Senator McCaskill to Hold New Hearing on DCAA

Sen. McCaskill's Subcommittee on Contracting Oversight (The Senate Committee on Homeland Security and Governmental Affairs) will be holding a hearing tomorrow on "Improving Federal Contract Auditing". According to the committee's website,

The hearing will examine how federal agencies use contract audits to detect and prevent waste, fraud, and abuse in government contracts. In particular, the hearing will review the findings of the Subcommittee’s ongoing investigation of the type and number of contract audits at federal agencies. The hearing will also examine the role played by the Defense Contract Audit Agency (DCAA) in performing contract audits for agencies other than the Defense Department.

As you might recall, this is the Senator who in a previous hearing called the deficiencies disclosed in DCAA audits "capital crimes" and tweeted "the top of my head is about to pop off". It wouldn't surprise us if there will be more quotable moments at this hearing.

If you would like to watch the hearing live, follow this link. Its starts at 2:30 PM (East Coast Time).

On a somewhat related note, contractors are now complaining that DCAA has gotten too strict. If you missed the recent Washington Post article, follow this link. The gist of the article is that DCAA is increasing its levels of transaction testing and contractors are spending more time and effort to be responsive to those queries.

Auditor Jargon Part 6 - Material and Immaterial

The terms "material" and "immaterial" are part of the accounting lexicon. Accountants and auditors use these terms with hardly a passing thought but in a way that is readily understood among themselves. The terms represent well established concepts used to assess the significance of whatever cost is being examined at a particular moment. Materiality enters into risk assessments, in deciding whether to pursue a "finding", or whether to report an internal control deficiency. If something is determined to be immaterial, its not going to be pursued, quantified, or reported upon.

To illustrate, suppose you buy a $10 waste basket that will last 10 years. The accounting matching principle requires that you record the asset and depreciate it over those 10 years at $1 per year. The materiality principle allows you to expense the entire $10 in the year it is purchased. No one is going to get excited about $1 per year. Likewise, an auditor reviewing costs charged to Government contracts will focus on large dollar items because low cost resistors, capacitors, machine screws, or lubricating oil isn't going to significantly affect costs charged to the Government.

In financial reporting (e.g. a company's audited financial statements) the auditor issues an opinion on the financial statements as a whole. The opinion does not state that the financial statements are accurate down to the nickle. The opinion states that the financial statements present fairly in all material respects the financial position of the company. Determining what is material or immaterial therefore requires the exercise of professional judgment.

While the Financial Accounting Standards Board (FASB) and the Cost Accounting Standards Board (CASB) have refrained from giving quantitative guidelines for determining materiality, a few common standards have developed in the accounting industry and public accounting practice. One of those is the five percent rule; an error or misstatement equal to 5 percent of pretax net income or gross profit, or amount proposed.

While avoiding definitive guidelines, the Government, through the CAS Board, has issued some guidelines for assessing materiality (see CAS 9903.305)

In determining whether amounts of cost are material or immaterial, the following criteria shall be considered where appropriate; no one criterion is necessarily determinative:

• The absolute dollar amount involved. The larger the dollar amount, the more likely that it will be material.
• The amount of contract cost compared with the amount under consideration. The larger the proportion of the amount under consideration to contract cost, the more likely it is to be material.
• The relationship between a cost item and a cost objective. Direct cost items, especially if the amounts are themselves part of a base for allocation of indirect costs, will normally have more impact than the same amount of indirect costs.
• The impact on Government funding. Change3s in accounting treatment will have more impact if they influence the distribution of costs between Government and non-Government cost objectives than if all cost objectives have Government financial support.
• The cumulative impact of individually immaterial items. It is appropriate to consider whether such impacts:
• Tend to offset one another, or
• Tend to be in the same direction and hence to accumulate into a material amount.
•  The cost of administrative processing of the price adjustment modification shall be considered. If the cost to process exceeds the amount to be recovered, it is less likely the amount will be material.

CAS 409 - Depreciation of Tangible Capital Assets

CAS 409 - Depreciation of Tangible Capital Assets. CAS 409 is the second half of the capitalization/depreciation standards. Yesterday we discussed CAS 404, Capitalization of Tangible Assets and today we discuss how those capital assets should be depreciated. This Standard came about in order to "enhance objectivity and consistency" in allocating depreciation costs to Government contracts. For companies with a significant number of capital assets, this standard will require extensive record-keeping.

The first thing the standard requires is that contractors estimate residual values for all assets (or groups of assets). Residual value is deducted from capitalized value to determine the depreciable cost base. The Standard generally prohibits contractors from depreciating assets below their residual value unless residual values are immaterial. .

The next thing contractors need to determine is how long the assets are going to last - the estimated service life. The estimated service life of the tangible capital asset, over which the depreciated cost is assigned, must reasonably approximate the actual period of usefulness to its current owner, considering such factors as obsolescence and required quality and quantity of output. Here's where it gets tedious. The standard requires contractors to maintain adequate records which identify the age of the asset or asset group at retirement or withdrawal from active use. These records should contain such information as asset acquisition/disposition dates, date asset was withdrawn from active service, and any other factors that directly influence asset lives.

