Audits of Contractor Overpayments - Part III

For the past couple of days, we have been discussing OMB's "Payment Recapture Audit" initiative with a particular focus on how DCAA is supporting the initiative. DCAA is only one of numerous Governmental agencies participating in this iniative which ultimately affects any person or entity receiving Government funds of any type. Expenditures paid to health service providers are one of the main targets of OMB's initiative.

The Government expects contractors to have written policies and procedures covering their billing system functions. As we wrote yesterday, the auditors will initially come in and scoop up whatever documentation contractors have regarding the billing policies, procedures, and practices. They will then review the policies to determine their adequacy and perform tests to see if those polices have been implemented and are working effectively. The question we receive most often is "what are adequate policies and procedures"? The answer to that could fill a book but lets take a look at one single aspect of billings; comparison of billed and paid amounts. You will recall from yesterday's posting that this is one of the objectives of DCAA's payment recapture audits.

Contractors should have written policies and procedures to identify and resolve contract overpayments in a timely manner. Under these policies and procedures, contractors should:

• Perform comparisons of amounts received to amounts billed at the invoice level (e.g. for each public voucher, progress payment request, performance based payment, and delivery invoice) to readily identify contract overpayments.
• Document timely notification of overpayments to the contracting officer and paying office.
• Document compliance with contracting officer and paying office instructions to resolve overpayments.
• Resolve overpayments within 30 days after the overpayment was made and document significant activities during the resolution process.
• Ensure that on contracts with progress payments, that the appropriate progress payment liquidation is applied against the delivery invoice when the delivery invoice is submitted. These procedures should include
• Brief the contract to identify the appropriate liquidation rate
• Apply the appropriate liquidation rate against the delivery invoices and record the net amount in the amounts receivable records.
• Identify payment variances as a result of differences in application of liquidations between the paying office and the contractor.
• Research payment variances to determine if overpayments exist
• Immediately refund overpayments due to liquidation errors and coordinate with paying office and resolve within 30-60 days.

The foregoing might seem excessive but for medium and large contractors, it would constitute minimum essential requirements. Of course it also needs to be tailored to fit the specific circumstances. For example, contractors who do not prepare progress payments do not need policies and procedures covering potential overbillings on progress payments.

The foregoing covers only one of the "payment recapture audit" objectives that auditors will review. We did not discuss the essential policies and procedures for reconciliations of recorded to billed costs, contract administration adjustments, demand letters, subcontractor billings (very critical), offsets, and refunds. Our advice to contractors is to review your billing systems before an audit to ensure adequacy. It will make the audit process smoother and avoid negative audit findings.

 

Audits of Contractor Overpayments - Part II

Yesterday we discussed DCAA's response to OMB's (Office of Management and Budget) "Payment Recapture Audit" initiative. DCAA rolled out a program specifically designed to test contractor billing policies and procedures for ensuring overpayments do not occur or if they do, are quickly repaid. Or, to state it more formally, to verify that the contractor's billing system procedures and internal controls are in place to assure timely identification and resolution of contract overpayments. We then listed the nine objectives of these audits. If you missed that posting, you may read it here.

Contract overpayments are payments that the contractor receives that are in excess of billed amounts. Usually overpayments occur because of contractor internal control weaknesses or paying office errors but could also occur because of contract administration adjustments. Contract administration adjustments include payments the contractor received in accordance with contract provisions which need to be reduced because of subsequent events or actions. Examples include progress payment adjustments due to a contract loss position, changes in contract billing prices, liquidation rates, and foreign exchange rates, quarterly limitation of payment adjustments, government withholds as a result of contract performance problems and settlement of final indirect rates, CAS noncompliances or postaward audits.

When the audit is initiated, the auditors will hold an entrance conference with the contractor and ask for quite a lot of information. For example, auditors are instructed to request a comparison of billed and paid amounts and then have the contractor explain its procedures for comparing amounts billed to amounts received at the invoice level, its accounting procedures for applying progress payment liquidations on delivery invoices and recording the net delivery invoice amount in the accounts receivable records for comparison to amounts received, and the process for resolving payment variances (including notifying the Government or prime contractor when overpayments are identified and retuning the overpayments). Additionally, the auditor is instructed to request a listing of all current outstanding payment variances, current accounts receivable and accounts payable aging reports.
 
Other information that will be requested include

• Listing of contract administration adjustments processed over the last 12 months (with explanations)
• Demand letters (Demand letters are letters issued by the paying office or contracting officer demandi9ng payment of specified amounts by the contractor. The demand letter notifies the contractor that amounts not paid with 30 days of the demand letter shall bear interest).
• Subcontractor billings
• Offsets (An offset is a reduction applied to an invoice submitted to the paying office as a means of resolving payments issues such as overpayments, contract administration adjustments, and paying office/contractor errors).
• Refunds (checks submitted to the Government).

Tomorrow we will continue this theme by detailing some of the specific steps that auditors might take once they obtain this initial information.

Audits of Contractor Overpayments

DCAA is stepping up its audits of contractor billing systems to determine whether there have been any overpayments. In a new audit program released last November entitled "Audits of Contractor Overpayments", DCAA signaled its support for OMB's "Payment Recapture Audit" initiative, also announced last November. You can read more about OMB initiative here. Essentially, the initiative was a challenge to all executive departments and agencies to increase their efforts to recapture improper payments by intensifying and expanding payment recapture audits. The memorandum makes some astonishing assertions such as "One of the biggest sources of waste and inefficiency is the nearly $110 billion in improper payments made in Fiscal Year (FY) 2009 it individuals, organizations, and contractors."

 

If the auditors have not yet been into your facility to look at billings, be they cost-reimbursement vouchers or progress payments, or T&M contracts, or invoices, they will be. Expect them, no matter your size. We will spend the next couple of days unpacking the new audit program to find out what it might mean for you.

The following is a listing of what the auditor will do during one of these audits. If your billing policies and procedures or your billing practices do not meet these standards, you are at risk.

