When "Adequate" is the Best that You Can Be

The following is a slightly edited version of an article we published in our June 2007 Government Contracting Update newsletter. We discontinued the newsletter format in 2009 in favor of this blog.

Many times during our years as Government auditors, we would sit down with contractors at the conclusion of an audit of one or more of their internal control systems and proclaim that their system was “adequate”. 

“Adequate, only adequate?” they would ask. “We’ve done this and we’ve done that, we have great policies and procedures, we have superb internal controls, we test for compliance and we have other checks and balances. How can you say our system is only adequate?”

We would then explain that “adequate” was as good as it gets. Under Generally Accepted Government Auditing Standards (GAGAS), an internal control system is declared adequate when no significant deficiencies are found. The only other reporting option is that the system is "inadequate". 


An "inadequate" opinion arises whenever a significant deficiency or material weakness is disclosed by the audit. A significant deficiency is a control deficiency, or combination of deficiencies, that adversely affects the company's ability to initiate, authorize, record, process, or report Government contract costs in accordance with applicable Government contract laws and regulations, results in a reasonable possibility that unallowable costs will be charged to the Government, and the potential unallowable cost is not clearly immaterial. A material weakness is a significant deficiency, or combination of significant deficiencies that results in more than a remote likelihood that unallowable costs will be charged to the Government.


Sometimes audits disclose conditions that do not materially affect the adequacy of the system but if corrected, would enhance the system of internal controls. Until 2008, these would have been reported as “Suggestions to Improve the System” rather than deficiencies and would not have affected the overall audit opinion. In 2008, DCAA discontinued its practice of reporting "Suggestions to Improve the System" since such reporting was not required by GAGAS.


Some internal control audits are required by FAR (e.g. purchasing system and estimating system) while others are based on perceived risk to the Government (e.g. accounting system and labor system). Generally, contractors should not fear internal control audits. Fundamentally, the goals and objectives for both contractors and the Government are the same. Good internal controls are fundamental to good business practices and provide the government with some assurances that its procurement dollars are well spent.


The audit programs that DCAA and other governmental audit agencies use to assess the adequacy of contractor internal controls are available on DCAA’s website, 

"DCAA Approved" Timekeeping Systems

We read about them, we hear about them, we see the advertising and press releases, many we've seen in practice and we're frequently asked advice about them. We saw another new one advertised just last week. What are we talking about? We're talking about vendors who are promoting "DCAA approved timekeeping systems" or DCAA compliant timekeeping systems. There are at least a couple dozen competing products out there, probably many more. One thing they all have in common however, is that none of them have been "approved" by DCAA (Defense Contract Audit Agency). DCAA does not "approve" commercial timekeeping software/systems. (The same goes for  commercial accounting software). DCAA is a Federal Government audit organization and follows strict guidelines (i.e.Generally Accepted Government Auditing Standards) for maintaining their independence in fact as well as appearance. The Agency does not endorse products.

So what's going on here? What are all these claims touting DCAA's approval? At best, these electronic or web-based timekeeping systems have been bought, installed, and used at one or more Government contractors who, after an audit by DCAA of their timekeeping system, received an audit opinion that their timekeeping system was "adequate" (By the way, "adequate" is as good as it gets when it comes to audit opinions. There is no higher rating than that). So these vendors can claim that since no deficiencies were found during the audit, their systems must be good enough for Government work. Or perhaps vendors compared the features of their product to DCAA audit guidance (see DCAA Contract Audit Manual 5-909.2) on what to look for in an electronic timekeeping system and were able to self-assess the sufficiency of their product.

In reality, the software used to collect employee hours is only part of a timekeeping system - usually the simplest part. Most of these electronic timekeeping systems are very similar in the way they work. They are very simple databases with a user interface. The employee logs on with a user ID and password and enters his/her time for the day. Later, supervisors review and approve the employees' electronic timesheets. Then the hours are tallied according to the needs of the organization (usually by project, work order, task, etc). Most of these products include an audit trail so that one can determine who made entries and whether any changes were made and by who and for what reason.

But, as we stated, the software component is only one part of the timekeeping system. The most significant part of the system and the most difficult to implement is the policies, procedures, and practices and the internal controls. Perhaps the most difficult aspect of all is getting employees to record their hours on a timely basis (daily, according to DCAA). This requires policies, procedures, training, compliance reviews, and reporting. It probably necessitates some form of disciplinary action when employees do not comply (e.g. progressive from oral reprimand all the way to removal). It requires a genuine commitment from management who must set the "tone at the top".