If supporting records are not available on the date the contractor must first complywith the standard, the estimated service lives should be those used for financial accounting. However, the required supporting records must be developed by the end of the second fiscal year after that date and used as a basis for estimated service lives on assets subsequently acquired. When a new asset is acquired for which the contractor has no available data or prior experience, the estimated service life must be based on projection of the expected useful life using IRS Revenue Procedure Guidelines.

After determining residual values and useful lives, contractors must then determine the depreciation methodology. Contractors may select any appropriate method of depreciation which reflects the pattern of consumption of services over the life of the asset. For example, an accelerated method is appropriate where the expected consumption of services is greatest in the early years of the asset life. The method used for financial accounting is usually appropriate for contract costing unless it does not reasonably reflect expected consumption.  The method used for income tax purposes is almost never appropriate for contract costing purposes because it does not approximate the consumption of services over the life of the asset.

Depreciation costs are generally allocated as indirect costs to the cost objectives for which the assets provide service. They may be charged directly to cost objectives at average rates only if the charges are based on usage and the costs of all like assets used for similar purposes are also charged directly. Depreciation costs for assets included in service centers, where significant, must be charged to the service center.

CAS 404 - Capitalization of Tangible Assets

CAS 404 - Capitalization of Tangible Assets. Cost Accounting Standard 404 establishes criteria for determining the acquisition costs of tangible assets which are to be capitalized. It does not cover depreciation or disposition of fixed assets. Depreciation and disposition is covered under CAS 409 which we will look at tomorrow.

This standard requires contractors to capitalize the acquisition cost of tangible assets in accordance with a written policy that is reasonable and consistently applied. There is an emphasis here and an expectation that the policy will be in writing. The written policy must include the following:

1. A minimum service life criterion which shall not exceed two years but which may be a shorter period. This is logical. Companies "expense" rather than "capitalize" short-lived assets.
2. A minimum acquisition cost criterion which shall not exceed $5 thousand but may be a smaller amount. The acquisition cost criterion is something that contractors should carefully consider and probably discuss with their IPAs (Independent Public Accountant). A $5 thousand capitalization threshold could significantly distort the financial statements of small businesses. Based on our experience, a $1 thousand capitalization threshold seems to be very common among small businesses.
3. Identification of the asset accountability units to the maximum extent practical. An "asset accountability unit" is defined elsewhere in CAS 404 as a tangible capital asset which is a component of plant and equipment that is capitalized when acquired or whose replacement is capitalized when the unit is removed, transferred, sold, abandoned, demolished, or otherwise disposed of. Typically this applies when there are buildings or complex manufacturing equipment.
4. Establishment of minimum dollar amounts for the capitalization of original complements of low cost equipment and for betterments and improvements.  "Original complement of low cost equipment means a group of items acquired for the initial outfitting of a tangible capital asset or an operational unit, or a new addition to either. The items in the group individually cost less than the minimum amount established by the contractor but in the aggregate, represent a material investment.

CAS 404 also requires that "acquisition costs" include not only the purchase price but all costs necessary to prepare the asset for use. This includes the cost of placing the asset in location and bringing the asset to a condition necessary for normal or expected use such as shipping, initial inspection and testing, installation, and similar expenses.

Thirdly, CAS 404 requires that costs incurred subsequent to the acquisition of a tangible capital asset which result in extending the life or increasing the productivity of that asset (e.g. betterments and improvements) shall be capitalized. Costs incurred for repairs and maintenance to a tangible capital asset which either restore the asset to, or maintain it at its normal or expected service life or production capacity shall be treated as costs of the current period. This is perhaps the most contentious aspect of the Standard because it requires the exercise of judgment. When does an expenditure extend the life or increase the productivity of the asset and when does the expenditure merely represent a repair cost?

CAS 404 is not highly technical but there have been a number of contractor noncompliances over the years. The ones that we have seen involve inadequate written policies and procedures (i.e. the written policies and procedures did not cover the minimum requirements) and a disagreement over the definition of "repair and maintenance" (it was too broad and included elements of "betterments and improvements").

2011 Standard Mileage Rates

Last month, the Internal Revenue Service issued the 2011 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business.

Beginning on Jan. 1, 2011, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be 51 cents per mile for business miles driven. This is a reduction from the 2010 rate of 50 cents per mile but still well under the 2009 rate of 55 cents per mile. The mileage rate for 2011 reflect generally higher transportation costs compared to a year ago. It is based on an annual study of the fixed and variable costs of operating an automobile.
 
If gasoline prices keep rising as they have in the past month or so, we may see a mid-year adjustment to this rate like we saw in 2008 where the rate was 50.5 cents per mile for the first half of the year and 58.5 cents per mile for the second half.

FAPIIS Information Set to Go Public

Last April, the Government launched its contractor responsibility database called FAPIIS (Federal Awardee Performance and Integrity System). The purpose of this database is to enhance the government's ability to evaluate the business ethics and quality of prospective contractors competing for Federal contracts. Access has been limited to Government acquisition personnel for use in making responsibility determinations prior to award of a contract. 