1. Compare billings with cash receipts to identify contract overpayments and ensure amounts due the Government are refunded or offset in a timely manner;
2. Identify and resolve overpayments due to liquidation differences in a timely manner;
3. Reconcile recorded to billed costs to ensure costs are not over billed;
4. Identify contract administration adjustments to determine if adjustments are needed to billings and, if so, that they are computed correctly and appropriate refunds or offsets are processed timely;
5. Ensure timely and documented responses are prepared in response to demand letters;
6. Review contractors’ processes for monitoring subcontractor billings and identifying/resolving any overpayments timely;
7. Ensure offsets are properly authorized, adequately documented, and applied against billings for previously identified overpayments;
8. Ensure refunds are processed in a timely manner; and
9. Timely notification to the cognizant paying office and contracting officer timely of significant overpayments.

Profit on T&M Contracts

Contractors can earn profit on the labor component of T&M contracts but not on the material component.

The Government uses time-and-materials (T&M) contracts when it is not possible at the time of placing a contract to accurately estimate the extent or duration of the work or to anticipate costs with any reasonable degree of confidence. A T&M contract provides no positive profit incentive to the contractor for cost control or labor efficiency. Therefore, the Government usually increases its level of surveillance of contractor performance to provide reasonable assurance that efficient methods and effective cost controls are being used. T&M contracts are quite common even though the use of T&M as a contracting mechanism, is discouraged within FAR.

T&M contracts have a labor component and a materials component. The labor component consists of separate fixed hourly rates that include wages, fringe, overhead, general and administrative expenses and profit for each category of labor. The materials component is more broadly defined than what is typically considered material costs. Materials, in a T&M scenario, include direct materials, supplies, and other direct costs (e.g. incidental services for which there is not a labor category specified in the contract, travel, computer usage charges, etc.) and applicable indirect costs (FAR 16.601(a)). Note the absence of “profit” in this definition of materials. The actual contract clause included in T&M contracts, states it more specifically; “…the Government will not pay profit or fee to the prime Contractor on materials.”

Withholding or Withdrawing Purchasing System Approval

Last week, we discussed one of many important reasons for maintaining adequate purchasing systems – an approved system will facilitate the awarding of subcontracts. And a few weeks ago, we discussed the proposed DoD regulations that will require contracting officers to withhold billings whenever inadequacies are disclosed in certain internal control systems, including the purchasing system. Contractor purchasing systems are a big deal for the Government. An adequate purchasing system is one of the first lines of defense in ensuring the reasonableness of materials, purchased parts, and subcontracted items charged to Government contracts.


Today we want to address the process used by DoD to monitor and resolve purchasing system deficiencies. The process described is not dissimilar to that used by other agencies, however the DoD has taken the effort to formalize it in Part 244 of the DFARS (DoD FAR Supplement).

The ACO shall maintain a sufficient level of surveillance to ensure that the contractor is effectively managing its purchasing program. First of all, the administrative contracting officer (ACO) is solely responsible for initiating reviews of the contractor's purchasing systems, but other organizations may request that the ACO initiate such reviews. Those “other organizations” are often times DCAA (Defense Contract Audit Agency) or the PCO (Procuring Contracting Officer) or a PCO representative.

Whenever purchasing system weaknesses are identified, the ACO (or the purchasing system analyst (PSA) with the concurrence of the ACO) may initiate a special review of specific weaknesses. Weaknesses, according to PGI 244.304, may arise because of major changes in the contractor’s purchasing policies, procedures, or key personnel or changes in plant workload or type of work. Weaknesses may be discovered during reviews of subcontracts submitted under advance notification and consent or from information provided by Government personnel.

15, 10, and 10: At the conclusion of these reviews, regulatory timeframes kick in. The ACO is required to hold an exit conference with the contractor to present the review team’s recommendations and request the contractor submit a formal plan for correcting deficiencies or making improvements within 15 days. At this time, the ACO will not comment on the pending decision to grant or withhold approval of the purchasing system.

Once the corrective action plan is received from the contractor, the PSA (or whoever performed the review) has ten days to complete a report to the ACO. The ACO reviews the report and the contractor response before making any decision on granting, withholding, or withdrawing purchasing system approval. The ACO must notify the contractor within ten days of receiving the report.

When a contractor advises that it has corrected deficiencies that led the ACO to withhold or withdraw the purchasing system approval, the ACO will request the PSA to verify that the contractor has indeed corrected the deficiencies and implemented any other recommendations the ACO made. This is important for contractors to know. Contractors must initiate this phase whenever it has completed the corrective actions.

Merry Christmas from PNWC

We wish our many readers and clients a Merry Christmas

and a Successful 2011.

Bill, Paul, Ron, and Terry

Pacific Northwest Consultants



Recent Case Illustrates Dangers in Prime/Sub Relationships

Last week, a subcontractor prevailed in a suit brought against a prime contractor in Virginia's Fairfax Circuit Court. In this case, the prime subcontractor refused to reimburse its subcontractor for interim indirect rate variance invoices until the Defense Contract Audit Agency (DCAA) completed a final audit of the rates. (That could take a long long time given how far behind DCAA is in auditing final indirect rates - especially at small contractors) The prime contractor's position is of course, contrary to FAR 52.216-7, which allows for interim rate adjustments prior to contract closeout. Besides, the parties went through a lengthy and time consuming reconciliation process to verify the invoices and correct any mistakes. In addition, during the reconciliation process, a supervisor at the prime contractor stated in an e-mail to the subcontractor that "[i]t is unreasonable to expect you [the subcontractor] to wait for some undetermined amount of time for the DCAA to work your rate adjustments" and offered to pay 70% of the invoices.

However, before the prime contractor made the partial payments on the variance invoices, it reversed course and refused to pay the invoices. This decision occurred at a time when the prime and sub began competing for the same government contracts to provide linguistic services to support the war effort. In addition to failing to pay the invoices due, the prime also refused to provide past performance (when it had done so previously) and trashed the sub to the government client by falsely stating (without solicitation) in an e-mail "[t]he solvency of [the subcontractor] is an issue (not sure if they even still exist)…" The Court found that this was an attack on a competitor.

The Court ruled in favor of the subcontractor. The prime had to pay up $2.8 million In unreimbursed costs plus about a half million dollars in interest. Although we don't believe this happen very often, it does illustrate some of the dangers in subcontracting.