We know of contractors who have implemented these so-called DCAA approved software products yet have failed audits of their timekeeping systems, not because of the software but because the implementation was not adequate or was adequate but compliance was not sufficient. Do not be misled by the claims of software publishers. Do not become complacent in thinking that your timekeeping systems is fine just because you have purchased or licensed a product that claims to be "audit proof".

"Fatally Flawed" Compensation Audit - Part 2

Yesterday, we reported on a recent ASBCA decision that calls into question the methodology used by the Government to assess the reasonableness of contractor compensation levels. The Government of course could appeal that decision. But in the meantime, we have a new methodology, accepted by the ASBCA, for determining "reasonable" compensation levels. The Board's methodology generally results in higher benchmark compensation level when compared to the Government's methodology, We recommend you use it. The methodology is somewhat technical and beyond the scope of this blog but if you are in a situation where your compensation levels are being reviewed and/or questioned, we recommend you seek out expert help in that field.

Compensation for each employee or job class of employees must be reasonable for the work performed. Compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total. In determining the reasonableness of total compensation, contractors must consider factors determined by the contracting officer (who has the ultimate responsibility for deciding whether compensation is reasonable) to be relevant. According to FAR 31.206.b.(2), this would usually entail a comparison with compensation practices of other firms of the same size, in the same industry, in the same geographic area, and engaged in similar non-Government work under comparable circumstances. Making such comparisons, indeed finding the raw data with which to make such comparisons is very difficult. Such work has often been called an "art" rather than science or analysis.

There are a few, benchmarking surveys on the market. Their cost however is often prohibitive for small contractors. Even though the Government relies on them to perform benchmarking studies, these surveys have limitations because its often difficult to find enough companies of the same size, industry, geographical area, doing commercial work under comparable circumstances to make meaningful comparisons. Also keep in mind that there is no FAR requirement for contractors to purchase these surveys, even though the Government often tries to push them into doing so.

"Fatally Flawed" Compensation Audit

In a decision likely to affect the methodology by which the Government assesses the reasonableness of contractor compensation levels in the future, the ASBCA (Armed Services Board of Contract Appeals) issued a decision last week stating that the methodology used by DCAA (Defense Contract Audit Agency) to assess the reasonableness of compensation was "fatally flawed statistically and therefore unreasonable". The methodology that DCAA used in this case followed the guidance in its Contract Audit Manual (Chapter 5) and the same one used in thousands of compensation reviews over the years. If you have ever had employee compensation questioned by the Government, you will want to read this decision.

In the present case, the contractor challenged DCAA's methodology for determining reasonable executive compensation based on four discrete arguments. The first argument contended that the Government's methodology was fatally flawed as a matter of basic statistical analysis. The Board found that the contractor's first argument was sufficient to prove its case so it did not need to address the contractor's other arguments.

The Government didn't help itself in this case either. In its decision, the Board wrote:

The government made no effort at the hearing or in its brief, to respond to the statistical arguments made by appellant and thus we are left with unrebutted evidence that the methodology used by DCAA was fatally flawed statistically and therefore unreasonable. Moreover, the government effort to support its own methodology was supplanted by an expert witness of questionable judgment. Consequently, we conclude that there are statistical flaws in the government methodology for determining reasonable compensation and that the computations performed by (the contractor's expert) to overcome those flaws are reasonable.

Order of Precedence - Contract Modifications

The Department of Defense is proposing to amend its FAR supplement (the DFARS) to establish an order for application of contract modifications to resolve any potential conflicts that may arise from multiple modifications with the same effective date. Although it does not happen frequently, there are enough cases involving contract modifications with conflicting contract provisions that have the same effective date, to make such a regulation desirable.

Currently there are no rules to describe in what order to apply modifications to determine the actual content of a resulting modified contract. In order to determine the sequence of modifications to a contract or order, a method for determining the order or application for modifications will resolve any conflict arising from multiple modifications with the same effective date.

Under the new regulations, modifications will be applied in the following order:

1. Modifications will be applied in order of the effective date on the modification.
2. In the event of two or more modifications with the same effective date, modifications will be applied in signature date order.
3. In the event or two or more modifications with the same effective date and the same signature date, procuring contracting office modifications (contract modifications beginning with the letter "P") will be applied in numeric order, followed by contract administration office modifications (contract modifications beginning the the letter "A") in numeric order.

Proposed Change to Definition of Cost or Pricing Data

DoD is moving to replace all references to "Cost or Pricing Data" to "Certified Cost or Pricing Data in its FAR Supplement (DFARS).  This is not a significant change to the procurement regulations but it should clear up some confusion by making it clear when cost or pricing data submitted in response to a Government solicitation must be certified. The change should also improve consistency between DFARS and FAR. FAR was amended several months ago to add the word "certified" to the definitions of Cost or Pricing Data.