The FAPIIS data base tracks five years worth of contractor misconduct and performance data. It includes criminal, civil, and administrative proceedings (input by contractors and prospective contractors through the CCR system), past performance evaluations, records of suspensions and debarments, administrative agreements issued in lieu of suspension or debarment, nonresponsibility determinations, terminations for default, defective pricing determinations, and instances where a contractor's behavior "might" have put its employees in harm's way. Also, cases where procurement officials denied or reduced contractor's award fees because of reckless or negligent behavior must now be disclosed. For contracts above the simplified acquisition threshold (currently $150 thousand), contracting officers must check the FAPIIS data base and document (in writing) its responsibility determination.

On January 24, 2011, the FAR Councils published an interim rule that will make all information in the FAPIIS database, except for past performance data, publicly available on April 15, 2011. The actual wording states that all information posted by contractors, offerors, and the Government after April 15, 2011 will be made publicly available which presumably means that data already in the database will not be made available to the public. There is a 60 day public comment period however since this new regulation is required by statute (section 3010 of the Supplemental Appropriations Act of 2010), don't count on significant revisions.

As expected, Government watchdog groups are enthusiastic about the increased transparency available through this new regulation while contractors and industry groups are not. A PSC (Professional Services Council) representative stated that "Making this data public opens the door to all kinds of misperceptions, misunderstandings and even mischief.” The Government is aware of these concerns and is emphasizing the importance of ensuring the integrity of the data base, cautioning procurement officials to redact company proprietary data, avoid information related to pending litigation, and give "thought and consideration" to the information they enter.

If you would like more information on FAPIIS, watch this short Federal Acquisition Institute trailer.

New Government Contractor Survey Shows Unsurprising Results

The accounting firm of Grant Thornton just published the results of its 16th annual government contractor industry survey. This survey is intended "...to measure the impact of new requirements in Government contracting regulations, as well as the effects of changing priorities in the enforcement of procurement regulations by Government personnel involved in the procurement process". We didn't find a reference in the study as to the number of contractors surveyed but one news article reported there were more than 100 companies. The study did say that these companies came from 26 States plus the District of Columbia. Here are some of the highlights from the executive summary section.

• 55% of the companies experienced increased revenues from Government sources.
• Only 28% foresee modest growth as a result of Government stimulus programs. The other 72% expect no significant impact.
• Of the companies surveyed, 32 filed bid protests with GAO. Eleven were sustained.
• 47% of the companies lost employees as a result of Government "insourcing" activities.
• Here's something to use as a benchmark. Average labor multipliers are 2.3 for work in company facilities and 1.9 for work at customer (e.g. Government facilities) site. The difference represents "facility costs".
• These companies reported a 35% win rate on proposals submitted to the Government.
• EVMS seems like a waste of resources. Only 37% believe that EVMS is a cost-effective management tool and 75% of them would discontinue the system if they had a choice.
• 14% of companies reported deteriorating relationships with DCAA while 12% reported improvement.
• 74% of companies consider the Government to be slow and inefficient in addressing issues. 56% of those believe that the inefficiencies are caused by DCAA auditors.

If you would like to read the complete "Highlights Book", click here.

DCMA Rebuilding its Cost/Pricing Capability

Last September, DoD revised its guidance to limit contracting officer requests for audits of contractor proposals to fixed price proposals over $10 million and cost-type proposals over $100 million. According to one estimate, this is going to leave about $92 billion (in 2009 dollars) unaudited by DCAA. Stepping in to fill that gap to review under threshold pricing actions will be the Defense Contract Management Agency (DCMA). The Agency has been working for some time now to rebuild its cost/pricing capability.

In 2010, DCMA re-established pricing branches at all of its Contract Management Offices (CMOs) and hired 30 new pricing branch chiefs. It also hired 150 new cost/price analysts and cost monitors by May of last year with a target to hire a total of 200 by the end of the fiscal year. It also has plans in place to hire 100 new engineers to provide technical support to negotiations.

DCMA also established a new cost and pricing center. It created five hub sites to assist CMOs with pricing expertise, training and specialized assistance/surge capacity. It hired experts in CAS and indirect costs.

DCMA claimed to have improved its forward pricing rate engagements. The Cost and Pricing Center now reviews all FPRAs (forward pricing rate agreements) prior to finalization. It issued guidance to re-establish formal cost monitoring programs and it plans to engage with its customer base (buying commands) to increase their involvement in the forward pricing rate process.

Additionally, DCMA is developing a capacity to conduct overhead should cost reviews and it is creating training programs to meet the demands of an influx of new cost/pricing employees.

DCMA also has plans for this fiscal year for rebuilding its cost/pricing capability. It plans to hire an additional 100 cost/pricing personnel (that's above the 200 hired in 2010). It plans to provide more internal oversight of the FPRA process, improved advance planning of overhead should cost reviews, improve relations with DCAA by ensuring priorities are better communicated and coordinated between the two agencies, increase coordination with program offices in forward pricing rate and proposal pricing collaboration efforts.

