Award Fee Reduction or Elimination

Last September, we reported on an interim Department of Defense rule that requires contracting officers to include in the evaluation criteria of any award-fee plan, a review of contractor and/or subcontractor actions that jeopardized the health or safety military and civilian Government personnel through gross negligence or reckless disregard for the safety of such personnel.

That interim rule is now a final rule. It was adopted without change effective February 24, 2012. The purpose of this rule was to implement sections of the National Defense Authorization Acts for fiscal years 2010 and 2011 that provided increased authorities to reduce or deny award fees to companies found to jeopardize the health or safety of Government personnel.

It seems to us that this rule might have the most applicability in a "war zone" however there is nothing in the rule or the statutory basis that limits it thus. The rule applies even where it is not specifically identified as an award fee criteria. Contractors with award fee contracts (e.g. CPAF contracts) or contemplating award fee contracts should take note.

More Auditors to be Hired to Audit Incurred Costs

For contractors waiting for DCAA (Defense Contract Audit Agency) to perform their annual incurred cost audits so that they can close out old contracts and bill for remaining costs and fees, relief may be in sight. DCAA released its fiscal year 2013 budget estimate this month and is planning to significantly increase the resources dedicated to auditing incurred costs. The Agency is proposing to increase the number of staff years dedicated to incurred costs by 50 percent, from 1,409 staff years in fiscal year 2012 to 2,118 staff years in fiscal year 2013. Some of this will come from new hires and the rest from shifting priorities from other audit areas. The Agency wants to hire 506 new audits or fiscal year 2013 on top of the 484 it is hiring this fiscal year. That represents a 25 percent increase in audit staff over a two year period.

The budget documents put it this way:

The FY 2013 budget estimate contains a significant increase for the specific purpose of reducing the backlog of unaudited contractor incurred costs. Over the past 3 years, DCAA shifted resources away from audits necessary to close contracts (incurred cost audits) in order to focus on performing Generally Accepted Government Auditing Standards (GAGAS) - compliant audits for large contract proposals where audits can help contracting officers negotiate lower prices. This resulted in an increase in the incurred cost backlog of approximately $420 billion between FY 2008 and FY 2011. DCAA will use the increased funding in FY 2013 for additional audit staff specifically to reduce the backlog. Beginning in FY 2012, DCAA is establishing incurred cost teams who will focus all of their efforts on the incurred cost audits until the backlog is reduced to an acceptable level. These dedicated teams will increase efficiencies by lowering learning curves and eliminating disruptions from competing audit assignments. DCAA is also seeking authority to examine only a sample of incurred-cost audits that pose lower risk. Clearing the incurred cost backlog is necessary to (1) assist in achieving auditable financial statements, a Secretary of Defense priority; (2) provide DCAA with data needed for forward-pricing audits; and (3) prevent undue delays in payments of fees to contractors (a portion of fees to contractors is delayed until the contract is closed).

Many contractors cringe at the idea of becoming a training ground for hoards of new and inexperienced auditors. They tend to require a significant amount of support effort and cause other inefficiencies. For very small contractors where employees wear several "hats", these inefficiencies detract from other productive work.

Alliance Northwest Conference - March 15

Companies and individuals in the Pacific Northwest might be interested in attending the Alliance Small Business Conference to be held March 15, 2012 at the Puyallup Fair & Events Center in Puyallup, WA.

Alliance is a small business conference and trade show where companies are able to speak directly with large Government contractors, government agencies and other small businesses. This event features the who's-who of federal contracting and is a must-attend for firms interested in pursuing federal market opportunities. This annual conference is a great opportunity to start making or strengthening contracting connections. 

Besides the exhibits, there will be a number of educational breakout sessions and presentations including:

• Surety Bond Guaranty Program
• Bureau of Indian Affairs
• System for Award Management (SAM)
• SBA updates and certification
• Prime panel and subcontracting requirements
• GSA and Marketing your Schedule
• Exporting - is this for me and where do i start.

Stop by our exhibit and say hello.

17th Annual Government Contractor Survey

The accounting firm of Grant Thornton just published the results of its 17th 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". The survey included small, medium, and large Government contractors in 24 states and the District of Columbia. Here are some of the highlights from the executive summary section.

