profits)
3 Reasonable costs. … The question of the reasonableness of specific costs must be scrutinized with particular care in connection with organizations or separate divisions thereof which receive the preponderance of their support from awards made by Federal agencies. In determining the reasonableness of a given cost, consideration shall be given to:
a. Whether the cost is of a type generally recognized as ordinary and necessary for the operation of the organization or the performance of the award.
b. The restraints or requirements imposed by such factors as generally accepted sound business practices, arms length bargaining, Federal and State laws and regulations, and terms and conditions of the award.
c. Whether the individuals concerned acted with prudence in the circumstances, considering their responsibilities to the organization, its members, employees, and clients, the public at large, and the Federal Government.
d. Significant deviations from the established practices of the organization which may unjustifiably increase the award costs.

If employees of an organization normally do not travel first class, they do not have permission to fly first class simply because a federal award is paying the tab.  In general, the rules do not permit flying first-class. However, suppose that your boss informs you that you need to fly across the continent immediately. The only coach seats available are on a red-eye that makes two stops and arrives around noon the next day. Since such a trip would be considered unreasonable, you may very well justify flying first-class.

What about charging the costs of an out-of-town meeting for the staff of an organization to a grant? Let us assume, for purposes of this example, that the meeting is necessary for the efficient delivery of grant services. It could be argued that, to assure uninterrupted training, holding the meeting at a location other than the grantee’s place of business is necessary.  But, if a federal reviewer finds that the costs or the location selected is inappropriate (e.g., a mainland organization holds a meeting in Honolulu or in a five-star hotel), then the costs may be disallowed as unreasonable and not necessary to properly administer the federal award.

The rules do not expect grantees to suffer the use of poor quality equipment, beg for supplies on the street corner, or work for food. The rules simply require the wise use of federal award funds by grantees. The delivery of grant services should always be paramount but within the constraints of the cost principles.

One guideline that is often used is the "Washington Post" test (or substitute the name of your local newspaper). If the paper found out what you were doing, would they report it on one of the first three pages? They don’t put the good news on those pages. If the newspaper were to consider it reportable, it doesn’t consider the cost to be reasonable.

The Giggle Test

There are other similar tests. The "red-face" test asks if you can explain the cost without blushing. The "giggle" test asks if people start to giggle as you explain why the cost is acceptable.

I often use the giggle test when I am teaching a class. A student will ask about the acceptability of a cost that he is clearly not comfortable with. I sometimes pretend not to have understood the question and ask the student to ask it again.  The second time the student starts to smile as he asks the question. I will then point out that he is failing the giggle test. The costs are not allowable.

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Leita Hart-Fanta, CPA, CGFM
Resides in Austin, Texas and can be reached at www.auditskills.com.

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