Profit on Cost of Facilities Capital?

FCCM (Facilities Capital Cost of Money) is allowable under FAR 31.205-10. Essentially, it allows contractors to claim an imputed interest on the capital costs employed when performing Government contracts. To overly simplify the process, the costs are calculated by multiplying net book value of assets (purchase price less depreciation) times the current "treasury rate" and then allocated to contracts (or proposals) over an equitable base - usually the same base used to allocate depreciation costs.

The question arises from time to time whether contractors can apply profit or fee on FCCM. The answer is 'no. FAR 15.404-4(c)(3) instructs contracting officers to exclude any FCCM from any cost objective amount before developing profit/fee positions.

By the way, if you've got assets you're using on your Government contracts and are not claiming FCCM, you're losing out on some allowable costs.

Consent to Subcontract - Part II

Contractors without Government approved purchasing systems must go through a long and tortuous process before they can subcontract any effort over $100 thousand or 5 percent of the (estimated) contract price. Yesterday we took a look at the data package that contractors must prepare and submit to the contracting officer for review and approval. If you missed that posting, you can read it here. Today we will explain the requirements placed upon the Contracting Officer in reviewing these Consent to Subcontract" requests.

The contracting officer responsibility for reviewing consent to subcontract requests is delineated in FAR Part 44. The overall objective of the contracting officer review is to ensure that the proposed subcontract is appropriate for the risks involved and consistent with current policy and sound business judgement. The contracting officer responsible for consent must, at a minimum, review the request and supporting data and consider the following:

• Is the decision to subcontract consistent with the contractor’s approved make-or-buy program, if any (see 15.407-2)?
• Is the subcontract for special test equipment, equipment or real property that are available from Government sources?
• Is the selection of the particular supplies, equipment, or services technically justified?
• Has the contractor complied with the prime contract requirements regarding—
• Small business subcontracting, including, if applicable, its plan for subcontracting with small, veteran-owned, service-disabled veteran-owned, HUBZone, small disadvantaged and women-owned small business concerns (see Part 19); and
• Purchase from nonprofit agencies designated by the Committee for Purchase From People Who Are Blind or Severely Disabled
• Was adequate price competition obtained or its absence properly justified?
• Did the contractor adequately assess and dispose of subcontractors’ alternate proposals, if offered?
• Does the contractor have a sound basis for selecting and determining the responsibility of the particular subcontractor?
• Has the contractor performed adequate cost or price analysis or price comparisons and obtained certified cost or pricing data and data other than certified cost or pricing data?
• Is the proposed subcontract type appropriate for the risks involved and consistent with current policy?
• Has adequate consideration been obtained for any proposed subcontract that will involve the use of Government-provided equipment and real property?
• Has the contractor adequately and reasonably translated prime contract technical requirements into subcontract requirements?
• Does the prime contractor comply with applicable cost accounting standards for awarding the subcontract?
• Is the proposed subcontractor in the Excluded Parties List System?

The guidance goes on to caution that particularly careful and thorough consideration under certain circumstances, especially these "high risk" considerations.

• The prime contractor’s purchasing system or performance is inadequate;
• Close working relationships or ownership affiliations between the prime and subcontractor may preclude free competition or result in higher prices;
• Subcontracts are proposed for award on a non-competitive basis, at prices that appear unreasonable, or at prices higher than those offered to the Government in comparable circumstances; or
• Subcontracts are proposed on a cost-reimbursement, time-and-materials, or labor-hour basis.

If a contracting officer cannot make these determinations based on the data provided in the consent package, the package will often be returned as "inadequate". Sometimes, if the deficiencies are not too significant, the contracting officer will simply request the contractor to submit the data that is missing. In any event, the process is extended.

Contracting officers do not have a statutory time frame for turning around these requests. We have seen everything from a few days to 60 days. In any event, if you are contemplating subcontracting out some of your work, you need to factor in the time it takes to prepare and obtain contracting officer approval of your consent to subcontract packages into overall contract performance.

Government's Consent to Subcontract

There is a procedure found in FAR Part 44 that applies to Government contractors who wish to subcontract some of its contracted effort. The procedure kicks in when a contractor does not have an approved Purchasing System although contractors with approved purchasing systems are not entirely off the hook if a contracting officer decides to specifically invoke the requirements because of he/she feels it is necessary to protect the Government's interest because of contract type, complexity, value, or because the subcontract needs special surveillance. DCMA (Defense Contract Management Agency) is the organization responsible for reviewing and approving a contractor's purchasing system. Without an approved purchasing system, contractors are required to submit substantial amounts of paperwork for contracting officer review, consideration, and approval.

If the contractor does not have an approved purchasing system, consent to subcontract is required for cost-reimbursement, time-and-materials, labor-hour, or letter contracts, and also for unpriced actions under fixed price contract greater than $100 thousand or five percent of the total estimated cost of the contract. That's a pretty low threshold. The data required to be submitted to support the "consent" request includes:

• A description of the supplies or services to be subcontracted
• Identification of the type of subcontract to be used
• Identification of the proposed subcontractor
• The proposed subcontract price
• The subcontractor’s current, complete, and accurate cost or pricing data and Certificate of Current Cost or Pricing Data if required by contract provisions.
• The subcontractor’s Disclosure Statement or Certificate relating to Cost Accounting Standards when such data are required by other provisions of this contract.
• A negotiation memorandum reflecting -
• The principal elements of the subcontract price negotiations;
• The most significant considerations controlling establishment of initial or revised prices;
• The reason certified cost or pricing data were or were not required;
• The extent, if any, to which the Contractor did not rely on the subcontractor’s certified cost or pricing data in determining the price objective and in negotiating the final price;
• The extent to which it was recognized in the negotiation that the subcontractor’s certified cost or pricing data were not accurate, complete, or current; the action taken by the Contractor and the subcontractor; and the effect of any such defective data on the total price negotiated;
• The reasons for any significant difference between the Contractor’s price objective and the price negotiated; and
• A complete explanation of the incentive fee or profit plan when incentives are used. The explanation shall identify each critical performance element, management decisions used to quantify each incentive element, reasons for the incentives, and a summary of all trade-off possibilities considered.

