CHAPTER 11
Government Contract Audits
Any audit can be cause for anxiety. Being familiar with the various types of audits that may be conducted, however, will help a contractor be prepared. When an audit is to occur, a contractor should: (1) be aware of why the audit is a requirement, (2) understand what the auditor will be looking for, and (3) request an entrance and exit conference with the auditor to avoid any misunderstandings.
For contractors audited by DCAA, the auditing concept and process changed significantly in 2010. Formerly, DCAA’s mission was to provide financial advice in the administration of contracts. In response to criticism by the Government Accountability Office (GAO), the DCAA mission has shifted emphasis and added that DCAA is to “protect the interest of the taxpayer.” This seemingly minor addition to the mission has created a much more independent audit organization. Recently, DCAA has rejected systems as inadequate that the agency had accepted for many years. In addition, audit recommendations may now be based on an individual auditor’s opinion of how much the taxpayer should pay rather than on rules, regulations, and contract terms. For example, one auditor reported “excessive profits” when related rules, regulations, and laws had been removed from the books three decades earlier. It is now DCAA policy not to cancel an audit request if the agency believes the contracting officer is attempting to avoid a negative report. DCAA also now encourages its auditors to report contracting officers who do not accept DCAA’s recommendations for suspected irregular conduct.
A rule proposed in late 2010 would require adequate internal controls for six key contractor business systems. Three of these systems would be within the purview of DCAA: accounting, estimating, and material management and accounting. These three systems are discussed in this chapter. The other three systems would be within the purview of DCMA: purchasing, earned value management, and property. Purchasing is addressed in this chapter as well as in Chapter 10; earned value management and property are addressed in Chapter 10. This rule would permit the government to withhold up to 5 percent (2 percent for small businesses) when a system is declared inadequate. After a contractor submits an acceptable corrective action plan, the withholdings may be reduced to 2 percent (1 percent for small businesses).
ACCOUNTING SYSTEM REVIEW
An accounting system review typically occurs when the government contract auditor makes his or her first review of an accounting system to determine whether that system is adequate for accumulating costs under cost-type contracts, for determining progress payments under fixed-price contracts, and for estimating future costs on new contracts. This review tends to be quite difficult for smaller companies that are facing it for the first time.
It is essential to the success of the accounting system review that the contractor have an accounting policy and procedures manual. The disadvantages of not having written policies are twofold. First, when the auditor begins an accounting system review, he or she wants to see what the contractor’s ground rules are for cost accounting. The auditor will test the accounting system to determine whether the company’s practices are what the written procedures require. If the company does not have these procedures clearly documented, the auditor will have to review a myriad of detailed accounting records to determine what the procedures actually are. The second disadvantage of not having clearly written procedures is that a company runs the risk of not having consistent practices for booking costs. If an accounting practice is in writing, it will provide more consistency to the company’s internal operations for charging costs.
The accounting for unallowable costs should also be explained clearly in the accounting procedures because when auditors make their review, they want to see such segregations. If the written procedures do not have separate classifications for what are clearly unallowable costs, government auditors might perform an account-by-account analysis and remove any unallowable costs that might have inadvertently been included in another type of account.
The internal controls of an accounting system are also quite important. The government auditor looks for different internal controls than do most external auditors. For example, the government auditor will look for an assurance that the accounting system has detailed written procedures and works effectively in practice; that is, that the costs (both direct and indirect) charged against the individual contracts are valid as charges against those contracts. The government is concerned that the direct costs by contract are proper because different government agencies buy under different contracts, using many different contract types. Similarly, contracts can share differently in indirect costs from the various pools. As a result, if the indirect costs are not charged to the proper pool, the charges against the contracts may be distorted.
An adequate accounting system for tracking costs and providing vital financial information to management is not only important, but is required for the performance of government contracts. An accounting system represents a combination of records, internal controls, and written policies and procedures that function together in the process of accumulating and reporting financial data. During the performance of government contracts, the contractor is required to develop its accounting systems in a manner consistent with generally accepted accounting principles (GAAP). However, government regulations, particularly FAR Part 31 and the CAS, play a significant role in the tailoring of a contractor’s accounting system.
Typically, an adequate accounting system for the accumulation of costs under government contracts has to include: (1) segregation of costs by contract and by contract line item; (2) data at interim periods to allow for contract repricing or negotiating revised contract targets; (3) accounting for specific unallowable costs as established in FAR Subpart 31.2; (4) separation of preproduction costs from production costs; and (5) reliable data for purposes of pricing follow-on procurements.
Basic Record Keeping
The types of books and records used in an accounting system are based on what is most suitable for a contractor’s business. The objective is to provide accounting and financial data that are adequate for government contract costing purposes. At the very least, the basic record keeping system must provide visibility of contract costs at a sufficiently detailed level so that costs can be determined at interim levels for purposes of repricing, negotiating revised targets, and determining billings. The use and design of certain specific accounting records will vary from contractor to contractor; however, a standard requirement for essentially all companies involved in government contracts is that their books and records include a general ledger, job cost ledger, labor distribution, time records, subsidiary journals, chart of accounts, and financial statements.
Several key factors are essential to the adequacy of any basic record keeping system: (1) segregation of direct costs by contract or job, and indirect costs by account and title; (2) accumulation of costs on a current and cumulative basis; (3) periodic reconciliation of time sheets to labor costs included in job cost ledgers and basic cost records to the general books of account; (4) posting of costs to the books on a current basis; and (5) separation of unallowable costs in the regular books of account or by means of any less formal cost accounting technique that establishes and maintains adequate cost identification.
Internal Controls and Written Policies and Procedures
Good internal controls—established in written policies and procedures and followed by management—are the backbone of any accounting system. The government regulations do not prescribe specific internal control procedures; however, the CAS require the establishment and use of written procedures for several areas of cost accumulation and allocation, including depreciation, capitalization of tangible assets, accounting for acquisition of material costs, and allocation of direct and indirect costs. In addition, government auditors will be evaluating the strengths and weaknesses of contractor internal control systems in determining the overall adequacy of the contractor’s accounting system. If they find significant deficiencies, the auditors will qualify their audit reports submitted to government procurement officials by citing the inadequacy of the contractor’s record keeping system for government contract costing purposes.
Every good accounting system requires adequate internal controls if it is to operate in an efficient and effective manner. The following are some of the more significant positive internal control features, identified in generic form, of an acceptable accounting system for government contract costing purposes:
Separation of authority between key accounting functions (e.g., payroll vs. timekeeping, requisitioning of materials and services vs. purchasing vs. accounts payable)
Policies and procedures establishing the purposes and requirements of the accounting system (e.g., timekeeping, payroll, purchased services and materials, direct and indirect cost control, asset capitalization and utilization)
Internal reviews by management to ascertain employee compliance with policies and procedures
Periodic reconciliation of cost control records from the point of original entry through the cost accumulation summaries to the billing records
Management authorizations of critical accounting functions and events (e.g., issuance of payroll checks, signing of timesheets, purchasing of materials and services)
Budget control procedures established for comparison of actual costs to budgets and contract financial status
Productivity measurement techniques used to allow management to focus on problem areas and improve overall economy and efficiency (e.g., application of work measurement techniques)
Organizational charts created to define lines of authority and responsibility and to provide for division of responsibility in operating, recording, and custodial functions
In-house “hotlines” established to encourage employees to inform management of possible areas of fraud, waste, or abuse.
Payment Requests
A contractor usually obtains payment from the government during contract performance by submitting either standard public vouchers or progress payments. Public vouchers are used to obtain payment for cost-reimbursable and time-and-materials contracts. Progress payments apply to fixed-price contracts. In either case, the contractor’s accounting system must be adequate to support the payment of costs incurred on a current basis.
When submitting a standard public voucher, the contractor must ensure that the costs included reflect costs incurred in the current period and cumulative to date. Direct costs should be included as actually incurred, and the applied indirect costs should reflect a billing rate based on an estimate of year-end allowable actual costs, or contractually established provisional costs. Any cost reductions resulting from contractually established cost ceilings or limitations must also be reflected in the voucher. As a general rule, cost-reimbursable contracts are subject to a withholding of 15 percent of fee until the contract is completed and the contractor submits its final voucher.
A fixed-price contractor’s submittal of progress payments is governed by FAR 52.232-16. The government requires that the claimed costs must have been incurred or actually paid, depending on the contract terms. For example, the standard progress payment clause requires that the costs of “supplies and services” purchased by the contractor directly for the contract may be included in the progress payment claim only after actual payment. Costs for such items as direct labor, materials issued from inventory, and properly allocable and allowable costs must only be incurred, not necessarily paid, at the time the progress payment is submitted. However, the contractor must not be delinquent in making payment on these items. Government auditors will review a contractor’s historical payment record to ascertain whether delinquency is a problem. As of October 1, 1999, the requirement that subcontractors be paid before a prime contractor could seek reimbursement from the government was being considered for deletion.
The government also requires that the contractor provide a reasonable indication of the percentage of contract completion. This requirement underscores the need for the contractor’s accounting system to accumulate costs by contract and allows for the visibility of actual costs incurred compared to budgeted costs. The accounting data will have to be merged with the engineering estimates to enable management to assess project status fully.
Limitation of Cost Clause
An adequate accounting system must provide sufficient financial information to allow management to comply with the reporting requirements of the limitation of cost (LOC) clause (FAR 52.232-20). The LOC clause requires the contractor to give the government notice whenever the costs incurred on a cost-reimbursable contract reach a certain percent of completion (generally, 75 percent or 85 percent), or whenever estimated costs on the contract are expected to be either greater or substantially less than the contractual estimated cost. The burden is on the contractor not only to track its actual costs incurred on a periodic and regular basis, but to project, within reason, year-end “allowable” costs. Once the required percent of contract cost completion is reached, and at any time the contractor expects an overrun on the contract, the contractor must provide notice to the government that it is stopping work on the contract until additional funds are provided.
It is essential that contractors comply with the LOC clause and develop a system of accounting that will keep management abreast of project status as well as actual and projected indirect rate fluctuations at all times throughout the cost accounting-period. The company must establish a procedure whereby a letter of notification is submitted to the contracting officer im-mediately upon the incurrence of the applicable percent of completion and potential overrun events. The letter must state—and the contractor must be prepared to initiate action—that formal notice is given accordingly and contract work will be stopped unless further authorization is received from the contracting officer to exceed total estimated costs.
ESTIMATING SYSTEM REVIEW
An estimating system review has a direct effect on the acceptability of any cost proposal submitted. The ability to develop a system for the purpose of preparing a cost proposal should be a high priority in any company, especially in light of the significant cost of proposal preparation. This audit may involve many government reviewers, not just the auditors, and is usually quite comprehensive.
When a contractor is required to submit cost or pricing data with a proposal for a negotiated contract, the contractor will have to certify that the data are current, accurate, and complete. The contractor’s cost accounting system serves as the basis for deriving cost estimates for input to the proposal. The overall adequacy of the cost accounting system and the statistical data it contains are primary factors contributing to the sufficiency of the contractor’s estimating system.