Under existing regulations, contracting based on the submission of certified cost or pricing data is considered a last resort. If there is adequate price competition, if prices are set by law or regulations, or if acquiring commercial items, etc, contracting officers are precluded from requiring certified cost or pricing data. The contracting officer can however request "information other than cost or pricing data" necessary to make a determination that proposed prices are reasonable. Sometimes this "information other than cost or pricing data" is required to be submitted in a format and detail that looks just like regular cost or pricing data. And that's where the confusion set in. There was anecdotal evidence that contracting officers were requiring prospective contractors to certify the "information other than cost or pricing data.

By the way, the threshold for requiring certified cost or pricing data (FAR 15.403-4) remains at $700 thousand.

Proposal to Streamline Submission of Interim Vouchers

The Department of Defense is proposing to make a significant revision to its procedures for processing interim vouchers by taking away the Defense Contract Audit Agency's (DCAA's) authority to approve contractors for direct billing. Under current regulations (DoD FAR Supplement 242.803), DCAA can authorize contractors to directly submit their vouchers for provisional payment to the disbursing office when DCAA is satisfied that the contractor's billing system is adequate. For contractors without approved billing systems, interim vouchers must first go through DCAA for review and approval. Contractors that are able to submit interim vouchers directly Government paying offices, can often significantly reduce the cycle time between voucher submission and payment and that means faster cash flows.

Under the proposal published January 19, 2012, every contractor is automatically approved for direct billing. DCAA has no say in the matter. The only interim vouchers that DCAA can review prior to payment are those "selected using sampling methodologies". This proposal represents a significant diminution of DCAA's authority and responsibility and is yet another example of how DoD is systematically dismantling its auditing arm or, as some have called "its first line of defense" against contract irregularities.

You can read the entire proposal here.

Any comments received by March 19, 2012 will be consider in the formation of the final rule.

Improving Job Opportunities for Individuals with Disabilities - Part 4

Today we conclude this series on the Labor Department's proposed rules to enhance the requirements for contractors to take affirmative action to employ, advance in employment, and otherwise treat qualified individuals without discrimination on the basis of disability in all employment practices. Today we will discuss the Office of Federal Contract Compliance Program's (OFCCP's) compliance evaluations and the sanctions and penalties available to it to  enforce the new regulations.

Under the proposed regulations, the OFCCP may conduct compliance evaluations to determine whether the contractor is taking affirmative action to employ individuals with disabilities. Compliance evaluations may consist of any one or any combination of the following investigative procedures.

1. Compliance review. A comprehensive analysis and evaluation of the firing and employment practices of the contractor, the written affirmative action program, and the results of the affirmative action efforts undertaken by the contractor.

2. Off-site review of records. An analysis and evaluation of the affirmative action program (or any part thereof) and supporting documentation, and other documents related to the contractor's personnel policies and employment actions that may be relevant to a determination of whether the contractor has complied with the requirements of section 503 and its regulations.

3. Compliance check. A determination of whether the contractor has maintained records consistent with the new regulations. OFCCP may request the documents be provided either on-site or off-site.

4. Focused review. A review restricted to one or more components of the contractor's organization or one or more aspects of the contractor's employment practices.

In addition, for contracts and subcontracts expected to exceed $10 million, the new regulations require the contracting officer to request a pre-award compliance evaluation. The pre-award evaluation would focus on the contractors policies, procedures, and practices. The OFCCP has only 30 days to perform the pre-award evaluation. After that, the awarding agency is allowed to proceed with the award.

The proposed regulations provide for penalties and sanctions for contractors that are not in compliant with the rules or for violations of the requirements as when someone files a complaint. There is a due process afforded contractors within the proposed regulations but assuming fault, there are a number of actions the Government may take against a contractor to enforce the rules. These are:

• Withholding progress payment
• Terminating the contract, and
• Debarment from receiving future contracts for six months to three years.

If you wish to read the full text of the proposed regulation, click here. This link also provides information on how to submit comments, if you're so inclined.

Improving Job Opportunities for Individuals with Disabilities - Part 3

For the past two days, we have been discussing the proposed rules published by the Department of Labor that will require Government contractors to significantly alter the policies, procedures, and practices regarding the recruitment of individuals with disabilities. Here are some of those added requirements:

Data collection - The proposed rule requires contractors collect and maintain several measurements and comparisons related to individuals with disabilities, including the

• number of individuals with disabilities referred to them by employment agencies
• number of individuals with disabilities referred to them by other entities, groups or organizations with which the contractor has a linkage agreement
• number of individuals with disabilities that applied for positions with the contractor; and
• number of individuals with disabilities hired by the contractor.

