By Richard Hirschen, CPA, CGMA
Gray, Gray & Gray, LLP
Architects, engineers and construction companies that work under federal contracts and received a Paycheck Protection Program (PPP) loan face a dilemma when performing their annual overhead rate calculation. If you received a PPP loan that was forgiven – or are considering applying for loan forgiveness – it is important to understand how that loan forgiveness will impact your overhead rate.
Current FAR regulations (FAR 31.201-5) require that any portion of a PPP loan that has been forgiven must be credited back to the government in the form of a credit that reduces the indirect cost calculation used to determine a firm’s overhead rate. The credit must be applied in the year in which the loan forgiveness is recorded as income. Depending on the accounting policy chosen to account for the forgiveness, this could either be in the year the PPP loan proceeds were used or the year in which the loan is forgiven.
This credit against overhead costs will have the effect of lowering the allowable overhead rate, which will have a negative impact on revenue realized from future contracts. The potential reduction in the FAR overhead rate in the year the loan forgiveness is recorded as income could be significant, depending on the balance of a firm’s government vs. private work. Firms with a higher percentage of government work may even find themselves “paying back” a portion of the actual loan forgiveness through reduced overhead rates.
Here’s a simple example: A company calculates their overhead rate using direct labor as the base. Let’s assume that before accounting for the forgiveness, the company’s direct labor is $1,000,000 and their allowable overhead expenses are $1,500,000, leading to an overhead rate of 150%. Now let’s assume the company had a $300,000 PPP loan forgiven. The loan forgiveness would most likely reduce the allowable overhead expenses to $1,200,000, causing the overhead rate to drop to 120%.
Keep in mind that any reduction in the overhead rate will be held in place for the length of a contract. As a result, a multi-year contract signed at a time when the overhead rate is reduced will likely diminish the firm’s revenue for the duration of that contract.
Minimizing the Impact
You may be able to soften the application of loan forgiveness credit by applying the forgiven portion of a PPP loan to direct labor on commercial contracts (so long as the loan proceeds were actually spent in such manner). Thereafter, forgiveness could be applied to unallowable indirect costs before being applied to allowable indirect costs. Let’s assume the same facts as the example above, but that the company was able to allocate $250,000 of the forgiveness to direct labor costs on commercial or non-FAR contracts, and the remaining $50,000 was applied to a combination of indirect labor and rent expense. In this scenario, the overhead expenses of $1,500,000 would only be reduced by $50,000 causing the overhead rate to be 145%. A significant improvement.
Should You Forego Forgiveness?
If your firm received a loan from either the first or second Payroll Protection Program draft you should carefully consider how the proceeds of the loan were spent, whether it would be more beneficial to apply for loan forgiveness and accept the reduction in overhead rate, or to pay back the loan over the five-year loan term so as to leave the overhead rate intact. A detailed analysis should be performed of estimated overhead rates prior to requesting loan forgiveness. This analysis should consider the balance of the overall contract portfolio (private work vs. government work), and the potential for new government projects that would be subject to lower overhead rates.
Further complicating matters is the federal Employee Retention Credit (ERC). The interaction between the ERC, PPP loans, and headcount requirements may dictate how the credit is treated. For 2021, the ERC offers potentially much more significant savings, but the second draft PPP could factor into calculations, as does any change in a firm’s headcount. Of course, the ERC would also reduce the allowable overhead expenses.
This regulation affects federal contracts. Additional rules may apply to your overhead rates and how PPP funds are used or applied if you have state contracts or state contracts with federal funding.
Many groups, including the American Council of Engineering Companies (ACEC), have been lobbying Congress for more guidance on this issue. Robin Greenleaf, CEO of Architectural Engineers, Inc. (AEI), a women-owned engineering firm in Boston, Massachusetts, and Chair-elect of ACEC, recently testified before a Congressional committee seeking relief for the industry.
But at this point architectural and engineering firms doing business with the government should move forward under the assumption that they will have to credit their overhead in the period a PPP loan is forgiven.
Richard Hirschen is a Partner at Gray, Gray & Gray Certified Public Accountants and Advisors in Canton, Mass. He can be contacted at (781) 407-0300 or at firstname.lastname@example.org