Proposals require the input of cost estimates based on historical data as recorded in the accounting system, plus an application of escalation and projected future amounts based on the contractor’s policy on pay raises and expected economic factors. For example, proposed direct material units may be based on directly applicable experience by product or task, plus an application of scrap/attrition as realized on similar work, all of which are supported in the accounting records.
An optimal estimating system is one where the estimating procedures are firmly established and consistently applied, but allow sufficient flexibility for changes. Factors such as the dollar size of the proposal, anticipated contract type, clarity of government specifications, and availability of information from a similar proposal or contract may influence a contractor’s methods of estimating. The particular estimating methods used are of key importance when developing a proposal because they will impact the accumulation of costs subsequent to contract award.
If a contractor has a contract covered under the CAS, CAS 401 requires that the methods used for estimating costs be consistent with the methods used for accumulating and reporting costs. Therefore, a contractor who estimates costs, for example, using “no actual” costs will not be able to accumulate costs after contract award on the basis of “standard” or “average” costs.
Effective implementation of a cost estimating system is based on a team concept. Participants from various functional areas of the company—such as engineering, marketing, quality control, purchasing, pricing, and accounting—should be involved in developing the proposed cost and quantitative estimates. The proposal manager should coordinate interactions between and among the various participants, providing input that is guided by established written procedures.
A comprehensive budgeting system is another critical factor in the development of an adequate estimating capability. The purpose of a budgeting system is twofold: (1) to control costs during contract performance; and (2) to provide necessary information to develop forecasts of sales and rate data. An accounting system that tracks contract costs on the basis of actual costs incurred to date and compares the information to established budgetary amounts will provide valuable information not only on contract financial status, but also on areas of inefficiency that need improvement. The end objective in the budgetary process is to obtain optimal use of resources. Historical budgetary data, combined with various marketing and economic considerations, provide the basis for developing sales and rate forecasts.
An effective estimating system—from the government’s viewpoint, an acceptable system—requires the establishment of written policies and procedures. Written procedures are necessary to provide guidance to the various participants of the proposal estimating team in developing the cost and quantity estimates, as well as to create a communication network that includes various checks and balances to ensure that current, accurate, and complete data are being developed. Of course, written policies and procedures are of no value unless management implements them. Contractors can be sure that government auditors will be reviewing their estimating systems for both the adequacy of the written policies and procedures and for related compliance.
Organizational Relationships
A full and complete description of organizational relationships among the various contributors to the estimating team (e.g., engineering, marketing, manufacturing, quality control, purchasing, accounting) is absolutely essential if the estimating system is to operate effectively and efficiently. Contributors need to appreciate the purpose of their role in proposal formulation, how it relates to the total proposal effort, and what is expected of them. Effective lines of communication between and among the primary proposal participants need to be established so that the proposal team operates in harmony to the maximum extent practicable.
Review Requirements
Any proposal development system requires a quality control or review system. Ideally, independent reviews of work accomplished should be conducted at each functional area prior to submittal to the proposal manager for incorporation into the final product. The objective of this review is to determine that all the necessary steps have been taken consistent with policies and procedures, and that the quality of the output is at an acceptable level. The proposal manager should perform another quality control check prior to submitting the proposal. Some contractors like to establish a quality control team consisting of members from management of the various functional areas and administration to provide final approval to large dollar proposals.
Make-or-Buy Decisions
The make-or-buy decision is a very important concept for proposal estimating. A “buy” means that an item or work effort will be produced or performed by a subcontractor. A “make” item means that an item or work effort will be produced by the prime contractor or its affiliates, subsidiaries, or divisions. The FAR requires contractors to submit make-or-buy programs for all negotiated acquisitions whose estimated value is $10 million or more, except when the proposed contract is: (1) for research or development and, if prototypes or hardware are involved, no significant follow-on production is anticipated; or (2) the price is based on adequate competition or is established by catalog or market. The government reserves the right to review and agree on the contractor’s make-or-buy program whenever deemed appropriate to ensure a fair and reasonable contract price.
The reporting requirements place a significant burden on the contractor to establish an adequate make-or-buy program, and to define its requirements in written policies and procedures. The FAR requires that specific information be provided in a contractor’s make-or-buy program. This information should be clearly defined in a contractor’s written policies and procedures, and should include: (1) description of the factors to be used in evaluating the proposed program; (2) description of each major acquisition item or work effort involved; (3) categorization of each major item or work effort as “must make,” “must buy,” or “can either make or buy”; and (4) reasons for categorizing items as “make” or “buy” balanced against the evaluation factors.
Updating Cost or Pricing Data
It is important for a contractor to establish procedures that require management to update cost or pricing data up to a negotiated agreement on price. The Truth in Negotiations Act requires that contractors certify certain cost or pricing data. The certification states that the cost or pricing data as submitted are current, accurate, and complete. The certification requirement applies to most negotiated contracts and subcontracts as well as to modifications, except when price is based on adequate competition or established by law, or where the acquisition is for a commercial item.
FAR Subpart 15.4, Contract Pricing, addresses what data no longer require certification. (See Chapter 9 for a complete discussion.) If certification is not required, contractors should not provide any type of certification. The consequences of defective certification are onerous, and contractors who are unsure of their position should seek professional advice and assistance.
The government’s remedy against the contractor’s submittal of noncurrent, incomplete, or inaccurate cost or pricing data is significant. The government has the authority to make price adjustments, including profit or fee, of any significant amount by which the price was increased because of the defective data.
Given the significance of a defective pricing allegation, it is very important for the contractor to establish effective written policies and procedures—and associated internal controls—to protect against the submittal of inaccurate, incomplete, or noncurrent cost or pricing data. The contractor’s procedures should cover such subjects as changes in the make-or-buy decisions, submittal of updated forward-pricing rates, changes in escalation factors, updated vendor quotes or purchase orders, anticipated alterations in production methods, and availability of residual materials from previous contracts.
DOD Estimating System Requirements
All contractors submitting cost or pricing data to DOD must have an estimating system that produces well-supported proposals that establish an acceptable basis for negotiating fair and reasonable prices. A clause requiring such a system will be included in all solicitations and contracts to be awarded on the basis of certified cost or pricing data. In addition, large contractors (i.e., those with more than $50 million per year in negotiated contracts) must disclose in writing their estimating systems to the contracting officer responsible for contract administration.
“Estimating system” is a term used to describe a contractor’s policies, procedures, and practices for generating cost estimates that forecast costs based on the information available at the time. It includes the: (1) organizational structure; (2) established lines of authority; (3) duties and responsibilities; (4) internal controls and managerial reviews; (5) flow of work, coordination and communication, and estimating methods and techniques for the accumulation of historical costs; and (6) analyses used to generate estimates of costs and other data included in proposals submitted in the expectation of receiving contract awards.
An estimating system should be consistent with and integrated into the contractor’s related management system and should be subject to applicable financial control systems. To be considered adequate, a contractor’s estimating system must be established, maintained, reliable, and consistently applied, and must produce verifiable, supportable, and documented cost estimates.
As noted, it is DOD policy that all contractors have adequate estimating systems. In addition, certain large contractors must disclose their estimating systems to the ACO and must respond to any reports that identify deficiencies in the systems. A contractor is subject to the disclosure and response provisions if: (1) it is a large business, and in its prior fiscal year received DOD contracts or subcontracts totaling $50 million or more for which certified cost or pricing data were required; or (2) in its prior fiscal year, received such DOD contracts totaling $10 million or more when the contracting officer determines it is in the best interest of the government.
If a contractor is required to disclose its estimating system to the ACO, the disclosure must be adequate. A disclosure is adequate when the documentation: (1) accurately describes the policies, procedures, and practices used in preparing cost proposals; and (2) provides sufficient detail for the government to reasonably make an informed judgment regarding the accuracy of the contractor’s estimating practices. To meet the maintenance requirement, the contractor must disclose any significant changes to the cost estimating system on a timely basis to the ACO.
The DOD rule does not spell out specific requirements for adequate estimating systems, but instead provides general guidance. The rule states that adequacy is dependent on the successful interrelationship of many variables. The relative importance of each is determined by the particular circumstances facing each contractor. In general, adequate systems should: (1) provide for the use of appropriate source data; (2) use sound estimating techniques and appropriate judgment; (3) maintain a consistent approach; and (4) adhere to established policies and procedures.
The rule also lists examples of the types of characteristics that the ACO should consider when evaluating a system. Though not intended as a checklist, these examples are useful for both government and contractor personnel. Specifically, the ACO should consider whether the contractor’s estimating system:
Establishes clear responsibility for the preparation, review, and approval of cost estimates
Provides a written description of the organization and the duties of personnel responsible for preparing, reviewing, and approving estimates, and the various functions that contribute to the process (e.g., accounting, planning)
Ensures that personnel have sufficient training, experience, and guidance to perform estimating tasks in accordance with established procedures
Identifies the sources of data and the estimating methods and rationale used in developing cost estimates
Provides for appropriate supervision throughout the estimating process
Provides for consistent application of estimating techniques
Provides for detection and timely correction of errors
Protects against cost duplication and omissions
Provides for the use of historical experience where appropriate
Requires the use of appropriate analytical methods
Integrates information available from other management systems as appropriate
Requires management review, including verification that the company’s estimating policies, procedures, and practices comply with the regulation
Provides for internal review of, and accountability for, the adequacy of the estimating system, including the comparison of projected results to actual results and an analysis of any differences
Provides procedures to update cost estimates in a timely manner throughout the negotiation process
Addresses responsibility for review and analysis of the reasonableness of subcontract prices.
The DOD rules provide further guidance on estimating systems by listing some indicators of conditions that may produce or lead to significant estimating deficiencies:
Failure to ensure that relevant historical experience is available and used
Continuing failure to analyze material costs or to perform subcontractor cost reviews as required
Consistent absence of analytical support for significant proposed cost amounts
Excessive reliance on personal judgment where historical experience or commonly used standards are available
Recurring significant defective pricing findings within the same cost elements
Failure to integrate relevant parts of other management systems
Failure to provide established policies, procedures, and practices to persons responsible for preparing and supporting estimates.
The DOD regulation specifies detailed government review procedures. Audit and contract administration activities are required to establish and maintain regular programs for reviewing selected contractors’ estimating systems. Reviews are to be on a team basis, with the contract auditor designated team leader. Teams will include audit, contract administration, and technical specialists.
Reviews will be conducted at least every three years of contractors who meet the criteria for disclosure and maintenance requirements. This period may be extended if the auditor and the ACO determine that past experience and a current vulnerability assessment indicate low risk. On the other hand, reviews will be performed more frequently if the auditor and the ACO determine that the government is at high risk.
The auditor will issue to the ACO a report outlining the findings and recommendations of the review team. If the team identifies significant estimating deficiencies, the report will recommend disapproval of all or part of the estimating system. Field pricing reports will also note any significant deficiencies that remain unresolved.
The ACO will provide a copy of the audit report to the contractor and allow 30 days for submission of its written response. If the contractor agrees with the report findings and recommendations, it should make corrections to identified deficiencies or submit a plan of action for doing so. If the contractor disagrees with the report findings, its response should provide its rationale for the disagreement.