Compliance reviews - to improve the Office of Federal Contract Comploance Program's (OFCCP's) efficiency in conducting compliance evaluations, the proposed rule permits OFCCP to review contractor records for compliance checks and focused reviews wither on-site or off-site, at OFCCPs discretion. The proposed rule also allows OFCCP to perform pre-award compliance evaluations.

Mandatory job listing requirement - The proposed rule requires contractors to list all job openings with the nearest "One-Stop Career Center". One-Stop Career Centers provide job seekers with a full range of assistance under one roof. One-Stops operate in all 50 states and offer training referrals, career counseling, job listings, and similar employment-related services. This rule is designed to benefit both the contractor and the disability community by improving the contractor's ability to attract qualified applicants with disabilities.

Reasonable accommodation. The proposed rules require that contractors develop and implement specific written procedures for processing requests for reasonable accommodation, and details the minimum elements the procedures must include. Having these written procedures will assist the contractor in consistently satisfying its reasonable accommodation obligation by serving as a blueprint for the prompt handling of reasonable accommodation requests. The maintenance and dissemination of these procedures will also ensure that applicants and employees know how to request a reasonable accommodation, who is responsible for handling accommodation requests, and the maximum amount of time within which the contractor must complete the processing of an accommodation request.

Improving Job Opportunities for Individuals with Disabilities - Part 2

Yesterday we discussed the Labor Department's proposed rules for Government contractors designed to improve job opportunities for individuals with disabilities. These rules will require federal contractors and subcontractors to set a hiring goal of having seven percent of their workforces be people with disabilities, among other requirements.

These proposed rules would strengthen the affirmative action requirements established in Section 503 of the Rehabilitation Act of 1973 obligating federal contractors and subcontractors to ensure equal employment opportunities for qualified workers with disabilities. The proposed regulatory changes detail specific actions contractors must take in the areas of recruitment, training, record-keeping and policy dissemination - similar to those that have long been required to promote workplace equality for women and minorities.

According to Secretary of Labor, Hilda L. Solis, "This proposed rule represents one of the most significant advances in protecting the civil rights of workers with disabilities since the passage of the Americans with Disabilities Act". We would add that the proposed rules will significantly increase the administrative and reporting burdens on government contractors.

Highlights of the proposed rule include:

• Goals: Establish, for the first time, a single, national utilization goal for individuals with disabilities. Federal contractors and subcontractors would be required to set a hiring goal of having 7 percent of their employees be workers with disabilities in each job group of the contractors’ workforce.
• Data Collection: Improve collection of data on employment of people with disabilities by modifying the invitation for workers to self-identify by requiring that contractors invite all applicants to voluntarily self-identify as an “individual with a disability” at the pre-offer stage of the hiring process. Contractors also will be required to invite post-offer voluntary self-identification and to survey all employees annually in order to invite their self-identification in an anonymous manner.
• Record-Keeping: Require that contractors maintain records on the number of individuals with disabilities applying for positions and the number of individuals with disabilities hired.
• Accommodation Requests: Require, for the first time, that contractors develop and implement written procedures for processing requests for reasonable accommodation.
• Outreach: Require that contractors engage in a minimum of three specific types of outreach and recruitment efforts to recruit individuals with disabilities.
• Job Listings: Require that contractors list job openings with One-Stop Career Centers or other appropriate employment delivery systems.
• Annual Reviews: Require previously recommended steps contractors must take to review their personnel processes, as well as their physical and mental job qualifications.

Most Government contractors and subcontractors will recognize a large gap between these rules and their current practices.

Improving Job Opportunities for Individuals with Disabilities at Government Contractors

Government contractors, when entering into contracts subject to Section 503 of the Rehabilitation Act of 1973 (which are all contracts greater than $10,000 unless a waiver is granted), are required to take affirmative action to employ, and advance in employment, qualified individuals with disabilities, without discrimination based on their physical or mental disability. The specific procedures are laid out in 41 CFR Part 60-741 and incorporated into contracts by 48 CFR 52.222.36.

These rules have bee in place for nearly 40 years and require contractors to make a good faith effort to recruit and hire people with disabilities. However, according to the Labor Department's Office of Federal Contract Compliance Programs (OFCCP), the existing rules are not working. The current unemployment rate for people with disabilities is 13 percent, significantly higher than the rate of those without disabilities. Additionally, data recently published by the Bureau of Labor Statistics show disparities facing working-age individuals with disabilities, with 79.2 percent outside the labor force altogether, compared to 30.5 percent of those without disabilities.