The question remaining to be answered is whether DCMA can deliver its new cost/pricing advisory services in a timely manner.

Generally Accepted Accounting Principles (GAAP)

The Standard Form 1408 (Preaward Survey of Prospective Contractor Accounting System) is used to document the Government's assessment of whether a contractor's accounting system is acceptable for the award of the prospective contract. The conclusion on whether a system is adequate or not will depend on the type of contract (or subcontract) contemplated. There are differing requirements for fixed price, cost type and T&M (time and materials). The Government organization in charge of assessing the adequacy of an accounting system will tailor the review for the contract type contemplated. If you have not been through an accounting system review, it would be useful to download the form (just search on the term "SF Form 1408") to see how close your accounting system comes to meeting the Government's expectations. Alternatively you can hire an outside firm (such as Pacific Northwest Consultants) to come in and perform a "mock audit". A "mock audit" should identify any weaknesses in your accounting system and provide an opportunity to take corrective actions before the official audit begins.

The first attribute addressed by the form is whether the system is maintaine in accordance with Generally Accepted Accounting Standards (GAAP). If your company has had an outside audit, reivew, or compilation by an independent accounting firm (a CPA firm), this is easy to answer - just refer to the auditor's opinion. However, for companies that have not had outside assessments of their financial position (and that's most small businesses), it is a little more difficult to make that assessment.

In June 2009, the FASB (Financial Accounting Standards Board) issued FAS (Financial Accounting Standard) No. 168 which approved the ASC (Accounting Standards Codification) as the single source of authoritative non-governmental U.S. GAAP for financial statements. At that time, all existing GAAP pronouncements were superseded. The objective of the ASC project was to integrate and combine existing GAAP pronouncements into one authoritative GAAP. In determining whether your accounting system is compliant with GAAP, you need to consult the ASC. You can access GAAP free of charge under the "basic view" on the FASB website. 

The SF Form 1408 is sometimes completed by non-accountants as a "desk review". Sometimes the scope of the review might be as simple as asking a contractor if they have an accrual basis accounting system. If the contractor (or prospective contractor) answers in the affirmative, the non-accountant will most likely check "yes" to that accounting system attribute. If a Government Audit Organization (such as DCAA) is performing the accounting system review, they will not rely solely on contractor assertions and representations but will also perform substantive testing to ensure that the system is maintained on an accrual basis and compliant with applicable GAAP. The problem with a faulty pre-award review manifests itself when it comes time to get paid. The Government might perform a Post-award accounting system review or a billing system review, or a provisional billing rate review prior to approving any payment requests. Any deficiencies at this juncture will need to be fixed before payment is approved.

The best advise is to ensure you bring your accounting system into compliance before pursuing Government contracts. It will facilitate all aspects of contracting including estimating, accounting, and billing.

Contractor Notification Letters

Auditors are required by GAGAS (Generally Accepted Government Auditing Standards, aka the GAO "Yellow Book") to communicate certain information regarding their understanding of the services to be performed. This communication is to be in writing and is addressed to both the requester and the contractor to be audited. This is to occur during the planning stage of the audit, before any "field work" begins. Specifically, the GAGAS 6.07 requires the following minimum information;

• The nature, timing, and extent of planned testing and reporting
• The level of assurance the auditor will provide
• Any potential restrictions on the audit report

Often times, Government auditors (especially DCAA) will forgo written communication and simply communicate verbally with contractors during an entrance conference. This does not fully comply with GAGAS requirements and contractors should insist on a formal notification letter. Recently, DCAA issued guidance reminding auditors of the GAGAS requirements to issue Contractor Notification Letters.

A typical notification letter pertaining to an audit of a price proposal might read something like this:

We received a request from the ACO at Wright Patterson AFB to examine your January 1, 2011 CPFF proposal submitted in response to Solicitation No. F1468-11-R-0001 to determine if the proposed costs are acceptable as a basis to negotiate a fair and reasonable contract price.

Our audit will include

• Gaining an understanding of the contractor's internal controls, assessing control risk, and determining the extent of audit testing needed based on the control risk assessment
• Examining, on a test basis, evidence supporting the amounts and disclosures in the proposal
• Assessing the accounting principles used and significant estimates made by the contractor
• Evaluating the overall proposal presentation
• Determining the need for technical specialist assistance

We will evaluate the proposed costs using the applicable requirements contained in the

• FAR
• Agency FAR Supplements
• CAS (if applicable

We will start our audit on or about January 15, 2011 and expect to issue the report expressing an opinion on whether the proposed costs are acceptable as a basis to negotiate a fair and reasonable contract price on approximately February 15, 2011. The audit report will be subject to the following restrictions:

• The contents of the report should not be released or disclosed, other than to those persons whose official duties require access, without the approval of the Contracting Officer
• The report will be subject to the restrictions of 18 USC 1905 which restricts the disclosure of proprietary information and if the information is contractor bid or proposal or source selection information, 41 USC 423 which restricts disclosure of contractor bid or proposal or source selection information
• If the report is on a subcontractor proposal/submission, the release of the report or specific information in the report to the higher-tier contractor will be restricted if the subcontractor objects to the release.