The ACO, in consultation with the auditor, will evaluate the contractor’s response and determine whether: (1) the estimating system contains deficiencies that need correction; (2) any of the deficiencies are so significant as to result in disapproval of all or a portion of the system; and (3) any proposed corrective actions are adequate to correct the deficiencies.
If such deficiencies are found, the ACO will notify the contractor that corrections or a corrective action plan is due within 45 days. The auditor and the ACO will monitor the contractor’s progress toward correction. If adequate progress is not made, the ACO can consider the following actions: (1) bringing the issues to the attention of higher level management; (2) reducing or suspending progress payments; and (3) recommending nonaward of potential contracts.
If, within 45 days, the contractor has neither submitted an acceptable corrective action plan nor corrected significant deficiencies, the ACO will disapprove all or a portion of the estimating system in writing. A copy of the notice of disapproval will be sent to each contracting office and contract administration office that has substantial business with the contractor.
Under the regulation, when a contracting officer determines that an estimating system deficiency has a significant impact on a contract under negotiation, he or she should consider pursuing such alternatives as: (1) allowing the contractor additional time to correct the deficiency and submit a corrected proposal; (2) considering another type of contract; (3) segregating the questionable areas as a cost-reimbursable line; (4) reducing the profit or fee objective; or (5) including a contract clause that provides for adjustment of the contract amount after award.
LABOR RECORDING SYSTEM AUDIT
The cost of labor at many contractor locations is often the most sensitive cost element that the government is required to audit. Labor costs have various impacts on a contractor’s cost structure, and thus the price paid by the government. Direct and indirect labor costs are generally the single most significant cost element charged to government contracts. In addition, certain areas of labor (e.g., direct labor dollars or hours) are commonly used as the base element for indirect (i.e., overhead) cost applications. Labor costs and/or hours are also an essential element in a contractor’s estimating system used in providing quantitative and qualitative historical data necessary for determining estimated costs for follow-on government contracts.
Accordingly, the accurate recording of labor costs by contractor employees is of utmost importance. Unlike other cost elements, labor is not supported by third-party documentation such as an invoice, purchase order, or other receipt. The key document in a manual timekeeping system is the time reporting by individual employees. Time reporting can be either by a timecard or by an automated time reporting system. Since time reporting can be altered or controlled by other persons, it is essential that individual employees be made aware of their responsibility and realize the importance of accurate time reporting. The government relies heavily on basic internal controls to ensure the propriety of labor costs presented for payment, contract costing, and estimating. It is essential that the internal controls related to labor recording and distribution be firmly established and reviewed periodically by management.
In recognition of the overall sensitivity of labor charging in the pricing of government contracts, and as a part of the government’s overall program on fraud, waste, and abuse in government contracting, DCAA has developed a specialized audit to respond to these concerns. This audit, called a “comprehensive labor audit,” is intended to analyze labor-charging patterns. The basic objectives of a comprehensive labor audit are to determine: (1) the propriety of labor costs (i.e., are employees accurately charging what they work on?); (2) the adequacy and reliability of the contractor’s labor cost accounting and timekeeping system; and (3) the contractor’s compliance with established internal controls. DCAA claims that the discovery of unlawful or fraudulent activities is not its primary audit objective; nonetheless, fraudulent activity is often uncovered during such an audit. Regardless of the written objective, contractors should be aware that many auditors conducting this review are actively searching for labor mischarging.
Two fundamental themes of a labor audit are that the audit is both current and comprehensive. DCAA’s objective is to review labor costs as close to the date of their incurrence as possible. The intent is to identify problems close to their onset and to have ready access to current documentation. A labor audit involves not only the basic verification of costs incurred, but also includes a detailed analysis of existing policies, procedures, and internal controls, as well as employee compliance in these areas. The auditors also review the propriety of labor charging. Audit emphasis is on comparing recorded labor charging to actual work accomplished.
Comprehensive labor audits are usually conducted at larger contractor locations. However, any contractor can potentially be selected for one of these reviews. In addition, DCAA has increased its review of contractor off-site locations where activity is distant from normal audit scrutiny. Specific guidance has been provided to auditors from DCAA headquarters on exactly how to conduct one of these “off-site” reviews. The audit may be performed by representatives from a local audit office on an independent basis, or under the general supervision of regional management. The agency has also established labor audit teams in which the auditors are specifically trained in such special audit techniques as risk assessment, intensified audit analysis of accounting data, and employee interviews.
The comprehensive labor audit consists of a series of analytical steps:
Risk assessment
Employee interviews
Audit report (and possible referral to an investigative agency).
Methods are available for a contractor to strengthen its accounting system against potential problems that may be encountered during these steps.
Risk Assessment
The initial phase in determining audit risk is for the auditor to become familiar with a contractor’s organization, its budgetary controls, and its direct/indirect labor charging policies and procedures. An auditor’s basic understanding of a contractor’s operations serves as the initial starting point toward further evaluation. The auditor will begin to develop basic notions regarding the adequacy of a contractor’s accounting system for labor recording purposes. If the auditor’s initial impressions are favorable, it is likely that the risk assessment will progress at a faster pace, perhaps with less detailed evaluation.
It is thus essential for a contractor to have a well-defined, documented labor accounting system with adequate internal controls. The chances are that contractors with such systems may receive less audit scrutiny because the auditors may tend to place greater reliance on the accounting system’s established procedures. A carefully developed labor accounting system should help protect the contractor from potential problem areas.
The types of documents that the auditors will be reviewing during their preliminary audit work may include the following: (1) company organizational charts; (2) listing of contracts; (3) policies and procedures relating to labor charging and basic timekeeping requirements; (4) flowcharts establishing how labor costs are processed through the accounting system; (5) listings of all labor-related management reports, both manual and automated; (6) timecards, or review of the automated time reporting system; (7) internal audit reports; and (8) details on the existing workforce (i.e., number, location and type of employees).
At this stage of the audit, the auditor should conduct a formal entrance conference. At the conference, the auditor has the responsibility to advise the contractor on a number of areas, including: (1) areas of audit coverage and potential duration of the audit; (2) potential for employee interviews to be conducted; and (3) required contractor involvement during the audit. The entrance conference is a critical point for the contractor. At this stage of the review, it is absolutely essential that the basic ground rules be established for conducting the audit. The contractor should establish a liaison or contact point through whom all audit requests must be coordinated. The contractor should also request that the auditor identify the types of all accounting and related records that are anticipated to be reviewed. A control mechanism for reviewing these records may be established, and particular rules regarding access can be formalized.
In addition, it is advisable that the contractor obtain an agreement with the auditor regarding the performance of employee interviews. Areas of contractor concern may include: (1) prior notification of interview dates; (2) advance notification of employees to be interviewed; (3) identification of employees to be interviewed; (4) limitation of interview questions; (5) requirement for contractor representation at employee interviews; (6) reasonable time length of interviews; and (7) acceptable documentation to be reproduced during an interview. Auditors generally are not amenable to any form of restriction in their audits. However, these areas are of critical importance to the contractor in properly monitoring the audit. As long as the contractor neither refuses access to relevant audit documents, nor impedes audit performance, the company has a right to place certain reasonable controls on auditors in terms of their relations with employees and proprietary records.
Once the auditor understands the contractor’s labor accounting system, he or she will identify any risks to the government. The basic audit risk assessment as it applies to a contractor’s labor accounting system involves: (1) a risk analysis of problem areas that may result in a significant adverse cost impact to the government; and (2) an assessment of this analysis to determine the extent of exposure to “suspected irregular conduct”—or fraud. The results of this analysis are critical, as they determine not only the direction of the audit, but also the scope of audit effort. A contractor with “high” risk indicators that are not otherwise moderated (e.g., by solid internal controls and historical “high” audit marks relating to proper employee compliance) will be subject to closer and more intense audit scrutiny than will a contractor with relative low risk.
The auditor generally considers a number of factors during the risk assessment. Some of the more significant areas are discussed below.
Adequate internal controls are essential for the auditor to place any reliance on the contractor’s labor system regarding contract pricing and forward-pricing estimating purposes.
If a contractor has had a history of timekeeping problems (i.e., employees not completing timecards or not using the time reporting system properly), the risk indicators in this area will be graded as high. Proper timekeeping practices and basic employee awareness of their responsibilities in this area are absolutely essential to an adequate labor charging system.
Overrun (or potentially overrun) contracts are of concern to government auditors. When contract costs exceed the established contract values, contractors might tend to divert these excess costs to other contracts or to indirect accounts. As a general rule, contractors with established procedures and safeguards relating to the accounting for costs in overrun situations will be viewed more favorably in terms of audit reliance and risk than those with poor, or no, controls.
Auditors might prepare trend analyses to monitor changes in independent research and development and bid and proposal (IR&D/B&P) versus marketing/selling costs to identify significant changes, which may indicate possible switching of costs. The recent elimination of the formula limitation has greatly relieved this problem.
Auditors and contractors often disagree on the interpretation of what constitutes an IR&D/B&P cost as opposed to a marketing/selling expense. Questions also arise regarding when an IR&D or B&P project is actually started, what costs should be included, and over what basis they should be allocated. Numerous considerations come into play in evaluating this area, and the requirements provided in FAR 31.205-18 and CAS 420 should be evaluated closely in determining a corporate policy for classifying and controlling these costs.
The contractor’s mix of contracts refers to the relative composition of government cost-type, government fixed-price, and commercial work as a percentage of total contracts. A particular mix of work will have a direct bearing on the level of audit risk a contractor is assigned. For example, if a contractor has all cost-type or all fixed-price work, the perceived risk is considered low. The highest theoretical risk is a contractor with a 50/50 mix of government cost-type work and government fixed-price work, or government work and commercial work. The reason for a high risk assessment in a 50/50 contract mix situation is that auditors believe that contractors have a high motivation to allocate fixed-price costs to cost-type work, or commercial costs to government work.
Time-and-materials (T&M) contracts are assessed a high risk because of their inherent nature. T&M contracts provide for the procurement of supplies and services on the basis of direct labor hours at specified fixed hourly rates and material at actual cost. As referenced in FAR 16.601, particular care should be exercised in the use of this type of contract since its nature does not encourage management controls.
Various areas of audit concern are expressed relating to T&M contracts, including: (1) employees promoted to higher labor categories without the required government authorization; (2) transfers between task orders in which no credit was given to the “transferor” task order; (3) contractors billing costs by applying the estimated percentage of physical completion to the ceiling amount of the delivery order without regard to the actual costs incurred on the order; (4) employees not meeting the skill qualifications required by the contract; (5) employees charging specific task orders without performing any labor effort in order to use up available funds; (6) transfers between task orders made to avoid overruns; (7) precontract costs incurred without required contracting officer approval; and (8) employees billed outside of their respective labor categories, resulting in excess costs paid by the government.
Auditors also monitor the charging of labor to indirect accounts (e.g., marketing), which may represent employee idle time. The objective is to identify significant changes in cost levels. Such changes require further evaluation to determine the reasons behind the changes.
Changes in a contractor’s organization or classification of employees may present a high-risk situation. Auditors are particularly sensitive to this type of activity if it alters the allocation of costs between contract types. The bottom-line impact to the government will be closely evaluated. What this says to contractors is that any proposed change in organization, cost structure, or employee classification needs to be justified properly if it is to receive acceptance and reliance by government auditors.