Tomorrow we will continue our discussion on "Consent to Subcontract" by explaining what the contracting officer does with this information, once received.

Excessive Pass-Through Costs

Back in October of 2009, the FAR Councils adopted an interim rule intended to ensure that contractors (or higher-tier subcontractors) do not receive indirect costs or profit/fee (i.e. pass-through costs) on work performed by subcontractors to which the contractor (or higher-tier subcontractor) adds no or negligible value. “No or negligible value” means the Contractor or subcontractor cannot demonstrate to the Contracting Officer that its effort added value to the contract or subcontract in accomplishing the work performed under the contract.


On December 13th, this interim rule became final (with some minor changes) with an effective date of January 12, 2011. This provision applies to most DoD contracts (exceptions include competitive and commercial procurements) above the TINA threshold (currently $700 thousand) and Civilian Agency cost-reimbursable contracts greater than the Simplified Acquisition threshold (currently $150 thousand). However, it can apply to contracts below these threshold's at the discretion of the contracting officer.

There are two provisions in this new rule. FAR 52.215-22 applies to solicitations and FAR 52.215-23 applies to contracts.

Solicitation Phase (FAR 52.215-22)

The prospective contractor must identify in its proposal the total cost of the work to be performed by the offeror, and the total cost of the work to be performed by each subcontractor. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed, the offeror must identify

• The amount of the offeror’s indirect costs and profit/fee applicable to the work to be performed by the subcontractor(s); and
• A description of the added value provided by the offeror as related to the work to be performed by the subcontractor(s).

Contracting Phase (FAR 52.215-23)

The Government will not pay excessive pass-through charges and it is the contracting officer's responsibility to determine whether excessive pass-through charges exist.

Contractors must notify the contracting officer in writing after contract award when the level of subcontracted effort exceeds 70 percent of the total cost of work to be performed. The notification must include the cost of the subcontracted effort and verification that the contractor will provide added value.
If the Contracting Officer determines that excessive pass-through charges exist, the excessive costs are unallowable - either by a reduction in billings or a price reduction, depending upon the type of contract.

The Government has the right to examine and audit all the Contractor’s records (as defined at FAR 52.215-2(a)) necessary to determine whether the Contractor proposed, billed, or claimed excessive pass-through charges.

 

Overview of GAO's Handling of Bid Protests

The GAOs (Government Accountability Office) “Watchdog Report” features interviews with GAO officials on significant issues and newly published reports. It is an audio report that is recorded, hosted, and produced by GAO staff (using your tax dollars). These reports are informative, often interesting, and sometimes pertinent to the Government contracting community. This week’s report is an overview of GAO’s handling of bid protests.


Bid protests are arguments brought by a protester that the Government somehow violated a federal procurement law or some regulation in the selection of a particular contractor. The number of bid protests has increase significantly in recent years for a variety of reasons that the GAO discusses in its Audio Watchdog Report. Take five minutes and listen to the report by clicking here.

Government Increasing Oversight on Awards to "Small Businesses"

The Administrator of the Office of Federal Procurement Policy said recently that the current administration supports set-asides for small businesses as long as there is sufficient oversight. “The days of ‘No one is checking’ are over. For too long, there was inadequate oversight.” Inadequate oversight could mean any number of things but based on recent events, it certainly includes the increasing use of ANCs (Alaska Native Corporations), the propriety of the “small business” self-certification, and the concerns that some small businesses are merely “fronts” for traditional businesses. We don’t think the concern extends to contract performance and cost allowability issues, but it might. For contract administration and audit coverage, small businesses are treated like any other Government contractor. So if there are concerns here, those concerns would apply equally to small and large businesses. Consider these recent events.

• Last October, the SBA suspended a large company from all government business when it found that the company had used two small firms to illegally get contracts. 
• The Department of Homeland Security has begun a review to examine whether small businesses are performing the proper amount of work themselves and not handing it off to subcontractors. 
• The Defense and Interior Departments are investigating a $250 million Army contract given to an inexperienced Alaska native corporation subsidiary after the Washington Post reported that the company received the contract without award and could not do the work itself. 
• The SBA Inspector General's Office also is investigating contractors that SBA officials said "entered in a relationship with a subcontractor in order to defraud the government."  
• Senator McCaskill introduced legislation that, if passed, will take away significant preferential treatment privileges from ANCs.

 

There is widespread concern that the programs designed to assist small business are being significantly abused. Whether the anecdotal evidence that has been reported is indicative of a much larger problem remains to be seen. Stay tuned.

 

 

 

Commercial Items, Government Access to Records

FAR Part 12 prescribes policies and procedures for acquiring commercial items. To qualify as a commercial item, the product or service must meet the definition of commercial item found in FAR 2.101. That definition is long and involved but essentially, a commercial item is one that is customarily used by the general public and has been sold (or at least offered) to the general public. The definition has evolved over the years as the Government tries to qualify more and more items as commercial items on the presumption that it can save money by buying commercially.

 

The question arises from time to time whether the Government has any access to records rights when it comes to commercial item procurement. Generally the Government does not have access, but there is one situation where the Government does have limited access rights – Time and Material (T&M) contracts. On commercial T&M contracts, the rates are established based on commerciality. However, the hours expended, claimed and billed must still be supported to the Government. Therefore the Government has the right to access whatever records are necessary to determine the propriety of claimed hours.

 

Specifically, FAR 52.212-4 (Alternate I) gives the Government the following access rights on commercially priced T&M contracts:

1. Records that verify that the employees whose time has been included in any invoice met the qualifications for the labor categories specified in the contract. 
2. For labor hours (including any subcontractor hours reimbursed at the hourly rate in the schedule), when timecards are required as substantiation for payment— 
• The original timecards (paper-based or electronic); 
• The Contractor’s timekeeping procedures; 
• Contractor records that show the distribution of labor between jobs or contracts; and 
• Employees whose time has been included in any invoice for the purpose of verifying that these employees have worked the hours shown on the invoices.
3. For material and subcontract costs that are reimbursed on the basis of actual cost—
• Any invoices or subcontract agreements substantiating material costs; and
• Any documents supporting payment of those invoices.