Just to reiterate, if a Government audit organization does not provide you a notification letter, you should request one.

CAS 406 - Cost Accounting Period

CAS 406 - Cost Accounting Period. The purpose of CAS 406 is to provide criteria for selecting the time periods to be used as cost accounting periods for accumulating and reporting costs. At the time of its promulgation, the CAS Board felt it was necessary to reduce the effects of variations in the flow of costs within each cost accounting period. Secondarily, it could also enhance objectivity, consistency, and verifiability and promote uniformity and comparability in contract cost measurements.

The fundamental requirement of CAS 406 requires contractors to use a cost accounting period that lines up with its fiscal year (or some other 12 month period if agreed to by the Government). So when you forecast indirect rates, those rates should be based on a fiscal year. When submitting final indirect expense rates, the final rates should be based on a fiscal year.

This is pretty much a common sense requirement. What else would a contractor legitimately base a rate calculation on other than its fiscal year. Perhaps some contractors were using partial years' data on which to to base indirect rates rates and by using partial year data, was able to skew the results somehow. In the Standard's preamble comments, there was concern expressed that the use of partial year data could increase costs to the Government. But the main problem that the Standard addressed it "The lack of a firm requirement specifying the cost accounting period to be used."

Until last year, we could have said that we had never seen a CAS 406 noncompliance audit report issed. In 2010, one DCAA office issued a CAS 406 noncompliance which has yet to be resolved and will probably be thrown out by the contracting officer since there is no cost impact. It involved an indirect function that existed for only a part of a cost accounting period. The contractor allocated the costs of this new function to the cost objectives of that same part of the cost accounting period as required by CAS 9904.406-40(a)(1). The auditor believed that the contractor should have gone back to the beginning of the fiscal year and "recast" financial data into the new indirect methodology. This incident aside, there just are not many CAS 406 noncompliance.

CAS 406 applies to both full and modified CAS-covered contracts.

CAS 405 - Accounting for Unallowable Costs

CAS 405 - Accounting for Unallowable Costs. The fundamental requirement of this Standard is very simple. Contractors must set up a process to identify unallowable costs and then to segregate those costs in their accounting system. That way, unallowable costs should not impact the price of negotiated contracts (where history is used to estimate costs) nor get billed to the Government.

Unallowable costs are those expressly unallowable under FAR Part 31 cost principles, FAR supplements, regulations, and contract terms. The definition also includes costs that are mutually agreed to be unallowable as well as directly associated costs. Directly associated costs are those that are generated solely as a result of another incurred cost and which would not have been incurred otherwise.

Unallowable costs that would normally be part of an indirect rate allocation base must remain in the base for rate computation purposes even though the cost cannot be charged to the Government.

The Standard requires that records by adequate to establish and maintain visibility of identified unallowable costs (including directly associated costs). The adequacy of records has been a source of contention over the years. Contractors often feel that if they do not claim the costs, then the auditor has no right to review the underlying support. Auditors on the other hand, argue that they need the source documents in order to ensure that contractors have identified and excluded all "directly associated" costs.

CAS 405 applies to both full and modified CAS-covered contracts. However, the essence of this Standard has been incorporated into FAR 31.201-6, Unallowable Costs, and is therefore applicable to all Government contractors.

Next: CAS 406 - Cost Accounting Period

More on DoD's Proposed Regulations on Contractor Business Systems

We've written a few times about DoD's proposed rule on contractor business systems (e.g. purchasing, estimating, accounting, etc). We wrote several posts when the first proposal was issued about a year ago, more when the public comments to the proposal were published, and even more when DoD issued a revised proposed rule last December. If you care to read these prior posts, just click on the "Business Systems" topic under the "Labels" section on the right side of this screen). The comment period for the revised rule ended last Tuesday (January 11, 2011) and the public comments are now becoming available. These comments have a recurring theme, that while the revised proposed rules are significantly improved over the initial proposal, there are still many aspects of the rule that remain problematic. The Council of Defense and Space Industry Associations (CODSIA) wrote a very evened and comprehensive response on January 10, 2011. Bottom line, CODSIA identified a number of concerns with the "attributes" of the individual business systems and the withhold process. A lot of these concerns resonate with us and we will discuss a few of them following. If you would like to read the entire CODSIA report, click here.

Timeliness of DCAA followup processes.

There are a lot of well-founded concerns about whether DCAA can be nimble enough to perform follow-up reviews in a timely manner. Certainly, recent evidence suggests that it is not. And, for contractors with withholds waiting for DCAA to audit their corrective actions, cash flow could become a serious issue. CODSIA put it this way:

Over the past months, there have been numerous examples where DCAA’s audit rules and processes conflict with the department’s procurement objectives. Firms that “fail” the current binary adequate/inadequate regime are increasingly unable to get DCAA to conduct the necessary follow-up audits to validate that the company’s fixes have been made. While we appreciate the change made in this second proposed rule that provides authority for the contracting officer to reduce the ongoing withholds after a contractor has submitted a corrective action plan, existing withholds are not released because DCAA is unable to conduct a timely follow-up audit.