A very important area in terms of audit review is the evaluation of labor transfers through journal entries. The quantity and type of labor transfers will directly impact the risk assessed for that activity. For example, frequent transfers, or transfers between different contracts, particularly if one is cost-type and the other is fixed-price, will be reviewed very closely. In an effort to reduce risk in this area, contractors should have a strict policy on how and for what purpose journal entries are to be used. Furthermore, proper justification for any journal entry—labor transfer or otherwise—is essential.
Contractors often have numerous different physical locations where substantial labor charges are incurred. However, the accounting books and records relating to the costs incurred at these locations are usually maintained at the contractor’s main facility. Because of this, the actual labor activity at the off-site location receives less direct audit scrutiny. Consequently, with regard to the comprehensive labor audit, increased emphasis is now being placed on off-site locations. Contractors should take steps to strengthen their labor-charging practices at these locations.
Employee Interviews
Once an auditor has selected an area of perceived high risk to review in detail, the pre-interview analysis begins. The purpose of this part of the audit is to gather the necessary accounting and related data to evaluate more fully the propriety of labor charges relating to the area under review. Various types of contractor documents will be analyzed during this portion of the audit, depending on the nature of the area under review. Some of the more commonly reviewed records include: (1) timecards and/or time reporting systems reports; (2) travel reports; (3) labor reports; (4) contractual documents; (5) project status reports; (6) budgetary data; and (8) corporate memoranda.
As mentioned, the contractor should be careful to establish control procedures at the beginning of the audit with regard to the monitoring and release of records to auditors. The closer a contractor monitors the records being used by the auditors, the more aware management will be with respect to the audit areas being evaluated. It is to the contractor’s advantage to understand problems uncovered early so that resolution can be sought before a possible misinterpretation of the facts by the auditor, which could result in the unnecessary referral of an audit finding to a criminal investigator.
Auditors are often very sensitive about providing specific details regarding their audit findings, particularly in the area of labor mischarging. They will identify any apparent discrepancies found between labor charges, but not a great deal more. The purpose of their secretive nature is to avoid interfering with the results of any potential future criminal investigation. Therefore, it is incumbent upon the contractor to gather as much information as possible both from the auditor and independently to be able to respond to audit inquiries most effectively, and thereby potentially settle an issue before it gets passed along to investigators.
Auditors use various techniques in conducting their pre-interview analysis in an effort to complete their review in an effective and efficient manner. One technique of particular significance is the use of automated data retrieval software programs. The auditor will want to install these program(s) on a contractor’s computer system and use them to gather labor-charging data in a certain manner. Basically, these programs allow the auditor to retrieve labor charges over a particular period of time and accumulate them in a workable format—generally, by contract, account, or employee. Many contractors allow the auditors to use these programs on their computer systems while others simply refuse. The major risk involved in refusing to accept the use of these “retrieval” programs is that the government may allege a breach of its access-to-records audit rights.
Contractors should be aware that auditors will be using the results of their pre-interview analysis as a basis for questions while conducting employee interviews. The interview questions generated under this type of audit are specifically directed and much more effective than questions asked during DCAA’s standard periodic “floorchecks” used in conjunction with the annual incurred cost audit.
Upon completion of the pre-interview analysis, the auditor will want to start the interview process. The audit interview of employees represents the culmination of the labor analysis on select area(s) of high risk.
DCAA states that its primary authority to conduct employee interviews is based on generally accepted auditing standards (GAAS) as established by the American Institute of Certified Public Accountants (AICPA). Under GAAS, the third standard of fieldwork requires that significant competent evidential matter be obtained through inspection, observation, inquiry, and confirmation to afford a reasonable basis for an opinion on costs recorded.
Contractors should view the audit interview as a very significant part of the labor audit and treat it accordingly. That is, management should carefully evaluate the purpose and objective of the interview, and place adequate controls on its auditors’ conduct. Numerous areas of concern are often raised between contractors and auditors regarding interview procedure.
For example, DCAA’s standard audit procedure is to provide two auditors and to request a contractor representative. From the contractor’s perspective, and for its own protection, the company representative should be very knowledgeable about government contract costing issues.
Auditors do not like to provide advance notification of interview dates or individuals selected to be interviewed. They believe that the element of surprise is essential to the credibility of their review. Some contractors require that some reasonable degree of notice be provided so that they can plan for the proper representative to attend. This can sometimes be an area of compromise between the auditor and the contractor.
Auditors are not investigators; it is outside their charter of responsibility to “investigate.” However, sometimes contractors feel that certain questions asked and methods used by auditors are investigatory in nature. In fact, auditors are not to ask such questions as “Do you ever mischarge?” Perhaps the best policy for a contractor who has doubts regarding the nature of an audit question is to refuse to allow an employee to answer the question until legal advice can be sought. Various legal and constitutional rights may come into play, particularly if a contractor is actually under investigation, with respect to the inquiry of employees.
In fact, the auditor may actually be doing work for an investigator and the contractor may not know about it. For this reason, some lawyers have advised contractors that, prior to allowing any audit interviews, a contractor should ask the auditor if his or her work is in conjunction with an investigation. If the answer is yes, the contractor should seek legal assistance before allowing the auditor to proceed.
Auditors are hesitant to release any questions to the contractor before the interview. They may respond that they don’t know what the next question will be until an employee provides an answer. Some contractors have requested that DCAA provide them with at least the general type of questions to be asked. Other contractors have acted more aggressively and actually tried to limit the specific questions that may be asked during an interview. This is a sensitive area and may be tied into an access-to-records issue; however, a compromise can usually be reached with DCAA.
The interview process can be an intimidating experience for an employee. Auditors are often trained in specific interview techniques. Questions may be very effective, and are based on their pre-interview analysis. Auditors want to obtain a significant amount of documentation during the course of the interview (e.g., current time records, engineering logs, samples of work performed). The audit purpose is to verify that direct projects or indirect accounts charged are actually what is being worked on. Of primary concern to the contractor should be the auditor’s proper interpretation of the documents being received as they relate to particular projects. In addition, there is no obligation that employees provide personal documentation to auditors as long as these documents are not used as an official accounting record or as the primary basis for an official record (e.g., daily logs).
After completing the initial interview process, auditors will assess the impact of any problem areas uncovered and determine whether further analysis is warranted. If not, and if the auditor is satisfied with the scope of his or her work, an audit report will be written and the review completed. However, if the auditor believes that a particular area needs further development in terms of understanding the issue or assessing the full magnitude of the problem, additional analysis and another series of interviews may be conducted. From the contractor’s standpoint, as much information as possible should be obtained from the auditor to evaluate the problem area(s) and determine the auditor’s status of audit completion. Since a contractor representative should have attended the interviews along with the auditor, he or she should be generally aware of any problem areas.
The contractor would be well-advised to conduct its own internal review of the circumstances or to hire an independent accounting firm familiar with the issues to assist in this analysis if audit findings appear serious. It is critical that a contractor appreciate the full magnitude of any labor-related internal control weaknesses or possible areas of mischarging to be able to respond effectively to government auditors and protect itself against any possible allegations of fraudulent activity.
Audit Report
The results of a labor audit are formalized in a report addressed to the applicable ACO. The contractor should receive the results of this report through an exit conference; in some cases, the company may receive a draft copy of the report. The report will include discussions regarding the adequacy of the contractor’s overall timekeeping system and the propriety of its labor-charging practices. If the auditor identifies possible labor mischarging, then the contractor will be provided a general description of the mischarge and its associated dollar impact. Further particulars of the audit findings (e.g., documentation received during the course of the review that could implicate the contractor) will generally not be disclosed to management. The contractor will be asked to respond in writing to the audit report. The response should be carefully prepared so as not to damage the company’s position. At this point, it may be advisable to seek independent accounting and/or legal counsel.
PROCUREMENT SYSTEM REVIEW
The procurement system review is conducted by several different groups in the government, including procurement experts, auditors, and technical experts. The main purpose of the review is to determine the effectiveness of the company procurement system as it relates to a broad range of issues such as: (1) competition in buying; (2) sources of supply; (3) lead-time considerations; (4) inventory control; (5) production control; (6) price negotiation documentation; (7) compliance with regulations; (8) make-or-buy decisions; (9) quality control; (10) payment to suppliers; and (11) intercompany purchases.
For some contractors, the material content of cost proposals is higher than labor costs. Therefore, the cost of acquiring material in the most economical and efficient manner is of concern to the government auditors. The results of the review will influence the credibility of material cost amounts in future cost proposals. Poor marks in this review will cause the government to review proposed material costs in future proposals in more detail.
COMPENSATION SYSTEM AUDIT
The compensation system audit deals with two key areas: (1) reasonableness of compensation; and (2) uncompensated overtime.
Reasonableness of Compensation
The government’s efforts in assessing the reasonableness of compensation costs are for the most part conducted by DCAA auditors in a compensation review. A typical-result in the audits performed by DCAA is allegations of unreasonableness. These allegations are based on the results of the use of a data bank of information that DCAA has developed for different geographic areas. In applying this information, DCAA is comparing similar companies and services with similar sales volumes, in the same geographic area, to identify unreasonable amounts.
The cost principle that addresses the allow-ability of compensation costs is FAR 31.205-6. Compensation for personal services will be considered reasonable if total compensation is similar to that paid by other firms of the same size and in the same industry. Special circumstances may apply in evaluating the reasonableness of individual compensation if one or more of the following criteria apply:
Compensation of owners of closely held corporations (i.e., partners, sole proprietors, members of the immediate family, or persons having a substantial financial interest in the enterprise) must be reasonable for the services rendered and not reflective of a distribution of profits. Closely held corporation compensation amounts may not exceed those recognized under the Internal Revenue Code.
The nature of the contractor’s business is such that compensation levels are not subject to the normal restraints of a competitive business.
Changes in compensation plans are concurrent with changes in the mix of government contracts.
Compensation costs are in excess of amounts deductible for income tax purposes.
Compensation costs are not significant deviations from the contractor’s established practices.
If DCAA alleges that compensation, or a particular element thereof, is unreasonable, the “burden of proof” passes to the contractor to support reasonableness. However, as a practical matter, since DCAA has rarely made available the details of its database, the proof that its auditors are using all the criteria set forth in the regulation is lacking. Additionally, DCAA at times appears to use the median of its statistics as the ceiling and questions all compensation that exceeds the median. Clearly, this application of the FAR criteria might be susceptible to challenge.
In considering reasonableness of compensation, numerous factors should be evaluated. These factors apply equally to a challenge of the government’s allegation of unreasonableness as to the development of a contractor’s position. The highlights of some of the more significant areas are:
Validity of data used—Are the companies comparable? Are they producing similar services or products? Are they in the same industry? Are they in the same geographic area? Are they similar in size? How measured? By sales only? By numbers of employees? Are they performing a similar mix of government work relative to commercial? Fixed-price vs. CPFF?
Uniqueness of contractor—Has the company experienced unusual sales growth? Noteworthy growth or profitability? Noteworthy growth measured by return on investment or return on assets? Does the company perform work for a large variety of government agencies and contracting officers (requiring officials to be more efficient than other types of clientele or customers)?