To rectify this situation, the U.S. Department of Labor is proposing new rules that would require federal contractors and subcontractors to set a hiring goal of having 7 percent of their work forces be people with disabilities, among other requirements. The proposed rules were published last December and the period for public comment closes on February 7, 2012.

These new rules are designed to strengthen the affirmative action requirements established by the Rehabilitation Act of 1973. The proposed regulatory changes detail specific actions contractors must take in the areas of recruitment, training, record keeping and policy dissemination - similar to those that have long been required to promote workplace equality for women and minorities. In additions, the rule would clarify expectations for contractors by providing specific guidance on how to comply with the law.

Establishing a 7 percent hiring goal for the employment of individuals with disabilities would be a tool for contractors to measure the effectiveness of their affirmative action efforts and thereby inform their decision-making. The proposed rule also would enhance data collection and record-keeping requirements - including for documentation and processing of requests for reasonable accommodation - in order to improve accountability. Additionally, it would ensure annual self-reviews of employers' recruitment and outreach efforts, and add a new requirement for contractors to list job openings to increase their pools of qualified applicants.

These new rules, if adopted, will significantly increase the administrative and reporting burdens of Government contractors. Tomorrow, we will look more specifically at the new requirements to be imposed on Government contractors.

Bonuses and Incentive Compensation

Bonuses and incentive compensation are integral to companies compensation systems. These benefits are structured in many different ways. They can be based on production, cost reduction, efficient performance, a combination of all these factors, or any of a myriad of other factors.

Bonuses and incentive compensation fall under the Compensation cost principle (FAR 31.205-6) which means that to be allowable under Government contracts, the costs, when added to all other forms of compensation (including fringe benefits), must be "reasonable for the work performed". However, when it comes to bonuses and incentive compensation, there are a couple of other criteria that contractors must meet if they want to claim the costs on their Government contracts. These are;

1. The awards must paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered or pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such payment; and
2. The basis for the award is supported.

The most frequent challenge to bonus and incentive compensation costs come from auditor assertions that the costs were not paid pursuant to an agreement entered into before the services were performed. Careful planning and structuring of bonus plans should help avoid such challenges. Contractors need to avoid situations where they come to the end of the year, find they have some extra cash, and in a spate of goodwill, distribute bonuses to its employees.

A couple of things to keep in mind based on prior ASBCA (Armed Services Board of Contract Appeals). First, employees need not have had a right to receive the bonus, provided there was a reasonable expectation that the bonus would be paid. Secondly, some management discretion in making payments is permissible ("That is presumably what top management is for, and one of the requirements for the  attainment of such a position is the ability to bear such responsibility and to make the decisions which grow out of it").

Time and Material Contracts - Be Careful How You Bill

Under Time and Material (T&M) contracts, the Government pays contractors based on fixed hourly rates plus the cost of any materials used. The fixed hourly rates are fully loaded rates and include fringe benefits, indirect expense allocations, and profit. The final price of a T&M contract is tied to the actual hours a contractor works. The Government considers the T&M contract to be one of the riskiest contract types because there is really no positive profit incentive for cost control or labor efficiency. Not surprisingly, there are a number of FAR provisions that require to Government to prepare solid justification whenever a T&M contract is contemplated.

T&M contracts typically include hourly rates for various labor classifications. Thus, a senior engineer would  carry a different (and higher) rate than a technician. The rates are based on specific qualifications for the each particular labor category. The qualifications might be educational, certifications, years of experience, or any number of knowledge, skill, and ability criteria. When the Government "buys" labor under a T&M contract, it usually specifies the labor category it wants to "buy" as well as the number of hours needed.

Contractors are expected to assign employees to the contract that meet the requisite qualifications of the contracted position. If, for example, a Sr. Engineer required a Bachelor's degree in electrical engineering plus ten years of experience, the employees assigned to perform the contracted work, must possess those qualifications. It does not matter that an employee not meeting those qualifications can perform as well as or better than one that does meet those qualifications. The Government contracted for a particular qualification and expects that employees assigned to perform the work meet those qualifications.

Because T&M contracts are considered high risk, the Government performs increased oversight on those contracts. After contract award, the contracting officer establishes a surveillance plan that includes floorchecks and other oversight activities. Most likely, the contracting officer will require the contractor to demonstrate that it is performing efficiently and using effective cost control measures. Floorchecks are used to ensure that the employees assigned to specific job categories meet the qualifications of those positions. And, herein lies our advice. Be certain that you are not billing for time when the positions are filled by those who do not possess the requisite qualifications. Many contractors have had to compensate the Government when they were found to billed for work performed by under-qualified individuals. Some have even faced civil and criminal penalties.