There is nothing in the proposed rule that will hold DCAA accountable for performing timely followup reviews. One solution proposed by CODSIA is to allow contractors to go out and get their own independent audits from qualified third-party auditors.

Cost impact related to deficiencies

There is nothing in DCAA guidance or the proposed rule that requires the auditor to estimate the cost impact (or potential impact) of a particular deficiency. The way it will work is when DCAA identifies a deficiency, boom, 10% withhold. That deficiency may or may not have a monetary impact on Government contracts. Neither the original nor revised rule require that DCAA identify evidence of the actual or potential cost impact of the system deficiencies it has identified prior to the imposition of a payment withhold. This leads to concerns that the amount withheld may be grossly disproportionate to the actual impact. CODSIA expressed this concern and recommended that the proposed rule require DCAA audit reports to include an assessment of audit risk and cost impact associated with each reported business system deficiency or to explain why it was not possible to include such an assessment.

Maybe the public outcry over the revised proposed rule will be sufficient for DoD to consider a third iteration before going final. We were once auditors so we fully understand the Government's concern. Too often in the past, valid concerns over the adequacy of one system or another were essentially ignored. There is no incentive for contractors to fix problems nor is there a consequence if they do not. The resolution process bogs down, the issue(s) go stale, Government personnel turn over, everyone losses interest, the system deficiency continues, and the Government is potentially harmed by increased contract costs and prices. The new withhold mechanism in the revised proposed rule provides incentive for contractors to fix issues in a timely manner. The question from a lot of people is whether the Government can keep up.

CAS 402 - Consistency in Allocating Costs Incurred for the Same Purpose

CAS 402 - Consistency in Allocating Costs Incurred for the Same Purpose. The purpose of CAS 402 is to ensure that each type of cost is allocated only once and on only one basis to any contract or other cost objective. The fundamental requirement requires that all costs incurred for the same purpose, in like circumstances, are either direct costs only or indirect costs only with respect to final cost objectives. To state this another way, you cannot charge a cost direct to a contract if those same kinds of costs have also been charged indirect and you cannot charge a cost to an indirect cost pool that gets allocated to a Government contract if those same types of costs have also been allocated directly.

The key phrase in applying this standard are "costs incurred for the same purpose in like circumstances" and this is where arguments arise between contractors and Government oversight agencies. There are examples within the narrative of the standards that illustrate the Board's view of "same purposes" and "like circumstances" (see FAR 9904.402-60). One off cited example is the firefighters. In this example, a contractor proposed as a direct cost to perform a contract which required three firemen on 24-hour duty at a fixed-post to provide protection against damage to highly inflammable materials used on the contract. The contractor also had a firefighting capability for general plant protection that it charged indirect. In this case, the CAS Board said it was fine to charge the fixed-post firefighters direct because that was different circumstances.

There were a number of disputes soon after this Standard was issued involving proposal preparation costs. Most contractors charge B&P (bid and proposal) costs indirect. However, some contracts, as a contract line item, require the contractor to prepare some kind of follow-on proposal. The Board had to issue a formal interpretation on this to rule that if a contract required a contractor to prepare a follow-on proposal, that was differing circumstances than the usual B&P activity within the company.

In one case, a contract had a contract which required extra effort for planning and cost management, It hired extra people to accomplish this effort and accounted for all their labor cost as a direct charge to the contract. The contractor had other people performing the same functions for more than one contract and their labor was charged as an indirect costs. This contractor was in noncompliance with CAS 402. The work being performed is the same and the only difference is the amount of effort required to accomplish the function. To comply with CAS 402, the contractor would need to charge all these costs indirectly and develop an equitable allocation base or direct charge all of these costs.

CAS 402 applies to both full and modified CAS-covered contracts.


Next: CAS 405 - Accounting for Unallowable Costs

CAS 401 - Consistency in Estimating, Accumulating, and Reporting Costs

Cost Accounting Standard 401 - Consistency in Estimating, Accumulating, and Reporting Costs. This standard is designed to achieve consistency in the cost accounting practices used by a contractor in estimating costs for proposal purposes with those practices used in accumulating and report costs during contract performance. It is also designed to provide a basis for comparing such costs. The main idea here is that the consistent application of cost accounting practices will facilitate the preparation of reliable cost estimates used in pricing a proposal and then, once performance under the contract begins, a means to compare those cost estimates with the actual cost of contract performance.

This consistency requirement between estimating and accumulating costs is a two-part requirement. First, a contractor's practices used to estimate costs in pricing proposals must be consistent with practices used in accumulating actual costs. Second, the contractor's practices used in accumulating costs must be consistent with practices used to estimate costs in pricing the related proposal. Noncompliance with this standard can exist because a contractor has failed to estimate its cost in accordance with its established or disclosed accounting practices and can also occur when a contractor estimates in accordance with its disclosed or established practices but accumulates on a different basis.