Uniqueness of personnel—Does the company’s staff show evidence of great leadership, scientific renown, or other specialized skills?
Uncompensated Overtime
The issue of uncompensated overtime has historically caused numerous problems between contractors and auditors. The greatest problem arises when exempt employees are working uncompensated overtime, but are only recording and allocating their time to cost objectives based on the standard 40-hour work week. In other words, no recognition of costs incurred is associated with the excess hours. The concern of government auditors is that this practice might lead to an inequity in allocating costs to final cost objectives. In particular, there is the perceived risk of “gaming,” which could negatively impact government contracts.
The concept of “gaming” generally refers to the: (1) maximization of time charged to government cost-reimbursable contracts to fulfill the standard 40-hour cost allocation requirement; and (2) minimization of time allocated to government fixed-price and commercial contracts. In other words, assume an employee works 50 hours during a week and charges 40 hours to cost-reimbursable contracts and 10 hours to fixed-price contracts. Under this scenario, at least two potential problems arise: (1) improper cost allocation; and (2) fraudulent time charging. In the cost allocation area, the government auditors will state that if only 40 hours of work receive the full allocation of costs, then other cost objectives associated with the extra 10 hours are not receiving a fair cost allocation. Furthermore, if the charging of 40 hours is related to cost-reimbursable contracts, system complications arise that present unacceptable conditions to contractors.
The issue of uncompensated overtime requires an evaluation on a case-by-case basis before the most appropriate allocation procedure can be identified. Before deciding on any system for controlling and recording uncompensated overtime, a contractor should direct special consideration to the materiality of results. Government auditors should be concerned with the same issues. For example, would there be a significant difference between present and revised allocations of costs to final cost objectives? Is the government (as a whole or on particular programs) suffering inequities because of the present allocations? Would the cost of controlling and recording uncompensated overtime exceed the benefits of improved accounting?
In light of these considerations, the following is a sample list of methods that contractors use to account for uncompensated overtime. The first method listed is generally the least acceptable to government auditors; the second method usually represents the auditors’ preference. Auditors and contractors generally have the exact opposite preferences in this area.
Labor costs are distributed only to cost objectives worked on during the first 8 hours of the day; no accounting is made for hours worked in excess of 8 hours per day or 40 hours per week.
Costs are distributed to all cost objectives worked on during the week based on an average weekly labor rate (i.e., weekly salary divided by total actual hours worked during the week).
Costs are distributed to all cost objectives worked on during the week based on a labor rate predicated on a 40-hour workweek. Amounts distributed that are in excess of salaries paid are credited to overhead.
All cost objectives worked on during the day are charged an amount representing a pro rata allocation of the total hours worked. For example, if an employee worked 3 hours each on three different cost objectives during the day, each cost objective would be charged with one-third of the employee’s daily salary.
Costs are distributed to all cost objectives worked on at an estimated hourly rate. The estimated hourly rate is calculated by dividing the employee’s annual salary by the total hours the employee is expected to work during the year. Any variance between actual salary cost and the amount distributed is charged/credited to overhead.
PRICE PROPOSAL REVIEW
Cost or pricing data submitted by a contractor enables the government to perform cost or price analysis that will ultimately enable the two parties to negotiate fair and reasonable contract prices. In connection with this analysis, a contracting officer should request an audit review of a contractor’s price proposal by the contract auditor when the information available is inadequate to determine the reasonableness of the proposed cost or price. Legislation also has exempted certain categories (e.g., commercial products and services) from submittal of cost or pricing data for audit. Contractors need to be aware of exactly what data are required to be submitted and what data are exempt.
Developing Cost Estimates
Developing cost estimates can be a complicated and involved process. The contractor is concerned with maintaining a competitive posture, as well as responding to the government in a timely fashion with minimal costs questioned by the auditors. Often, problems arise in the estimating process with respect to: (1) developing labor hours; (2) obtaining necessary and timely quotes from vendors and subcontractors; (3) applying scrap and attrition factors; and (4) computing escalation rates and indirect cost rates. A high degree of coordination is required between the proposal pricing staff and the various contributing functional groups. The propriety of the estimates may be subject to review by government auditors. If this happens, all estimates will have to be supported by documentation, such as: (1) multiple price quotes; (2) rate information supported by the accounting records; (3) budgetary data; and (4) production records relating to similar units produced.
Key areas relating to the development of cost estimates include the following:
Direct Labor Costs
Period of time during which the contract is going to be performed
Method of determining labor rates (i.e., average vs. actual) and applying associated escalation
Categories of labor that will be used on the job
Mix of labor categories required to accomplish the work
Experience on prior similar work and the potential application of a learning curve
Application of manufacturing labor standards (i.e., engineered or estimated work measurement standards)
Indirect Cost Rates
Budgeted overhead expenses with offsets for anticipated unallowable costs
Planned changes in the indirect cost base (i.e., growth or decline of direct labor dollars associated with a particular overhead pool or changes in total costs for a G&A pool)
Mix of variable and fixed indirect expenses and their associated impact as a result of changes in the indirect base
Forecast increases or decreases in business volume and anticipated creation of new product lines or organizations, which may require new indirect rates
Materials, Subcontracts, and Other Direct Costs
Experienced usage factors (i.e., number of units required in the end product) and loss factors (e.g., attrition, scrap)
Availability and accuracy of price quotations (government auditors often like to see two or three current quotations for each significant item of material/subcontract)
Determination of prices from catalogs or established markets (e.g., travel costs from airline guides)
Development and support relating to decrement factors (i.e., experienced reduction in price)
Auditor Approaches
The best way to prepare for an audit of a cost proposal is to prepare the backup to the proposal before the auditor arrives. In other words, if the company assumes that all its proposals will be audited, supporting documentation will be prepared on a recurring basis by all the individual company elements. This discipline is required to minimize, to the extent possible, any audit problems concerning lack of audit support. The government auditor will typically review the following areas of a cost proposal: (1) direct labor rates; (2) direct labor hours; (3) material prices; (4) indirect cost rate projections (i.e., overhead, fringe benefits, and G&A); and (5) other direct costs, including cost of money.
The audit entrance and exit conferences are the most important parts of the audit from a contractor’s point of view. The DCAA guidance in DCAM 4-302 requires the auditor to hold a formal entrance and exit conference on each audit performed. The contractor has a right to know the purpose of the audit, the expected duration of the audit, and what the auditor will need to accomplish the audit. At the conclusion of the audit (and preferably throughout the course of the audit), the auditor is required to discuss any factual matters concerning the results of audit—such as items that do not add up, whether or not a quote is adequate, etc. The auditor is not required to discuss judgmental findings—such as the escalation is too high, the proposed overhead is 6 points too high, etc. However, most auditors are willing to discuss the audit in general terms, like the labor rates are a bit high, a lot of prior prices need to be updated, etc.
Direct Labor Rates
Basis of the proposed labor rates (e.g., average category, weighted average)
Reasonableness of current compensation
Verification of the midpoint of effort
Actual labor rates for the prior year and current fiscal year to date
Direct Labor Hours
Basis of the proposed labor hours
Whether the proposed hours are based on historical data and how reliable the historical records are
Whether all nonrecurring effort is eliminated for projection purposes
If hours are based upon estimates, the basis of the estimates (i.e., do the hours reflect current practices?)
Whether any direct labor is proposed that could be recorded as indirect
Whether any contingencies are included in the proposed hours
Material Costs
Whether a combined bill of material has been prepared
Basis of the proposed unit prices and their validity (generally using statistical sampling)
–If pricing is based on current or prior purchases, comparison of proposed quantities to previously acquired quantities
–Age of purchase orders used and applicability of escalation
If pricing is based on vendor quotes, reasonableness and competitiveness
Whether material requirements have been combined with other contracts to obtain lower prices
Whether contractor performed a cost or price analysis on major subcontractors
Whether proposed quantities include scrap and attrition
Indirect Cost Rates
Whether allocation bases for various cost pools are consistent with prior history, and adequately reflect anticipated business volume
Whether proposed indirect costs are compatible with prior periods and years (i.e., ratio analysis)
Whether direct and indirect costs are classified correctly
Whether all expressly unallowable costs have been specifically excluded (e.g., interest, bad debts)
Whether bid and proposal and independent research and development costs have been segregated properly
Other Direct Costs
Travel costs (e.g., number of trips, costs per trip)
Reproduction or computer services (e.g., are those tasks proposed in-house or by outside vendors?)
Cost-of-money calculations (e.g., are the allocation bases and net book values used the same as those used for indirect expense rates?)
INCURRED COST AUDIT
The purpose of an incurred cost audit is to establish final, government-approved direct and indirect costs for the cost accounting period under review to facilitate the final closeout of cost-reimbursable contracts. An auditor’s primary objective in conducting an incurred cost audit is to examine the contractor’s cost representations, and to express an opinion on whether the incurred costs are reasonable, allocable, and not prohibited by the contract, by government statute or regulation, or by previous agreement with or decision of the government contracting officer. In addition, the auditor is interested in determining whether the contractor’s accounting system is adequate for subsequent cost determinations that may be required for the current contract or for subsequent contracts.
According to FAR 42.703, if a contractor has a cost-reimbursable contract with the government, the contractor is required to submit a summary of actual indirect and direct contract charges on a fiscal year basis. This “cost submission” is supposed to be submitted to the contracting officer, or auditor, within six months after the close of the fiscal year. The cost submission is to show a summary of costs incurred under flexibly priced contracts, detailing incurred costs for direct labor, material, overhead, and other direct costs for each auditable contract. The submission should also include the details of the overhead rates for the fiscal year showing the rate(s) developed, supported by indirect expense schedules for each cost pool. DCAA also requires that a copy of financial statements and the general ledger trial balance be submitted.
The Department of Defense has given the contracting officer the authority to determine final rates. Alternatively, DOD has given DCAA auditors the authority to set final indirect rates through “audit determination.” The parameters for audit-determined rates are set forth in FAR 42.705. If a contractor does not agree with the auditor’s conclusion (in an audit-determined situation), the contractor has the right to appeal to the contracting officer or an appropriate court of appeals to settle the disputed costs. This practice differs from the practice of “audit-negotiated” rates, where the DCAA auditor was advisory to the contracting officer and the contracting officer would set the rate (after negotiation with the contractor). In addition, DOD contractors must certify that their overhead submissions do not contain expressly unallowable costs. Most larger contractors have indirect cost settlements by negotiation.
Labor Costs
In determining the propriety of labor costs for any given cost accounting period, auditors are interested primarily in reviewing the contractor’s labor and accounting policies, internal control procedures, and organizational responsibilities. The purpose of this part of the audit is to ascertain whether the policies, procedures, and internal controls are well-defined and reasonable in concept, and whether they are being implemented effectively by contractor personnel.
The auditor is generally interested in determining whether or not: (1) time charges are being recorded on a current basis; (2) the work performed reflects the confirmation of the supervisor in charge or of an independent timekeeper; (3) the rates paid to employees are commensurate with the type of work being performed; (4) the labor distribution or other records prepared by the contractor are prepared on a current basis, and labor costs chargeable to contracts are recorded accurately and in accordance with the price proposal submission; (5) indirect labor costs consist of types of items acceptable under the contract and meet the criteria of cost interpretations established by current directives and generally accepted accounting principles; and (6) management policies governing the hiring, assignment, reassignment, and control of the labor force are consistent with prudent business management practices.