Long Term Agreements

A "Long Term Agreement" (LTA) is an agreement entered into between a prime contractor and a subcontractor to establish pricing for future purchases of specified items. FAR 15.404-3(c) allows prime contractors to reach price agreements with subcontractors prior to an agreement with the Government on the prime contract so LTAs are acceptable pricing methods.

LTAs can benefit both the contractor and the Government by providing better subcontract pricing due to a more stabilized business volume and reduced acquisition cycle times. There are two aspects of LTAs that the Government will be concerned about. The first is whether the the prime contractor adequately evaluated the cost or pricing data as of the date of agreement on the LTA price. Secondly, the Government will require contractors to demonstrate that the negotiated LTA prices continue to be fair and reasonable at the time the prime contract is negotiated.

Generally, there is no specific time period for which LTA pricing should be considered adequate. The market and other conditions must be reviewed on a case by case basis. In some cases, the LTA pricing may be adequate for several years while in other cases, a single month may find that the LTA pricing is no longer fair and reasonable. For example, if a subcontractor made significant changes to its manufacturing process that materially impacted costs, and those changes were not reflected in the negotiated LTA pricing, the negotiated LTA price would no longer be considered fair and reasonable.

LTAs can help facilitate and streamline the estimating and purchasing processes. Contractors need to perform some level of testing however, to assure the Government that the negotiated prices continue to be fair and reasonable.

Revised Rule on Contractor Business Systems - Part V

Today we are conclude (at least temporarily) our discussion on DoD’s revised proposed regulation that requires defense contractors to maintain adequate business systems or face Government withholds of their billings. The revised regulation maintains the core requirements of the earlier one – maintain adequate business systems or face withholds. One positive change, from contractors’ perspective, is the reduction in the maximum amount of withhold. Perhaps the most significant change to the revised proposal is its organization. Compared to the initial proposal’s slap-dash construction, the revised proposal is significantly better organized and internal inconsistencies have been fixed. It now lists, in appropriate context, the various criteria that each of the six systems must meet in order for that system to be considered adequate.


There are two systems that apply to most every Government contractor; the accounting system and the purchasing system. The other business systems such as Government Property, Material Management and Accounting Systems, and Earned Value Management Systems apply only in limited situations. So we will take a look at the fundamental requirements of accounting and purchasing systems.

Accounting System

In order for your accounting system to be considered “adequate”, it must provide for the following (note, you might recognize most of these attributes from the SF Form 1408, Preaward Survey of Prospective Contractor’s Accounting System):

1. A sound internal control environment and accounting framework and organizational structure that is adequate for producing accounting data that is reliable and costs that are recorded, accumulated, and billed on Government contracts in accordance with contract terms;

2. Proper segregation of direct costs from indirect costs;

3. Identification and accumulation of direct costs by contract;

4. A logical and consistent method for the accumulation and allocation of indirect costs to intermediate and final cost objectives;

5. Accumulation of costs under general ledger control;

6. Reconciliation of subsidiary cost ledgers and cost objectives to general ledger;

7. Approval and documentation of adjusting entries;

8. Periodic monitoring of the system;

9. A timekeeping system that identifies employees' labor by intermediate or final cost objectives;

10. A labor distribution system that charges direct and indirect labor to the appropriate cost objectives;

11. Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account;

12. Exclusion from costs charged to Government contracts of amounts which are not allowable in terms of Federal Acquisition Regulation (FAR) part 31, Contract Cost Principles and Procedures, and other contract provisions;

13. Identification of costs by contract line item and by units (as if each unit or line item were a separate contract), if required by the contract;

14. Segregation of preproduction costs from production costs, as applicable;

15. Cost accounting information, as required--

(i) By contract clauses concerning limitation of cost (FAR 52.232-20), limitation on payments (FAR 52.216-16), or allowable cost and payment (FAR 52.216-7); and

(ii) To readily calculate indirect cost rates from the books of accounts;

16. Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms;

17. Adequate, reliable data for use in pricing follow-on acquisitions; and

18. Accounting practices in accordance with standards promulgated by the Cost Accounting Standards Board, if applicable, otherwise, Generally Accepted Accounting Principles.

Purchasing System

A purchasing system is the contractor’s system or systems for purchasing and subcontracting, including make or buy decisions, the selection of vendors, analysis of quoted prices, negotiation of prices with vendors, placing and administering of orders, and expediting delivery of materials. The purchasing system must:

1. Have an adequate system description including policies, procedures, and purchasing practices that comply with the Federal Acquisition Regulation (FAR) and the Defense FAR Supplement (DFARS);

2. Ensure that all applicable purchase orders and subcontracts contain all flow-down clauses, including terms and conditions and any other clauses needed to carry out the requirements of the prime contract;

3. Maintain an organization plan that establishes clear lines of authority and responsibility;

4. Ensure all purchase orders are based on authorized requisitions and include a complete and accurate history of purchase transactions to support vendor selected, price paid, and document the subcontract/purchase order files which are subject to Government review;

5. Establish and maintain adequate documentation to provide a complete and accurate history of purchase transactions to support vendors selected and prices paid;

6. Apply a consistent make-or-buy policy that is in the best interest of the Government;

7. Use competitive sourcing to the maximum extent practicable, and ensure debarred or suspended contractors are properly excluded from contract award;

8. Evaluate price, quality, delivery, technical capabilities, and financial capabilities of competing vendors to ensure fair and reasonable prices;

9. Require management level justification and adequate cost or price analysis, as applicable, for any sole or single source award;

10. Perform adequate cost or price analysis and technical evaluation for each subcontractor and supplier proposal or quote to ensure fair and reasonable subcontract prices;

11. Document negotiations in accordance with FAR 15.406-3;

12. Seek, take, and document economically feasible purchase discounts, including cash discounts, trade discounts, quantity discounts, rebates, freight allowances, and company-wide volume discounts;

13. Ensure proper type of contract selection and prohibit issuance of cost-plus-a-percentage-of-cost subcontracts;

14. Maintain subcontract surveillance to ensure timely delivery of an acceptable product and procedures to notify the Government of potential subcontract problems that may impact delivery, quantity, or price;