A recent settlement announced by the Department of Justice illustrates the importance of this advice. A contractor agreed to pay $700 thousand to settle allegations that it overbilled for labor on a T&M contract. The Government claimed that during the performance of an army contract, the company falsely billed the government for labor performed by employees who lacked the qualifications specified by the contract for the rates billed to the Government.

In this case, however, it wasn't Government oversight that disclosed the fraud. It was an employee of the company that blew the whistle and filed a "qui tam" action under the False Claims Act. The qui tam provision permits private parties to file actions on behalf of the US and receive a portion of the recovery if the Government takes over the case and reaches a monetary settlement with the defendant.

GAO Revises "Yellow Book" Auditing Standards

Late last year, the U.S. Government Accountability Office (GAO) published an update to Government Auditing Standards. This version, called the "2011 Revision", replaces the 2007 Revision. Government auditors are required to adhere to these standards (usually referred to as Generally Accepted Government Auditing Standards or GAGAS) whenever they perform audits or attestation engagements. If you've ever looked at a Government audit, you would see something like the following: "This audit was performed in accordance with GAGAS..."

From a Government contractor's perspective, there should be little, if any impact from this new revision. There are some major changes involving the independence of the auditor and the audit organization to the entity under audit. The added concepts address personal, external, and organizational impairments to independence. This reminds us of an incident that happened a number of years ago. A Government contractor notified an audit agency performing audits at their plant that the auditor assigned to the engagement had a close relative employed by the contractor. The audit agency swiftly reassigned that particular auditor so as to avoid any real or perceived independence issues.

The new revision contains requirements for the audit agencies to assess whether management possesses suitable skills, knowledge, and experience for a particular audit. Sometimes it seems that auditors are in over their heads on certain audits. Often this is due to a lack of experience, training and/or supervision. The revision requires auditors to now document this determination.

Another change to the 2011 revision involves the reporting requirement for fraud. The GAO is trying to put it into perspective by restricting reports to only those occurrences that are significant within the context of the audit objectives. Evidently, the previous requirement did not allow judgment or common sense and investigative agencies were flooded with immaterial and trivial reports of "suspected" fraud.

Auditing Compliance with CAS and FAR

The cognizant contract auditor (e.g. Defense Contract Audit Agency for DoD contracts) is responsible for conducting audits to ascertain whether a contractor's actual cost accounting practices comply with Cost Accounting Standards (CAS) and the Federal Acquisition Regulations (FAR) Part 31 Cost Principles.

In practice however, contract auditors do not typically initiate stand-alone audits to test contractors' compliance with FAR Part 31 and CAS. Rather, auditors are instructed to make compliance determinations an inherent part of ever audit performed, whether it is evaluating pricing proposals, examining incurred costs, or testing internal control systems. To do this effectively, auditors are expected to be knowledgeable of FAR Part 31 cost principles and CAS requirements.

Under this practice, it is not expected that the auditor will perform every step of a given CAS or FAR compliance audit, but rather, only those steps associated with costs that are material to the subject matter of the audit. The downside of this practice (or "upside", depending on your point of view), is that testing in this manner is almost haphazard and the potential for significant noncompliances slipping through the cracks is significantly increased.

The point of this post, and its a point we've made in the past, is that contractors should never assume that the contract auditor is narrowly focused on a single purpose. That auditor is observing, listening, probing, and developing audit leads for later. Although the auditor should communicate his/her purposes and objectives, such communication often doesn't take place. If not, contractors have the right to and should question the purpose of any audit procedures that appears beyond the stated scope of audit.

Price Reasonableness vs Price Realism

Within the context of Government contracting, there are many terms that have very specific meanings. Sometimes, terms are used interchangeably when they have very different meanings. Such is the case of "price reasonableness" and "price realism".

Price reasonableness looks at the price to be paid for goods and services. At its root, the Government performs price reasonableness analyses to ensure that it is not paying too much. When there is full and open competition for a fixed-price contract, the purpose of price reasonableness is to determine whether the price is too high.

Price realism on the other hand looks at the risk of low-balling, buying-in, or misunderstanding the requirements. Is the offeror's price overly optimistic or impractically low? Is the offeror asking too little? In a fixed-price environment, price realism is primarily focused on whether a contractor understands the requirements. Assuming the contractor understands the requirements, it is okay for it to choose to buy-in to win the competition. (This would be different if the solicitation were for a cost-type contract. Under cost-type solicitations, the Government would be performing "cost realism" as opposed to "price realism" and "buying-in" is often rejected).