Typically, in the auditor’s review of labor in the annual incurred cost audit, both direct labor as well as indirect labor categories are reviewed. Some of the techniques that the auditor will use in testing labor are:
Review policies and procedures for any changes in direct/indirect time charging procedures (e.g., engineering, program management, idle time).
Perform a comparative analysis of “sensitive” labor accounts to identify any areas for an in-depth review (e.g., bid and proposal costs dropping off near the end of the year, a large increase in idle time).
Verify that the labor cost distributions reconcile to payroll accruals and disbursements.
Review adjusting journal entries and exception reports for labor costs to identify any adjustments and/or exceptions that require further review (e.g., transfers of charges between contracts).
Perform a “floorcheck” to determine whether timekeeping policies and procedures (e.g., timecards are completed in ink with no “whiteouts,” proper corrections are made on time reporting systems, supervisors approve time reported either on cards or on a system) are being observed.
Sample selected employee-prepared records and trace their time for an entire transaction (e.g., the time reported by either a card or time reporting system), and payroll records to determine the actual pay rate, pay checks, job distributions, etc. (Usually this type of procedure is done on a statistical basis. If any problems are encountered in this audit step, the auditor will not be able to place a great deal of reliance on the labor accounting system, and will be required to extend this phase of testing.)
Material and Subcontract Costs
An auditor’s primary objective in reviewing material and subcontract costs is to determine whether the contractor’s accounting policies, procedures, and internal controls are well-defined, reasonable in concept, and effectively implemented. The auditor is also concerned with determining that costs were accurately charged to benefiting contracts. In performing the tests, the auditor will generally attempt to ascertain that the material was: (1) needed for the contract; (2) properly considered for “make” or “buy”; (3) purchased in reasonable quantity; (4) purchased at a prudent price; (5) used on the contract; and (6) properly accounted for in terms of both initial charge and residual value.
Generally, the auditor will perform some sort of transaction testing of selected items through the accounting system—from invoice, to voucher, to check, to job cost records—to determine the accuracy of the transactions tested. Unless problems are encountered, little audit effort is spent on this area.
Indirect Costs
In reviewing indirect costs in an incurred cost audit, the auditors are primarily interested in the following areas: (1) allowability of the costs allocated to government contracts based on FAR Subpart 31.2; (2) accuracy of the methods used to accumulate indirect costs; (3) propriety of the bases used to allocate indirect costs; (4) consistency in applying policies and procedures to governmental and to other operations; (5) mathematical accuracy of the computed amount of indirect costs allocated; and (6) reasonableness of indirect costs allocated to government contracts.
When evaluating issues of indirect cost allowability, auditors use FAR Subpart 31.2. as their primary regulatory source. During the course of applying these regulations, controversy often arises between the auditor and the contractor regarding the proper interpretation of an “allowable cost.” Conflicting positions are not unusual, particularly in those areas generally classified as “grey.” Grey areas often include selling costs, public relations, employee morale, and technical/professional activities. The following is a sample checklist of some of the more common questions raised by auditors relating to indirect costs. A “yes” answer to any of these questions would prompt an audit concern.
FAR 31.203, Indirect Costs—Did the company fail to include unallowable costs as part of its allocation base(s)?
FAR 31.205-1, Public Relations and Advertising Costs—Did the company advertise in newspapers, magazines, on radio, etc., for other than help wanted? Is the company involved in trade, exhibit booths, etc., relative to the products and/or services the company offers?
FAR 31.205-3, Bad Debts—Does any person spend the majority of his or her time involved in the collection of bad debts?
FAR 31.205-6, Compensation for Personal Services—Did the contractor defer any employee compensation? Are bonuses paid without the basis of a formal agreement between the company and the employees? Did the company terminate any pension, profit-sharing, bonus plans, etc.? Did the company fail to fund profit-sharing, bonus, or retirement plans? Were the plans funded on other than a quarterly basis? Does the leave policy allow employees to carry over hours to a future year?
FAR 31.205-11, Depreciation—Does the company use the accelerated cost recovery system (ACRS) for income tax and/or financial accounting purposes?
FAR 31.205-13, Employee Morale, Health, Welfare—Is a cafeteria maintained for employees? Is it operated on other than a break-even basis?
FAR 31.205-14, Entertainment Costs—Are there any noted weaknesses in the contractor’s support for luncheons, meetings, etc.?
FAR 31.205-15, Fines and Penalties—Were any tax returns filed late?
FAR 31.205-17, Idle Facilities and Idle Capacity Costs—Have any reductions in force resulted in unoccupied space?
FAR 31.205-19, Insurance and Indemnification—Does “key man” life insurance exist?
FAR 31.205-27, Organization Costs—Has the company reorganized, established a new division, merged with another company, etc.?
FAR 31.205-30, Patent Costs—Are patent costs incurred for other than a direct requirement of the contract?
FAR 31.205032, Precontract Costs—Does the company ever start working on a contract prior to its effective date? If so, was approval obtained from the contracting officer?
FAR 31.205-33, Professional & Consulting Service Costs—Did the company require legal services for organizing, reorganizing, antitrust suits, claims against the government, or bad debts? Does the company maintain supporting evidence for services rendered?
FAR 31.205-34, Recruitment Costs—Were any new people hired who left the company within 12 months of their hire date?
FAR 31.205-35, Relocation Costs—Does the relocation policy allow for payment of income taxes? Loss on sale of a home? Continuing mortgage principal on residence being sold?
FAR 31.205-36, Rental Costs—Did the company enter into any new leases or renegotiate any existing leases during the year? If so, was FASB #13 considered? Are there any rental payments for property leased from an owner, stockholder, or affiliate of the contractor?
FAR 31.205-41, Taxes—Have more taxes (state income taxes mainly) been accrued than paid?
FAR 31.205-42, Termination Costs—Were any contracts terminated during the year? If so, were any indirect costs charged direct as part of the termination?
FAR 31.205-43, Trade, Business, Technical and Professional Activities Costs—Does the company belong to any professional association? Is technical information discussed at meetings? Are any management meetings held at sites other than the main office? Did the company pay any costs for guests?
FAR 31.205-44, Training and Educational Costs—Were any grants, scholarships, fellowships, etc., provided to anyone? Did the company provide training and education to people other than employees?
FAR 31.205-46, Travel Costs—Have per diem ceilings been exceeded? Did any employee travel on first class airfare? Were any rebates, credits, or discounts given to the company by airlines, car rental firms, motels, etc.?
FAR 31.205-51, Cost of Alcoholic Beverages—Were alcoholic beverages served at any company functions?
The auditor will most likely spend the majority of his or her time in an incurred cost audit reviewing indirect costs. To accomplish the review, the auditor will perform the following analyses:
Indirect account analyses—The auditor will analyze selected indirect cost accounts or transactions, such as sensitive accounts, new accounts, and accounts with large variances to determine allow-ability, allocability, and reasonableness.
B&P/IR&D compliance—The auditor will review the bid and proposal and independent research and development costs for proper classification and completeness.
Indirect allocation bases—The auditor will review the various indirect cost pool allocation bases for consistency with prior years and applicable CAS.
Indirect rate computations—The auditor will test the accuracy of the various rate calculations.
Indirect adjusting entries—The auditor will review the adjusting journal entries related to indirect costs to identify any adjustments that require additional explanations.
Testing of indirect accounts—The auditor will select certain accounts to be reviewed in detail to test for any unallowable costs. The auditor will usually concentrate on sensitive (or controversial) areas such as business meals, travel, and corporate aircraft.
Other Direct Costs
In addition to direct labor and material (prime costs), which can be readily identified with a specific contract, there are other types of expenses that, under certain circumstances, may be charged directly to a specific job. These are generally referred to as “other direct costs.” Examples are: (1) special tooling, dies, jigs, and fixtures; (2) plant rearrangement; (3) packaging and packing; (4) consultants’ fees; (5) outbound freight; (6) expediting; (7) travel; (8) long distance telephone; and (10) cost of money. Costs of this nature may be charged direct to jobs, allocated on some representative basis, or charged partially direct and partially by allocation.
The auditor’s objectives in reviewing these costs are generally to determine whether: (1) the contractor’s cost representations are reliable and accurate; (2) the amounts charged to government contracts are reasonable in amount and are allocable to government contracts; (3) costs have been accumulated in accordance with generally accepted accounting principles appropriate in the circumstances; and (4) the contractor has been consistent in allocating such costs to commercial and government work.
POSTAWARD REVIEW (DEFECTIVE PRICING)
The Truth in Negotiations Act requires that contractors involved in negotiated procurements submit to the government details concerning costs anticipated to be incurred during performance of the contract. This disclosure, coupled with sanctions that can be brought against the contractor if the contractor fails to satisfy this obligation, permits the government to negotiate a price that is based on a realistic assessment of the contractor’s cost expectations. The Truth in Negotiations Act offers protection against what is commonly referred to as “defective pricing.”
The act’s provisions pertaining to defective pricing have been strengthened over the years as the government has recognized their effectiveness. Fundamentally, TINA requires contractors to disclose certain cost or pricing data and to certify that these data are current, accurate, and complete as of the date of the certification. To the extent that the certification is erroneous—that is, the data are not current, accurate, or complete—the government, in accordance with a price reduction clause inserted into government contracts, obtains a reduction in the contract price to the extent that the price was overstated as a result of inaccurate, incomplete, or noncurrent disclosure.
Certain cost or pricing data submitted for a contemplated negotiated contract $500,000 or greater must be certified as current, accurate, and complete. FAR 15.406-2 details the content of the required certificate, as follows: “This is to certify that, to the best of my knowledge and belief, the cost or pricing data (as defined in section 15.401 of the Federal Acquisition Regulation (FAR) and required under FAR subsection 15.403-4) submitted, either actually or by specific identification in writing, to the contracting officer or to the contracting officer’s representative in support of [the proposal] are accurate, complete and current as of [date]. This certification includes the cost or pricing data supporting any advance agreements and forward pricing rate agreements between the offeror and the Government that are part of the proposal.”
The contracting officer will specify whether cost or pricing data are required and whether or not certification is required. Generally, Table 15-2 in FAR Subpart 15.408 outlines how cost and pricing data will be submitted to the contracting officer.
Audit Emphasis
During the 1960s, both DCAA and GAO performed defective pricing audits. DCAA gradually assumed the predominant responsibility in this area, with GAO performing fewer and fewer reviews. GAO has historically been critical of DCAA’s efforts in performing defective pricing reviews because GAO believes that DCAA should perform more of these audits.
Since DCAA cannot review every pricing action for possible defective pricing, the agency has used various contract selection techniques for the past several years. Initially, DCAA developed a sampling plan, which required a review of contracts over a specific dollar level and a random sample of contracts below that level.
In an attempt to refine the selection process, DCAA abandoned the random sampling approach and added two judgmental approaches. One method considers the effectiveness of the contractor’s estimating system as an indicator of the need for more or fewer audits. The second method is a list of eight criteria that may indicate the need for a review. These criteria are:
Has significant time elapsed between the time the proposal was submitted and negotiations?