15. Document and justify reasons for subcontract changes that affect cost or price;

16. Notify the Government of the award of all subcontracts that contain the FAR and DFARS flow-down clauses that allow for Government audit of those subcontracts, and ensure the performance of audits of those subcontracts;

17. Enforce adequate policies on conflict of interest, gifts, and gratuities, including the requirements of the Anti-Kickback Act;

18. Perform internal audits or management reviews, training, and maintain policies and procedures for the purchasing department to ensure the integrity of the purchasing system;

19. Establish and maintain policies and procedures to ensure purchase orders and subcontracts contain mandatory and applicable flow-down clauses, as required by the FAR and DFARS, including terms and conditions required by the prime contract and any clauses required to carry out the requirements of the prime contract;

20. Provide for an organizational and administrative structure that ensures effective and efficient procurement of required quality materials and parts at the best value from responsible and reliable sources;

21. Establish and maintain selection processes to ensure the most responsive and responsible sources for furnishing required quality parts and materials and to promote competitive sourcing among dependable suppliers so that purchases are reasonably priced and from sources that meet contractor quality requirements;

22. Ensure performance of adequate price or cost analysis on purchasing actions; and

23. Establish and maintain procedures to ensure that proper types of subcontracts are selected, and that there are controls over subcontracting, including oversight and surveillance of subcontracted effort.

Revised Rule on Contractor Business Systems - Part IV

Today we are continuing our discussion on the revised proposed regulation that requires defense contractors to maintain adequate business systems or face Government withholds of their billings. We will wrap this discussion up tomorrow even though we have only scratched the surface of this significant and far reaching proposed regulation. Today we will address some of the concerns that were raised relative to the resolution process and the timing for releasing amounts withheld. The news is not particularly good for contractors.


One concern cited frequently by respondents was the negative impact that withholds will have on contractor cash flows. DoD acknowledged that the application of the payment withhold will impact and reduce a contractor’s cash flow. However, DoD was not sympathetic to that concern. DoD is focused on protecting the Government’s interests during performance in an amount sufficient to mitigate the Government’s risk (whatever that means) when contractors fail to maintain business systems as required by the terms and conditions of their contracts. DoD did revise the language of the proposed regulation however to provide for the contracting officer, in concert with the auditor, to discontinue withholding payments prior to audit verification if the contractor submits evidence that the deficiencies have been corrected. We don’t know how that will work out in practical terms since DCAA will not opine on the adequacy of the corrective actions without performing an audit in accordance with Generally Accepted Government Auditing Standards. Nor should they. It seems disingenuous for DoD to state that the contracting officer can release funds prior to audit verification. If the contracting officer does decide to release withheld funds prior to audit verification, it will most certainly be without the consultation and advice from the audit community.

The initial proposed rule contained an inconsistency as to when withholds could be released. In one section, the proposed regulation stated that a finding of system noncompliance will be withdrawn when the contractor has ``substantially corrected'' the system deficiencies. However, elsewhere, the proposed rule states that the withhold will not be released until ``all deficiencies have been corrected.'' DoD resolved this inconsistency by eliminating the “substantially corrected” language. Again, this change, while eliminating an inconsistency, is not good news for contractors.

Several respondents expressed concern that the proposed rule provides incomplete guidance for ACOs to approve systems when deficiencies were identified. These respondents question whether the ACO's determination to reduce or discontinue the withholding of payments is discretionary, even if the contractor has corrected all deficiencies. DoD revised the rule language to state that the contracting officer shall discontinue the withholding of payments and release any payments previously withheld when the contracting officer determines that the contractor has corrected all system deficiencies after receipt of auditor verification. But here again, DoD confuses the situation by stating that the contracting officer, in consultation with the auditor or functional specialist, to discontinue withholding payments prior to audit verification if the contractor submits evidence that the deficiencies have been corrected. Which is it; after audit verification or before audit verification?

We will conclude our coverage of the contractor business system proposal tomorrow.

Revised Rule on Contractor Business Systems - Part III

Today we are continuing our discussion on the revised proposed regulation that requires defense contractors to maintain adequate business systems or face Government withholds of their billings. Today we want to address audits and audit followup. There were many comments to the initial proposal directed toward DCAA (Defense Contract Audit Agency) and DCMA (Defense Contract Management Agency). These are the agencies tasked with determining whether contractors’ business systems are adequate or inadequate, assessing the adequacy of the corrective action plans, judging when things are sufficiently “fixed” to release withhold amounts, and administering the withhold process. Reviews of the six business systems covered by this proposed regulation are jointly conducted by DCAA and DCMA although DCAA takes the lead in most of them. We will examine four of the concerns expressed by respondents to the initial proposal and DoD’s response to those concerns.


Coming from the current environment where DCAA is not getting anything accomplished, a number of respondents expressed concern that DCAA lacks the resources to perform required audits timely and adequately. DoD’s response provides little comfort in alleviating these concerns. DoD stated that “DCAA has committed to making follow-up business system audits a priority. However, DCAA recognizes that resources are limited, and has taken steps to address staffing challenges.” Perhaps since DCAA has effectively abandoned its “pricing” function (see our post on changes to pricing thresholds), it will have more resources dedicated to performing audits of contractor business systems and for performing followup reviews when needed.

One theme that was addressed in several ways were concerns that audit reports were not written with enough information to help the contracting officer make effective decisions nor do the audit reports include an analysis of the materiality of the deficiency. Recently DCAA instituted a pass-fail system and respondents asserted that the internal control deficiencies cited as a basis for failing a system audit sometimes had no relevance to Government contracting or imposed no risk on overcharging. DoD addressed this issue by stating “DCAA policy is to report only deficiencies determined to be significant deficiencies or material weaknesses in accordance with generally accepted Government auditing standards.” To bolster that policy, DoD revised the proposed rule language to state that ``the report shall describe the deficiencies in sufficient detail to allow the contracting officer to understand the deficiencies and potential adverse impact to the Government.''

A number of respondents believe that the recent Commission on Wartime Contracting (CWC) hearings demonstrated that greater cooperation must be achieved between DCMA and DCAA to oversee Government contractors properly, and that this issue should be addressed before imposing more regulations on contractors, especially as severe and broad as those proposed. DoD responded by stating that it is currently taking measures to improve coordination between DCMA and DCAA. One of those measures is this proposed regulation itself - intended to further improve the effectiveness of DCMA and DCAA oversight of business systems as recommended by the Commission on Wartime Contracting.