The solicitation will specify whether price reasonableness, price realism, or both will be performed. Recently, a company protested the award of a contract to a competitor who, in their opinion, offered an unrealistically low price. The appellant argued that the Government did not perform an adequate price realism analysis. GAO rejected the appeal on the bases that the solicitation did not include a requirement for a price realism evaluation. GAO stated that the appellant's argument reflected a lack of understanding as to the distinction between price reasonableness and price realsim (see GAO B-405724).

Standard Automobile Mileage Rates for 2012

The IRS standard mileage rate for 2012 remains at 55.5 cents per mile - the same as the last six months of 2011. The standard GSA (General Services Administration) mileage rate for 2012 remains at 51 cents per mile, the same as 2011. Concerning the difference in the rates, GSA stated:

The IRS recently announced its standard automobile mileage rate of 55.5 cents will not change effective January 1, 2012. Although the results of our internal evaluation indicate no change in the Federal privately owned automobile, airplane and motorcycle mileage rates beginning January 1, 2012, we will continue to monitor the fuel costs and will adjust these rates if warranted. Any adjustments will be posted in the Federal Register and on this web site. Note: IRS and GSA do NOT necessarily have the same rate.

This distinction is important for contractors who have tied their reimbursement policies into one or the other's rates. See our posting from last July for more information as to why this distinction is important.

Conditions That May Indicate Significant Estimating System Deficiencies

The Government loves to devise lists of things that might be indicative of other things. The Inspector Generals of the Executive Agencies (Defense, Energy, Interior, Commerce, Homeland Security, etc), for example, have "fraud" indicators meaning that if one or more of the indicators are present, there could be a chance of fraud occurring somewhere in the contractor's organization. The Government has financial capability risk indicators meaning that if one or more of these indicators are present, the contractor may be in dire financial straights and at risk of going bankrupt.

We found another list the other day. This one pertains to contractors' estimating system. As you know from previous postings, the estimating system is one of the six business systems that if found deficient, will result in payment withholds.

Here's the list. The following have been identified by the DoD as conditions that may indicate potentially significant estimating deficiencies and excessive costs to the Government.

• Failure to ensure that historical data on the same or similar work are available to and utilized by cost estimators where appropriate.
• Continuing failure to analyze material costs or failure to perform subcontractor cost reviews as required.
• Consistent absence of analytical support for significant proposed costs.
• Excessive reliance on individual personal judgment where historical experience or commonly used standards are available.
• Recurring significant defective pricing findings within the same cost element(s).
• Failure to integrate relevant parts of other management systems (e.g., production or cost accounting) with the estimating system so that the ability to generate reliable cost estimates is impaired.
• Failure to provide established policies, procedures, and practices to persons responsible for preparing and supporting estimates.
• Management information that does not match the data in proposals.
• Standards for labor and material costs that are not current.
• Changes in make-or-buy decisions not disclosed.
• Inappropriate or misleading sampling techniques.

Contractors might want to use this listing to perform their own self-assessments.

Government Approach to Profit/Fee Analysis

We've discussed profit and fee several times in this blog but it is worth repeating because we continue to hear of situations where the Government attempts to coerce prospective contractors into accepting paltry profit and fee amounts during negotiations. This aggressiveness may well be contrary to Government policy.

The underlying assumption behind Government approaches to profit/fee analysis is the belief that contractors are motivated by profit/fee (see FAR 15.404-4(a)). The Government is required to use a structured approach (usually the weighted-guidelines method) which provides a disciplined approach for ensuring that all relevant factors are considered in developing Government profit/fee negotiation objectives.

It is in the Government's best interest to offer contractor's opportunities for financial rewards sufficient to

• Stimulate efficient contract performance;
• Attract the best capabilities of qualified large and small business concerns to Government contracts; and
• Maintain a viable industrial base to meet public needs.  

If the Government is to use profit/fee to motivate contractor performance and achieve the above goals, practices primarily intended to reduce profit/fee or diminish the impact of profit/fee analysis are not in the Government's best interest (see FAR 15.404-4(a)(3)).

• Negotiations aimed at reducing prices by reducing profit/fee without proper consideration of the profit function.
• Negotiation of extremely low profits/fees
• Use of historical average profit/fee rates without regard to the unique circumstances of the immediate negotiation
• Automatically applying predetermined profit/fee percentages without regard to the unique circumstances of the immediate negotiation.

While profit/fee calculations must consider the unique circumstances  of the immediate negotiation, contract fee cannot exceed statutory limits that apply to cost-plus-fixded-fee contracts;

• 15% for experimental, development, or research work
• 10% for all other cost-plus-fixed-fee contracts.