Were accounting changes made after the proposal was submitted?
Were supporting data introduced at the negotiation, but not audited?
Were there significant price differences between the proposed and negotiated amounts?
Was there adequate time for the contractor to prepare the cost proposal?
Was there adequate lead-time for an audit to be performed on the proposal?
Were there any unsupported costs in the audit review?
Does the contractor have any outstanding estimating system problems?
Applicability of the Truth in Negotiations Act
The Truth in Negotiations Act originally covered contracts entered into by DOD and NASA. Recognizing the benefits of the requirements of TINA for their own negotiated contracts, civilian agencies sought to implement the statutory provisions by regulation. Currently, both civilian agencies and the military have similar provisions with regard to defective pricing.
The defective pricing provisions in FAR 15.403-4 are applicable to the following types of contracts: (1) negotiated prime contracts $500,000 or greater; (2) contract modifications or changes over $500,000; (3) subcontracts $500,000 or over at any tier, but only in the event that the prime and higher-tier subcontractors have also provided cost or pricing data; and (4) any modification or change to a subcontract covered in (3) above. The provisions apply to modifications or changes to a contract over the threshold amount not only for negotiated contracts, but also for contracts that were initially the product of sealed bidding procedures. This application makes sense in light of the overall concern that the cost or pricing disclosure requirements be imposed in situations in which the government does not have adequate assurance that competitive forces will obtain a reasonable price. Usually when a contractor is undertaking a modification, no real competitive forces can be brought to bear, and so the government seeks the benefits provided through the disclosure of data.
TINA sets forth four exemptions from coverage, even in those cases in which the requisite dollar amount has been satisfied and the modification or contract award is the result of negotiated procedures. These exemptions (found in FAR 15.403-1) for contracts and subcontracts are applied when the price is based on: (1) adequate price competition; (2) commercial items; (3) prices set by law or regulations; or (4) in exceptional cases, where the head of the agency determines that the requirements may be waived and states in writing the reasons for such determination.
Price Reduction
The result of not providing current, accurate, or complete data will be a price reduction in the contracted value for the defective amount: “If any price, including profit or fee, negotiated in connection with this contract, or any cost reimbursable under this contract, was increased by any significant amount because the contractor or a subcontractor furnished cost or pricing data that were not complete, accurate and current as certified … the price or cost shall be reduced accordingly and the contract shall be modified to reflect the reduction.” (FAR 52.215-10)
The elements of this statutory provision and its regulatory implementation have been the subject of a multitude of decisions in the Claims Court and the various Boards of Contract Appeals. The significant decisions offer insight into the magnitude of a contractor’s responsibility for disclosure pursuant to the Truth in Negotiations Act.
Fraud in Defective Pricing
For a contractor to be guilty of fraud in the submission of defective data, it must have had “knowledge” of the defects. Under the False Claims Act, any one of three criteria may be applied to support a determination of culpable knowledge in an appropriate case: (1) intent to deceive; (2) misrepresentation; and (3) actual knowledge.
Situations of “intent to deceive” and “actual knowledge” are often difficult to prove since they require an inquiry into a person’s state of mind to determine liability. However, such factual areas as verbal admissions and documented items (e.g., correspondence, memoranda) may prove sufficient to support this test.
Under the “misrepresentation” standard, the courts have set forth two criteria: (1) intentional misrepresentation; and (2) negligent misrepresentation. Intentional misrepresentation, the more stringent criterion, may occur as a result of a contractor’s reckless disregard for the truth or falsity of a belief. Negligent misrepresentation, a less stringent criterion, has been defined as a lack of reasonable care in ascertaining the facts. However, carelessness that resembles a mistake will not meet the negligent misrepresentation definition. The negligence must be extreme enough to be considered functionally equivalent to actual knowledge.
Government auditors, in particular DCAA auditors, review defective pricing cases for any indications of possible fraud. Some of the key areas of auditor concern, which may trigger additional audit analysis and prompt an investigative referral, are:
High incidence of persistent defective pricing
Repeated defective pricing involving similar patterns or conditions
Continued failure to correct known system deficiencies
Consistent failure to update cost or pricing data with the knowledge that prices have changed
Specific knowledge that is not disclosed regarding significant cost issues that will reduce proposal costs (e.g., revising the price of a major subcontract, combining material requirements)
Denials by responsible contractor employees of the existence of historical records, which are subsequently found to exist
Use of unqualified personnel to develop cost or pricing data used in the estimating process
Indications of falsification or alteration of supporting data
Distortion of the overhead accounts or base information by the transfer of charges that have a material impact on government contracts
Failure to make complete disclosure of data known to responsible contractor personnel
11. Employment of people known to have previously perpetrated fraudulent acts against the government.
If the DCAA auditor reasonably concludes that a fraudulent act may have occurred, the agency guidelines state that the field auditor should notify the local investigative organization regarding what course of action he or she should pursue. Once the auditor suspects fraud, and the contractor becomes aware of a problem, the contractor may wish to seek legal advice. In most cases, the contractor is not even aware that an investigator has been called until records are subpoenaed or officials are questioned by an investigator.
Audit Techniques
The auditor’s main concern in performing a defective pricing review is to determine whether the costs proposed to the government were the most accurate, complete, and current when the contract was negotiated. Under “ideal” conditions, an auditor would prefer to perform this audit shortly after a contract has been negotiated. In this situation, both parties should easily remember what actually transpired at negotiations. However, in the current environment, a defective pricing audit generally takes place many months after contract award.
The auditor will review contractor cost performance records to identify any differences between costs as proposed/negotiated and costs as incurred. The auditor therefore considers performance records to be a valuable tool in determining what elements of costs are most susceptible in the defective pricing audit. The auditor will attempt to identify any overruns or underruns on a cost-element-by-cost-element basis to find out whether there were any “make-or-buy” changes, changes in production methods, changes in subcontractors proposed, different material prices, different labor mix, etc.
Generally, if the overrun or underrun exceeds 5 percent of the negotiated cost of the cost element, the auditor will conduct further reviews. If the incurred costs are similar to the costs proposed, the auditor will perceive a low risk of defective pricing—and might even curtail the review. The auditor rarely performs a defective pricing review on each and every cost element within a selected contract. Usually, cost elements that are perceived to be “high” risk are reviewed.
If judgment factors are prevalent in the estimation of direct labor hours, and if no other basis was available regarding how the hours were established, further review will not be likely. If prior actual hours were used, the auditor will perform a review to determine that the history was current at the time of price agreement. If an improvement curve was used, the auditor will verify the historical basis for accuracy as of the agreement date.
The auditor will review the basis of the proposed direct labor rates (e.g, weighted average, departmental, factorywide) and compare the proposed rates to the actual rates at the certification date. The auditor will also check to determine any impact of pending labor union agreements.
Statistics on completed defective pricing reviews have shown that materials and subcontracts are the most susceptible areas for defective pricing. The auditor will perform a statistical sample of large dollar items to determine whether the quoted price was the most current price. This is done by reviewing purchase order history files, “buy cards,” or other similar records that detail purchase history. The auditor will also review the actual quantities being purchased to determine if the company is combining material requirements to obtain lower-than-bid prices. Any changes in “make-or-buy” decisions will most likely be reviewed.
The auditor will compare the proposed indirect cost rates to the actual incurred rates. If there has been a substantial change—such as in the burden pool structure, or projected sales were greater than expected—a further review will be conducted.
The results of the auditor’s review are provided to the contracting officer for disposition. Usually, the company will be provided the opportunity to respond formally to any defective pricing allegations before the government’s decision is made.
COST ACCOUNTING STANDARDS
Although the ACO is responsible for administration of the CAS, the government auditor plays an important part in this administrative effort. Two major areas of government auditor involvement in CAS matters are: (1) conducting reviews of CAS disclosure statements for adequacy and compliance; and (2) assisting the ACO in analyzing cost impact proposals submitted in connection with changes to disclosed or established cost accounting practices.
Disclosure Statement
The disclosure statement (CASB-DS-1) was designed to provide the government with a detailed, authoritative description of a contractor’s cost accounting practices. The government’s objective is to use this disclosure statement to establish a clear understanding of the accounting practices used, or to be used, particularly practices related to direct vs. indirect costs and the allocation of costs to cost objectives.
The auditor will review a completed disclosure statement for adequacy of the descriptions and then for compliance with the CAS and the FAR. To be adequate, the disclosure statement must be current, accurate, and complete. “Current” is not restricted to present practices, but may be the practices that the contractor intends to follow if a contract is awarded. The “accurate” criterion is self-explanatory and seldom causes problems. The “complete” criterion is subject to considerable auditor judgment and controversy.
Several general cautions about completing the disclosure statement should be noted. These include the use of “not applicable,” the use of “other,” any response that requires a narrative explanation, and responses that are in obvious noncompliance with the CAS or the FAR. The use of “not applicable” is acceptable if the question pertains to a cost that currently does not exist. However, subsequent use of this cost category might lead the government to allege that an accounting change has occurred. Under these circumstances, the contractor should point out that this is a new cost practice and not a changed practice. Before any question is checked “not applicable,” the contractor should consider the need for a new or revised policy related to that question.
The response “other” and certain combinations of responses will require a narrative supplement. Generally, narratives should be avoided because of the judgmental factors in establishing what is considered to be a complete response. Narratives must be carefully written to describe the practice completely enough to meet the government’s requirements, but not limit the flexibility available to the contractor under the regulations.
Changes in Cost Accounting Practices
48 CFR 9903.302-1 states that “cost accounting practice” means any disclosed or established accounting method or technique that is used to measure cost, assign cost to cost accounting periods, or allocate cost to cost objectives. A contractor’s cost accounting practices can be revised for a number of reasons, including: (1) to implement the requirements of newly applicable standards; (2) to implement negotiated changes, involuntary or sanctioned, to accounting practices; and (3) to correct noncompliant practices.
48 CFR 9903.302-2 defines a “change” to a cost accounting practice as any alteration in a cost accounting practice, as defined above, whether or not such practice is covered by a disclosure statement, except for situations where:
The initial adoption of a cost accounting practice for the first time a cost is incurred, or a function is created, is not a change in cost accounting practice.
The partial or total elimination of a cost or the cost of a function is not a change in cost accounting practice. (As used here, “function” is an activity or group of activities that is identifiable in scope and has a purpose or end to be accomplished.)
The revision of a cost accounting practice for a cost that previously had been immaterial is not a change in cost accounting practice.
Once a change in a cost accounting practice has been initiated, the standard contract clause entitled “Administration of Cost Accounting Standards” requires the contractor to submit to the cognizant contracting officer: (1) a description of the change; (2) the potential impact of the change on contracts containing the clause; and (3) if not obviously immaterial, a general dollar magnitude cost impact analysis of the change that displays the potential shift of costs between CAS-covered contracts by contract type and other contractor business activity. If deemed necessary by the contracting officer, the contractor may be required to submit a cost impact proposal within 60 days after the date of determination of the adequacy and compliance of the change.