Somewhat related to item 1 above, two respondents suggested that DCMA and DCAA are under-resourced to execute the requirements of the rule, and that ACOs do not have the training to determine if a deficiency makes a system inadequate. DoD contends that “resource” issues are unrelated to effective oversight responsibilities. This proposed rule does not add additional oversight responsibilities onto DCAA or DCMA; it merely provides provisions to help protect the Government from the risks of loss due to a contractor’s failure to maintain business systems, as require by the terms and conditions of their contracts. DoD added that it is confident that contracting personnel will make appropriate determinations in accordance with this rule.

We will continue our coverage of the contractor business system proposal tomorrow.

Revised Rule on Contractor Business Systems - Part II

Yesterday we began a discussion on the revised proposed regulation that requires defense contractors to maintain adequate business systems or face Government withholds of their billings. The initial proposal came out in January 2010. Public comment was extensive and largely critical of the proposed action. Based on the 370 comments received, DoD made significant changes to the proposed regulation and has now reissued it for a second round of public comment. Today and for the next few days, we will be discussing some of the major changes in the revised proposal. Although extensive, these changes do nothing to alter the fundamental requirements of the proposed rule.


The underlying presumption behind the proposed regulation is that the Government may be at risk when contractor business systems contain deficiencies. This holds true regardless of contract type. The proposed rule concludes that “…it is appropriate for the ACO to withhold payments to protect the interest of the Government." The only contracts exempt from this rule are those awarded under FAR Part 12 regulations (commercial items). Other than that one exemption, contracts with the “clause” (eventually that will be all of them) will be subject to withhold.

There is some good news on the withhold percentages. A number of respondents expressed concern over the percentages to be withheld. For example, a number of respondents claimed that cumulative withholds of up to 50 percent per contract are unreasonable and therefore inappropriate. A few also thought that a maximum dollar amount to be withheld should be established.

As a result of these comments, DoD revised the proposed rule to reduce the amount that can be withheld for business system deficiencies from ten percent to five percent (two percent for small businesses). If and when he contractor submits an acceptable corrective action plan, the contracting officer will reduce the withholding to two percent (one percent for small business). The contracting officer will authorize the contractor to bill for amounts previously withheld when the contracting officer determines all deficiencies have been corrected.

Additionally, DoD revised the rule to reduce the cumulative percentage of payments that can be withheld on one or more business systems from 50 to 20 percent (10 percent for small businesses). This limitation refers to the amount that can be withheld on any payment if deficiencies exist in one or more business systems.

DoD did not move on its refusal to establish a maximum dollar amount that could be withheld, calling that idea “inappropriate”.

We will continue our coverage of the contractor business system proposal tomorrow.

Update on Proposed DoD Regulations on Contractor Business Systems

On January 15, 2010, DoD published proposed regulations that will require contracting officers to withhold billings when certain contractor business systems are found to be inadequate. The proposal covered six different business systems including:

• Accounting
• Estimating
• Purchasing
• EVMS (Earned Value Management System)
• MMAS (Material Management and Accounting System), and
• Government Property

The purpose of the proposed rule is good and noble. It acknowledges that contractor business systems and related internal controls are the first line of defense against waste, fraud, and abuse. Weak control systems increase the risk of unallowable and unreasonable costs getting charged to Government contracts. To many in the contracting community however, there seems to be no consequence for inadequate business systems and poor internal control systems. The proposed rule should, according to DoD, improve the effectiveness of Defense Contract Management Agency (DCMA) and Defense Contract Audit Agency (DCAA) oversight of contractor business systems.

The comment period on the proposed rule ended March 16, 2010. In all, 370 comments were received from 25 respondents. As a result of the comments received, DoD made significant changes to the proposed regulation and has reissued a revised proposed regulation. The comment period for the revised regulation ends January 11, 2011. 

We had a lot of reservations about the proposed regulation and have written extensively about it in this blog. Our main concerns were the subjectivity involved in determining whether a particular business system is adequate or not and the punitive withholding percentages which, if assessed, could adversely affect some contractors by disrupting cash flows. In reviewing the revised proposal, we still have those concerns.

Over the next few days, we will unpack and highlight the major changes in the revised 60 page proposal. To review earlier summaries and commentary on the initial proposal, read the following posts.

The Cost of Compliance is About to Increase
Withholds for Inadequate Business Systems
Inadequate System? How Much will the Government Withhold?
Business System Requirements - Purchasing
Business System Requirements - Accounting
Business System Requirements - Estimating
Business System Requirements - MMAS
Business System Requirements - Earned Value Management
Business System Requirements - Government Property

Work that Government Employees May Not Perform for Contractors

Yesterday we discussed the topic of inherently governmental functions and the prohibition against contracting for any services that are considered inherently governmental. There are similar prohibitons on Government personnel performing contractor functions. Now this might surprise some of you who have "hosted" Governmental audit and contract administration personnel - especially when those folks are permanently in residence at contractor locations. There is seemingly no limit to their intrusion into the perogatives of contractor management. But there are limits and its good for contractors to know those limits. Generally, Government employees may not:

• Supervise contractor employees
• Stipulate contractor duty hours
• Require contractor employees to report to them
• Maintain contractor personnel records/time cards
• Approve leave for contractor employees
• Approve bonuses for contractor employees
• Develop duty rosters including names of contractor employees

As a general rule, Government employees should not be involved in contractors’ personnel decisions. Federal employees’ participation in contractors’ hiring and firing decisions clouds the traditional and appropriate allocation of contract performance and cost risks between the Government and the contractor. That allocation is embedded in the contract (via the federal procurement process, e.g., by the choice of source selection technique, contract type, terms, and conditions).