To illustrate, a contractor who estimates average engineering direct labor rates by labor category and collects costs by labor category complies with this standards. On the other hand, a contractor who estimates engineering labor by cost function (i.e. drafting, manufacturing, etc) but accumulates total engineering labor in one undifferentiated account would not be in compliance.

CAS 401 applies to both full and modified CAS-covered contracts.

Next: CAS 402 - Consistency in Allocating Costs Incurred for the Same Purpose.

Cost Accounting Standards

Tomorrow we will begin an irregular series of posts to cover the essential requirements of the nineteen CAS Standards. In the next couple of months, we should be able to cover them all. The Cost Accounting Standards are promulgations designed to promote fair and consistent cost accounting practices among Government contractors. While many contractors are exempt from CAS, many of the CAS Standards have been incorporated into FAR by reference or in substance making them applicable to everyone. As we go through these standards, we will identify which ones have been incorporated in whole or in part into FAR.

We will not be covering the standards in consecutive order but rather, will group them by subject. For example, CAS 404 dealing with capitalization practices and CAS 409 dealing with depreciation of those capitalized assets are related and will be addressed separately, but consecutively. Both of these standards, by the way, have also been incorporated into FAR. Some standards are applicable to very few contractors. For example, CAS 413 and 416 deal primarily with defined benefit pension plans. Back in the 70's when these standards were adopted, defined benefit pension plans were popular. Now they're not and except for "grandfathered" employees, most contractors have adopted some form of defined contribution plan.


Some contracts are exempt from CAS. CAS applies only to negotiated contracts. Sealed bids, awards based on adequate price competition without submission of cost or pricing data, contracts in which the price is set by law or regulation, and commercial items are all exempt. Additionally, contracts under $700 thousand, contracts awarded to small businesses (as defined by SBA) and contracts executed and performed outside of the United States are also exempt.

There are two levels of CAS coverage, full and modified. The thresholds for full and modified coverage are $50 million and $7.5 million respectively in CAS covered contracts. Modified CAS coverage requires compliance with CAS Standards 401, 402, 405, and 406. Full CAS coverage requires compliance with all 19 CAS Standards.

Next: CAS 401 - Consistency in Estimating, Accumulating and Reporting Costs

VA Administration to Begin Verifying "Veteran" Status

The Department of Veterans Affairs announced on January 3rd that companies identifying themselves as small businesses or Veteran-owned businesses to gain priority for VA contracts must now provide documentation verifying their status within 90 days of receiving notice from the Agency. An Agency spokesperson stated that this is a necessary step to eliminate misrepresentation by firms trying to receive contracts that should go to service-disabled and other Veteran-owned businesses. Of course they didn't do this on their own. The requirement was part of the Veterans Benefits Act of 2010 that the President signed into law last October.

The law requires VA to notify currently listed businesses that within 90 days of receiving notice they must submit certain business documents. The first batch of notices (about 13 thousand) were mailed out mid-December. Those companies have 90 days to prove their bona-fides.

VA's press release didn't say what will happen to those companies that can't prove that they are Veteran-owned businesses. At a minimum, those companies will not be receiving any more contracts from the VA and possible face suspension or debarment actions that will affect their ability to win any Government contracts.

Aligning DCAA and DCMA Processes to Ensure Work is Complementary

In a January 4, 2011 memorandum, the Director, Defense Procurement and Acquisition Policy inventoried the progress that the Defense Contract Management Agency (DCMA) and the Defense Contract Audit Agency (DCAA) have made since September 2010 to realign their roles and responsibilities in order to reduce overlapping efforts. Actually, the progress made to date has been one-sided - DCAA gives up a lot to DCMA and DCMA gives up nothing. These so-called achievements include:

• Increased thresholds for cost/price proposal audits - DCAA gives up fixed price contracts under $10 million and cost type contracts under $100 million.
• Forward Pricing Rate Agreements/Recommendations - DCMA takes over this responsibility.
• Financial capability reviews - DCAA gives up these audits in favor of DCMA
• Purchasing system reviews - DCAA plans to withdraw from these types of reviews.
• Contractor Business System - If the rules are ever finalized, they'll include clearly defined responsibilities for both DCAA nad DCMA. 

The increased thresholds for pricing have been well publicized and discussed in this blog and many other places. The shifting of forward pricing indirect rates, financial capability reviews and purchasing system reviews responsibilities is news. Makes one wonder what work is left for DCAA.

The Year Ahead for Contract Oversight

A number of years ago, when we still published our quarterly newsletter, we took a stab at guessing where the various contract oversight agencies would be concentrating their efforts in the year ahead. As I recall, we were not very accurate in our predictions. Contract oversight is such a dynamic field that it takes only one scandal, one Congressional hearing, one investigation, or one audit report to completely alter carefully planned-out oversight activities. Many things that seemed very important in January are back burner topics by June, not because they've been completed or resolved but because newer concerns always seem to take precedence. So even though we are not very good prognosticators, we will take another shot at identifying the main focuses of contract oversight agencies in 2011.