Adjustments to contract prices resulting from a change in cost accounting practice are governed by the CAS clause in 48 CFR 9903.201-4. Classification of the accounting change and the required treatment of costs are summarized as follows:
Contract Price Adjustment
| Type of Accounting Change | Increased Costs |
Offsets |
| 1. Equitable Adjustment Change to comply with new CAS | yes | yes |
| 2. Voluntary Change— negotiated revision that the government does not consider necessary and/or beneficial to its interest | no | yes |
| 3. Sanctioned Change— negotiated revision that the government considers desirable and beneficial | yes | yes |
| 4. Noncompliance change to comply with CAS | no | yes |
“Increased costs” as interpreted in 48 CFR 9903.306(a) are deemed to have resulted whenever: (1) the cost paid by the government results from a change in a contractor’s cost accounting practices or from a failure to comply with applicable CAS; and (2) such cost is higher than it would have been had the practices not been changed or compliance with the applicable CAS had been maintained. Special attention is given to the interpretation of an “increased cost to the government” when referring to fixed-price contracts. FAR 9903.306(b) and the DOD CAS Working Group Guidance Paper No. 76-4 address this issue and define this situation to exist when costs allocated to the contract are less than would have been allocated if the method of allocation had not been changed. Just the opposite situation exists for a cost-reimbursable contract:
Increased/Decreased Cost to the Government
Regarding “offsets,” 48 CFR 9903.306(e) generally encourages the use of them in the course of determining a bottom-line price adjustment/impact. Offsets are described as: “The change or failure may increase the cost paid under one or more of the contracts, while decreasing the costs paid under one or more of the contracts. In such case, the government will not require price adjustment for any increased cost paid by United States so long as the cost decreased under one or more contracts are at least equal to the increased cost under the other affected contracts, provided that the contractor and all affected contracting officers agree on the method by which the price adjustments are to be made….” The DOD CAS Working Group Guidance Nos. 76-8 and 79-23 interpret the application of offsets to be generally allowed for all types of accounting changes.
CONTRACT TERMINATION AUDIT
The government may terminate a contract for default or for the convenience of the government. In the former situation, the government may attempt to recover money paid to the contractor and reprocurement costs. In the latter situation, the contractor must submit a termination claim settlement proposal, usually within one year of termination. When a termination for convenience occurs, the cost principles are not applied in the normal fashion. This requires special audit attention.
Frequently, government auditors are not familiar with termination claims. When this situation occurs, it may be necessary to spend time educating the auditor on the cost principles involved in a termination for convenience.
EQUITABLE CONTRACT PRICE ADJUSTMENT AUDIT
When the government directs a change to a contract, the contractor may submit a price proposal reflecting the impact of the change. This proposal is reviewed much like any price proposal. The exception is that sometimes the pricing occurs after the work has been performed. In such instances, it is necessary for the auditor to review incurred costs related to the change as well.
In addition to the formally directed contract changes, the government may—by action or inaction—cause a contract to be changed. The contractor may then submit a claim that ultimately is settled by the courts.
Two of the most common changes relate to delay and disruption by the government. These can be either acknowledged or denied by the government. If the government issues a stop-work order, the delay is seldom disputed and must be quantified for negotiations. If the government is late in delivering equipment or materials, it may argue that the cause of the delay is other than its own actions. In these instances, the delay claim is disputed and settled through litigation.
A disruption may occur if the government directs the work to be performed in a different manner. A disruption may also occur and not be acknowledged by the government. Like a disputed delay, this may result in litigation.
Auditors are very suspicious of any disputed claim. Often the auditor will refuse to audit the claim because the extra costs caused by the delay or disruption were not segregated at the time the cost was incurred. The auditor will cite a contract clause that requires separate accounting for changes in excess of $100,000. The auditor will challenge estimates as unauditable and refuse to audit, or will qualify the audit report as unacceptable for negotiations.
FINANCIAL CAPABILITY AUDIT
The government wants some assurance that its contractors are financially solvent and are thus able to perform the contract. If the contractor goes out of business while the contract is in process, the government has to locate another contractor to complete the contract. Small companies and those doing business with the government for the first time are prime targets for this type of review.
In a financial capability audit, the auditor will review the external financial statements, as either certified or reviewed by a CPA firm. Particular attention will be paid to the types of financial circumstances that could lead to insolvency, such as poor cash flow, lack of orders, excessive debt and/or lines of credit, and insufficient working capital and equity. If the auditor’s review is unfavorable, the government might not award the contract until the company takes some kind of corrective action.
OPERATIONS AUDIT
DCAA performs reviews of contractor operations to identify significant opportunities for reducing costs through improved economy and efficiency. These operations audits involve the systematic examination of particular organizational units or functions within a contractor’s business to determine whether efficient and economical methods are employed in the performance of government contracts.
An operations audit generally relates to specific areas of a contractor’s operations and usually results in recommendations to contractors for eliminating unnecessary costs or waste through contractor-initiated corrective actions. The two basic types of operations audits are “high technology” and “traditional.” “High technology” operations audit recommendations typically provide for the implementation of new, emerging technologies and usually require the acquisition of capital equipment associated with the new technology. Examples of high technology types of operations audits are computer-aided design/computer-aided manufacturing (CAD/CAM), or the use of robotics or lasers in manufacturing. “Traditional” operations audits generally recommend changes to existing contractor functions, policies, procedures, or practices to improve the effectiveness or efficiency of contractor operations. Some examples of traditional types of operations audits are repair/rework/scrap, equipment utilization and maintenance, and subcontract management.
DCAA performs follow-up reviews to confirm whether the contractor has initiated corrective action. During the follow-up reviews, the approximate cost impact of the corrective measures is assessed. Actions taken by contractors in response to operations audit recommendations may represent a change in procedure or process, or an investment in capital equipment to automate a function or operation previously performed manually. DCAA’s policy is not to report any contractor savings until the contractor has implemented the procedural or process change, or has issued a purchase order for the capital equipment. If the contractor does not implement the audit recommendation, the auditor’s only remedy is to question “wasteful” practices in accordance with the FAR contract cost principle on reasonableness.
In one operations audit, for example, DCAA recommended that a contractor affiliate with an independent travel agency to provide its travel needs. Use of an in-plant travel agency reduced the contractor’s operating expenses and provided commissions to its travel service department. The contractor’s implementation of DCAA’s recommendations resulted in an estimated annual cost avoidance of $700,000.
In another operations audit, DCAA recommended that the contractor upgrade its current interactive computer graphics system and acquire, on a time-phased implementation plan, sufficient equipment to accomplish those manual engineering and drafting operations susceptible to this technology. Contractor representatives at the business unit level agreed with DCAA’s recommendation and used the audit to convince their senior management of the need to expand and upgrade the graphics system. The contractor’s implementation of this recommendation resulted in cost savings of $650,000.
In another instance, DCAA recommended that the contractor solicit various vendors to obtain energy management surveys and, based upon the results, evaluate the feasibility and potential effectiveness of installing computerized energy management systems at its facilities. The contractor responded by including a computerized energy management system in its capital budget and issuing the initial purchase order for the complete design of such a system. Annual cost avoidance associated with this recommendation amounted to $1,600,000 for one of the contractor’s business units and $875,000 for another business unit.
For another contractor, DCAA recommended that management: (1) improve the system for measuring the cost of replacement material; (2) provide more detailed explanations in the supporting documentation for replacement material orders to identify specific reasons and individuals responsible for the orders; and (3) monitor the cost and reasons for replacement material to identify instances where corrective action can be taken to reduce replacement material cost. The contractor concurred with DCAA’s recommendations and improved its practices in controlling the level of replacements of direct material. Replacement material orders were reduced significantly during a representative period subsequent to the contractor’s implementation of DCAA’s recommendations, resulting in annual cost avoidance of approximately $1,000,000.
While many operational audits conclude with recommendations for cost avoidance, many contractors contend that there is no contractual requirement for DCAA to perform these types of audits. Recently, contractors have been expressing resistance to DCAA performing these types of audits.
MATERIAL MANAGEMENT AND ACCOUNTING SYSTEM
This contractor system relates to planning, controlling, and accounting for the acquisition, use, issuance, and disposition of materials. The DOD FAR Supplement at 252.242-7004 details the requirements for an acceptable material management and accounting system (MMAS). Generally these requirements include: (1) written policies and procedures; (2) a 98 percent bill of material accuracy and a 95 percent master production schedule accuracy; (3) a system for identifying, reporting, and resolving system weaknesses and manual overrides; (4) adequate audit trails; (5) 95 percent accuracy in inventory counts; (6) details on the process of transferring parts between cost objectives; (7) consistent criteria for pricing part transfers; (8) written procedures on the transfer of parts process; (9) adequate controls to identify specific materials as required by contract terms; and (10) periodic internal control reviews.
DCAA CONTRACT AUDIT MANUAL
DCAA updates its Contract Audit Manual (DCAM) every six months. Published by the U.S. Government Printing Office, this document is an important item for contractors to have in dealing with auditors from any organization. The DCAM is also available at the DCAA website: www.dcaa.mil/.
Chapter 1 of the manual addresses DCAA responsibilities and interactions with other government organizations, contractors, and the public. Chapter 2 describes audit standards and ties DCAA standards to the AICPA and the GAO standards. The chapter also provides DCAA’s justification for operations audits. Chapter 3 provides guidance to DCAA auditors on audit planning and on selecting areas for audit. Chapter 4 expands on the audit standards. Chapter 5 provides guidance to DCAA auditors on reviewing internal controls for all types of audits. Chapter 6 covers incurred cost audit procedures, including direct and indirect cost audits and suspension and disallowance of costs.
DCAA expands on the FAR cost principles in Chapter 7. This chapter addresses such costs as: computer cost allocations; leasing costs; allocation of special facilities operating costs; depreciation costs; insurance costs; pension costs; patent and royalty costs; labor settlement and strike period costs; employee training and educational costs; employee travel and relocation costs; dues, memberships, and professional activity costs; public relations and advertising costs; selling costs; taxes; independent research and development and bid and proposal costs; warranty and/or correction of defect costs; business combinations costs; and joint venture, teaming arrangements, and special business units.
Chapter 8 addresses the CAS. Chapter 9 covers the DCAA review of cost estimates and price proposals, detailing what the auditor is expected to do during these audits. Chapter 10 describes how DCAA audit reports are to be presented. Chapter 11 addresses such matters as limitation of cost clauses, C/SCSC (cost/schedule control system criteria) reviews, and DOD program management systems reporting requirements.
Chapter 12 addresses contract terminations, delay/disruption claims, and other claims. Chapter 13 provides special guidance regarding educational and nonprofit organizations. Chapter 14 covers several areas, including postaward reviews, progress payment audits, financial capability audits, government property audits, operations audits, contractor capital investment projects, and other operations areas. Chapter 15 addresses miscellaneous DCAA functions.
Appendix A contains the cost principles from the FAR, DAR, and DFARS. Appendix B provides guidance on statistical sampling. Appendix C provides guidance on auditing computer systems. Appendix D addresses obtaining technical assistance. Appendix E provides guidance on graphic and computational analysis. Appendix F provides guidance on improvement curve analysis. Appendix G is internal guidance on mobile audits, Appendix H is internal guidance on resident audits, and Appendix I addresses work sampling.