 

In rare cases, there might be circumstances where, due to the nature of the services or supplies being procured, a pressing Federal interest in the contractor’s selection of certain employees may call for some Federal officials’ involvement in the hiring decision. In those instances, the risks of violating the prohibitions regarding personal services or inherently governmental functions and of muddying the contractual relationship must be explicitly acknowledged. Then they must be appropriately mitigated, preferably by written communication from the contracting officer that includes the rationale for Federal involvement. An example of a Federal action that would be appropriate in some cases is the contracting officer’s expressing to contractor management that a contractor employee performed poorly in a critical area (e.g., safety or security) and should not continue to be assigned to that area. It would never be appropriate for any Federal official to direct or imply to the contractor that the employee should be terminated.

 

Government employees, such as procurement contracting officers, administrative contracting officers, contracting officer technical representatives, and auditors must not:

 

• Direct a contractor to hire a particular individual (but they may provide the contractor with the names of individuals that are competent)
• Direct a contractor to fire a particular individual
• Design work requirements around a single individual

Inherently Governmental Functions

It is sometimes difficult to determine which direction the Government is headed when procuring the goods and services it needs to function. We hear of great cost savings claims made to support outsourcing many services and functions. At the same time, we hear that the Government could save money by "in-sourcing". Related to the in-sourcing/outsourcing discussion is the concept of "inherently governmental functions".

Contractor employees may perform many functions for or on behalf of the Government. However, they may never perform "inherently governmental" functions. Contractor employees would be performing inherently governmental functions, for example when they exercise discretion in committing the government to a particular course of action and their decisions are not substantially limited by existing policies, procedures, and other guidance. The inherently governmental function issue concerns violating the precept that certain activities are so intimately related to the public interest as to require only Federal employees perform them. The Government must ensure contractor employees do not perform inherently governmental functions, including any of following examples, which are listed at FAR 7.503(c). Note, this listing is not exclusive:

 

• The direct conduct of criminal investigations
• The control of prosecutions and performance of adjudicatory functions other than those relating to arbitration or other methods of alternative dispute resolution
• The command of military forces, especially the leadership of military personnel who are members of the combat, combat support, or combat service support role
• The conduct of foreign relations and the determination of foreign policy
• The determination of agency policy, such as determining the content and application of regulations, among other things
• The determination of Federal program priorities for budget requests
• The direction and control of Federal employees
• The direction and control of intelligence and counter-intelligence operations
• The selection or non-selection of individuals for Federal Government employment, including the interviewing of individuals for employment
• The approval of position descriptions and performance standards for Federal employees
• The determination of what Government property is to be disposed of and on what terms (although an agency may give contractors authority to dispose of property at prices within specified ranges and subject to other reasonable conditions deemed appropriate by the agency)
• In Federal procurement activities with respect to prime contracts
• Determining what supplies or services are to be acquired by the Government (although an agency may give contractors authority to acquire supplies at prices within specified ranges and subject to other reasonable conditions deemed appropriate by the agency)
• Participating as a voting member on any source selection boards
• Approving any contractual documents, to include documents defining requirements, incentive plans, and evaluation criteria
• Awarding contracts
• Administering contracts (including ordering changes in contract performance or contract quantities, taking action based on evaluations of contractor performance, and accepting or rejecting contractor products or services)
• Terminating contracts
• Determining whether contract costs are reasonable, allocable, and allowable; and
• Participating as a voting member on performance evaluation boards
• The approval of agency responses to Freedom of Information Act requests (other than routine responses that, because of statute, regulation, or agency policy, do not require the exercise of judgment in determining whether documents are to be released or withheld), and the approval of agency responses to the administrative appeals of denials of Freedom of Information Act requests
• The conduct of administrative hearings to determine the eligibility of any person for a security clearance, or involving actions that affect matters of personal reputation or eligibility to participate in Government programs
• The approval of Federal licensing actions and inspections
• The determination of budget policy, guidance, and strategy
• The collection, control, and disbursement of fees, royalties, duties, fines, taxes, and other public funds, unless authorized by statute, such as 31 U.S.C. 952 (relating to private collection contractors) and 31 U.S.C. 3718 (relating to private attorney collection services), but not including
•  Collection of fees, fines, penalties, costs, or other charges from visitors to or patrons of mess halls, post or base exchange concessions, national parks, and similar entities or activities, or from other persons, where the amount to be collected is easily calculated or predetermined and the funds collected can be easily controlled using standard case management techniques and
• Routine voucher and invoice examination
• The control of the treasury accounts
• The administration of public trusts
• The drafting of Congressional testimony, responses to Congressional correspondence, or agency responses to audit reports from the Inspector General, the Government Accountability Office, or other Federal audit entity

Earmarks

Leading up to the mid-term elections and continuing even now has been controversy over whether earmarks are good or bad, necessary or needless, affordable or budget-busters. Some senators and representatives have proposed to ban them or set up a moratorium. Its probably a safe bet to presume that earmarks (or "plus-ups") will survive in one form or another. This is a good time to revisit this area in terms of the allowability of earmark activities charged to Government contracts.

A legislative earmark refers to a Congressional provision directing funds to be spent on specific projects. Typically, a legislator seeks to insert earmarks in spending bills that direct a specified amount of money to a particular contractor, organization, or project in his or her home state or district. The fiscal year 2008 DoD appropriations act included 2,092 earmarks valued at $6.6 billion. Government contractors sometimes expend a significant amount of effort and related costs to support earmarks associated with specific contractors and programs. These costs generally meet the definition of lobbying costs as defined in FAR 31.205-22 and considered unallowable on Government contracts.

Government auditors are especially tuned to the possibility of unallowable lobbying effort at contractors receiving earmark funding. There are a number of public and FOUO (for official use only) sources for information on which contractors received earmarks and the amount. As part of their audit effort, auditors are instructed to make inquiries to determine procedures the contractor uses to identify and collect the costs related to support earmarks.

Lobbying effort associated with earmarks is not necessarily limited to company executives and hired lobbyists. Auditors are going to inquire about program management, contracting, public relations, consultants and technical personnel. Auditors will interview responsible contractor personnel to ascertain the nature and extent of effort provided to support any identified earmarks. Additionally, they will also consider the existence of "directly associated costs" such as travel and conference expenses.

If you have pursued earmarks in the past, you should assess whether any costs associated with those activities have crept into billings to the Government. If you intend to pursue them in the future, you need to establish controls that ensure any unallowable costs are identified, segregated, and removed from any billings to the Government.