DCMA's ascendancy in contract pricing. Last September, the Department of Defense instructed contracting officers to no longer request audits of fixed price proposals under $10 million and cost reimbursable proposals under $100 million. This was done to "... align DCAA audit resources to those areas with greatest risk." and effectively removed $92 billion in pricing activities from DCAA oversight. Well, someone has to review contractor proposals so DCMA is stepping in to fill the void. Its "standing up" a pricing function within its organization to provide that service. Read more.

New rules on contractor business systems. The DoD recently published the second iteration of proposed regulations requiring contractors to maintain adequate business systems including accounting, estimating, purchasing, MMAS, EVMS, and Government property. Contractors that fail to maintain adequate systems will have some of the billings withheld until such time as the deficiencies are corrected. While these regulations have not yet been finalized, they probably will be in some form or another. And when they are finalized, expect DCAA and DCMA to be rather aggressive out of the gate. There is a lot of judgement involved in determining whether internal control systems are sufficient to reduce risks to an acceptable level. Sometimes it seems the Government's definition of "acceptable level" is much lower than a contractors'. Read more.
Payment Recapture Audits. The Obama Administration has made payment recapture audits one of its cornerstones in trimming spending, ferreting out fraud, waste, and abuse, and improving the overall efficiency of the Government. It announced the initiative last March and by November, the OMB (Office of Management and Budget) had issued requirements for all Executive Agencies to get moving. The OMB estimated that there were $110 billion in improper payments made to various organizations in FY 2009 and set a goal to reduce that amount by $50 billion. DCAA issued a new audit program to assess contractor billing systems as part of this initiative and has already initiated some reviews. This is expected to be a significant audit area for DCAA in fiscal year 2011. Read more.

Increased Scrutiny on Small Business Status. There is widespread concern that the programs designed to assist small business are being significantly abused. The Office of Federal Procurement Policy stated recently that there has been inadequate oversight on the Government's "overuse" of Alaska Native Corporations (ANCs) for expediency reasons, contractor's ability to self-certify their small business status, and "ill-conceived" teaming arrangements that allow non-small businesses to take on the bulk of the work intended to be set aside for small business enterprises. Expect oversight hearings once the new Congress gets rolling. Read more.

So, there they are, the emphasis of contract audit oversight activities for the coming year. Check back with us in December to see how well we did with our forecasts, or didn't.

Be Sure to Turn in Your Badges

Here's something else to add to your policy and procedure manual.

A final rule was just published in FAR addressing the concern that Government contractors do not always return their identification cards when they no longer need them. The Government issues CACs (Common Access Cards) in order to allow contractors access to Federal facilities (e.g. military bases). A CAC is the DoD term for a Personal Identity Verification (PIV) card. A year or so ago, the Inspector General's office found that these cards were not adequately accounted for after contract performance or completion.

Under the new rule which goes into effect on January31, 2011, contractors must establish policies and procedures to account for all forms of Government-provided identification issued to its employees in connection with contract performance. Contractors must return such identification to the issuing agency at the earliest of any of the following,

1. When no longer needed for contract performance
2. Upon completion of the employee's employment
3. Upon contract completion or termination

This clause flows down to subcontractors and for contractors who fail to comply, the contracting officer may withhold final payment under the contract.

Inspector General Finds a Need for Improved Contract Oversight

In a report released late December, the DoD Inspector General identified a number of deficiencies in contract oversight of the Broad Area Maritime Surveillance (BAMS) program. Specifically, the IG recommended that Navy and the Defense Contract Management Agency (DCMA) officials need to improve the management and administration of the contract. Those officials failed to review billings totaling $329 million, failed to keep track of Government-furnished property, failed to share specialized tooling and test equipment with other Government programs thereby potentially wasting $150 million. The IG concluded that these conditions occurred because contracting officials did not properly perform all of their assigned duties, comply with Federal and DoD policies, or complete necessary training requirements.

The aspect of this audit that is getting the most publicity right now is the contractor's billing of unallowable travel expense. The IG found that the contractor had included $206 thousand for such things as golf outings and other unallowable travel. Not only that, but the contractor had also earned "award fee" on these expenses. Although DCAA had reviewed some of these invoices, its review was limited to "tick marks" - tracing billings back to the accounting records, ensuring that the contractor was using the correct indirect rates,  and ensuring that the amounts billed did not exceed contract funding. DCAA had not performed any kind of review to determine the allowability, allocabilitiy, or reasonableness of claimed costs.

While the unallowable cost aspect of this gets the headlines, the other issues are perhaps more wasteful from a taxpayer perspective. The fact that tooling and test equipments were available to other programs but not used, considered, or offered, caused those other programs to expend perhaps $150 million that it didn't need to. The lack of adequate EVMS surveillance left the Government blind with respect to progress under the contract - leaving open the possibility of significant cost overruns that will be sprung upon the Government at some future date. The lack of accountability for Government property leaves taxpayers vulnerable to theft or misappropriation.

This is a significant audit and one that we will certainly be hearing more about in the near future.