Alaska Native Corporations (ANCs)

If you've been around Government contracting for any length of time, you've no double heard the term ANCs or Alaska Native Corporations. They're in the news a lot and its usually not positive coverage. For example, Eyaktek, an ANC, made the news recently when one of its employees was involved in an allegedly conspiracy to defraud taxpayers by $20 million under a U.S. Army Corps of Engineers contract. Senator McCaskill and other less vocal senators have railed for several years against the contracting preferences granted to ANCs. DoD is performing a comprehensive analysis to determine just how much money is going to ANCs through its contracts.

For the most part, ANCs try to take advantage of the opportunities afforded to them through legislation passed by Congress and signed into law by the President. And, why not? Its the smart thing to do and it makes good business sense. Many non-ANCs however would prefer a more level playing field. That's a reasonable position as well. However, as long as the laws stay on the books, ANCs will continue to avail themselves of the contracting preferences.

In our discussions with clients who are not ANCs, we find that there is a significant lack of knowledge as to what the ANC preferences are. There is also a lot of misinformation out there as well. So, to help elucidate the matter, we offer this brief explanation of ANC preferences.

In 1971, Congress passed the Alaska Native Claims Settlement Act which created thirteen regional Alaska Native Corporations (ANCs) and approximately 200 local village ANCs to stimulate Alaska's economy and settle land disputes between the United States Government and Alaskan natives.

Fifteen years after the passage of the Settlement Act, Congress, in 1986, authorized regional and village ANCs to be included in the SBA 8(a) program. The SBA is authorized by law to develop a program and promulgate regulations to assist socially and economically disadvantaged small businesses. The SBA's Section 8(a) program, the "Business Development Program" provids business development assistance to socially and economically disadvantaged small businesses, including help in obtaining federal contracts.

When Congress authorized ANCs to be included in the SBA 8(a) program, they also granted unique procurement advantages beyond those available to other Section 8(a) participants, including the following exemptions:

• ANCs were eligible to receive sole source 8(a) contracts regardless of dollar size, with no upper limit, while all other 8(a) firms could not receive sole source contracts in excess of $3 million for services and $5 million for manufacturing.
• The Alaska Native Claims Settlement Act automatically conferred "economically disadvantaged" status upon ANCs, while other 8(a) firms had to be managed by economically and minority disadvantaged owners.

Because of these preferences, ANCs are often awarded very large sole-source contracts. The contract between Eyatek and the Corps of Engineers discussed above for example, had the potential of reaching $780 million over a five year period.

Purchase, Existence, and Consumption

Material costs are usually significant for any production type contract. Contract auditors have a special review they perform annually whenever material costs are significant on cost-type contracts. This is a mandatory review as well, meaning that the auditor must perform the review before approving final costs on a contract. It is also required to be performed annually. The purpose of the special evaluation is to verify that purchased direct materials were in fact received and ascertain that they were

• needed for the contract
• purchased in reasonable quantities
• purchased at prudent prices
• used on the contract, and
• properly accounted for as to initial charge, transfer in or out, and residual value.

These reviews are a bit different from traditional audits in that the auditor will draw a sample of materials charged to Government contracts and then physically locate all items in the sample. The auditors will also obtain purchase orders for the sampled items and trace those purchase orders to receiving reports. Contractors that cannot physically locate sampled material items are at risk for internal control deficiencies and perhaps having some billings temporarily suspended.

To determine whether the item was needed for the contract, the auditor will compare purchase requisitions or purchase orders to contract requirements and/or bills of materials. Good internal controls would have all three of these documents (purchase requisitions, purchase orders, and receiving reports) prepared by different personnel.

Purchases should be made at optimum quantity levels. Contractors should not buy too few at a time and lose out on quantity discounts. On the other hand, sometimes, buying too many of a quantity will result in lower prices based on available quantity discounts.

When materials used on a contract come from inventory (as differentiated from purchasing directly for the contract) the auditor will be very interested in inventory valuation methodologies.

Prompt Payment Interest Rate Drops to 2%

The prompt payment interest rate dropped again for the sixth consecutive semi-annual period. The new rate for the period January 1, 2012 through June 30, 2012 is a flat two percent. This is down from 2.5 percent from the previous six month period.

Any Governmental agency that has acquired property or services from a business concern and has failed to pay for the complete delivery of property or service b the required payment date must pay the business an interest penalty. This applies to public vouchers under cost-type contracts, progress payments under fixed price, as well as many other payment methods.

Under the prompt payment act, if an interest penalty is owed to a business concern, the penalty shall be paid regardless of whether the business concern requested payment of interest. Agencies calculate interest penalty with the interest rate in effect at the time the agency accrues the obligation to pay a late payment interest penalty.The interest penalty shall be paid for the period beginning on the day after the required payment date and ending on the date on which payment is made.