• 50% of the companies experienced increased revenues from Government sources. In last year's survey, that number was 55%.
• 72% of the survey participants account for uncompensated overtime by computing a diluted hourly rate (compression method) to allocate labor costs to cost objectives.
• On average, survey participants reported a 30% win rate on proposals submitted in a competitive environment for new work (consistent with prior surveys).
• Only 37% of the survey companies with EVMS (Earned Value Management Systems) reporting requirements believe that EVMS is a cost-efficient management tool (the same as last year)
• Relationship between contractors and government auditors and contracting officers has deteriorated during the past year. The relationship with auditors was rated as fair or poor by 19% of the surveyed companies, compared to 11% in the prior survey. The relationship with contracting officers was rated fair or poor by 10% compared to 5% in the prior survey.
• Only 22% believe that contract issues are resolved efficiently. This represents a decline from 26% in the prior year.

Concerning the deteriorating relationships with auditors and contracting officers, the survey makes the following familiar refrain:

"...It is our view that the decline in efficiency and business relationships during the past few years can be traced directly to changes in DCAA policy adopted after the GAO reports were issued in July 2008 and September 2009. Unfortunately, the GAO criticized the DCAA for having a management and agency culture that focused on a production-oriented mission, emphasizing the need for timeliness in supporting the needs of contracting officers in the procurement process. Rather than praise the DCAA for its production-oriented culture, the GAO unfortunately chose to severely criticize the DCAA for a perceived lack of independence from contractors and insufficient documentation and audit testing in the work-paper files to support the audit opinion. The DCAA took these criticisms to heart, and has adopted policies that increase its independence, expand its audit testing, increase the standards required for accepting costs or business systems, and significantly delay the issuance of audit reports. Further, in our view, the quality of the audit reports being issued by the DCAA under the new policies is far lower than was the case prior to the GAO reports. It appears that the net result from the GAO reports is that the DCAA's production-oriented culture has been replaced by a system in which the DCAA takes far longer to issue lower quality reports to a contracting officer who must seek DCAA concurrence before conceding some of the DCAA's positions in negotiations with the contractor. A possible remedy for the current inefficiencies that plague government contracting would be a statement of the basic principle that an audit report must be completed in a timely fashion if it's going to be useful as part of an efficient and cost-effective procurement process.

If you would like to read the complete survey results, click here.

Proposed Amendment to FAR Cost Principle on Taxes

DoD, GSA, and NASA are proposing to amend the Federal Acquisition Regulations (FAR) cost principle on Taxes (FAR 31.205-41) to make the two percent tax levied on foreign persons that receive Federal procurement funds, unallowable under Government contracts.

The Health and Compensation Act of 2010 which became effective on January 2, 2011, imposes a tax on any foreign person (individual, partnership, corporation, or other form of association) that receives a federal procurement payment. This tax is two percent of such payment. In addition, the law stipulates that no funds are to be disbursed to any foreign contractor in order to reimburse the tax imposed.

To implement the law, the FAR Council is proposing to amend FAR 31.205-41 to inform the Government and contractors that the costs of the two percent tax are not allowable. This means that such costs cannot be reimbursed or included in the pricing of any fixed-priced contract.

The law became effective a year ago January and applies irrespective of its inclusion in FAR.

The Importance of Site Investigations - Construction Contracts

All construction projects have risks. Although participants in the process attempt to limit or minimize those risks, there is no contract that eliminates all risks. In Government contracting, the Government makes it incumbent upon bidders and winning contractors to take reasonable steps to understand the full scope and breadth of the project.

FAR 36.503 requires contracting officers to insert the "Site Investigation and Conditions Affecting the Work" clause in solicitations and contracts for fixed-priced construction. This clause, located at FAR 52.236-3 and states:

The contractor acknowledges that it has taken steps reasonably necessary to ascertain the nature and location of the work, and that it has investigated and satisfied itself as to the general and local conditions which can affect the work or its costs, including but not limited to

• conditions bearing upon transportation, disposal, handling, and storage of materials

• the availability of labor, water, electric power, and roads

• uncertainties of weather, river stages, tides, or similar physical conditions at the site

• the conformation and conditions of the ground

• the character of equipment and facilities needed preliminary to and during work performance.

The Contractor also acknowledges that it has satisfied itself as to the character, quality, and quantity of surface and subsurface materials or obstacles to be encountered insofar as this information is reasonably ascertainable from an inspection of the site, including all exploratory work done by the Government, as well as from the drawings and specifications made a part of this contract. Any failure of the Contractor to take the actions described and acknowledged in this paragraph will not relieve the Contractor from responsibility for estimating properly the difficulty and cost of successfully performing the work, or for proceeding to successfully perform the work without additional expense to the Government.

The Government assumes no responsibility for any conclusions or interpretations made by the Contractor based on the information made available by the Government. Nor does the Government assume responsibility for any understanding reached or representation made concerning conditions which can affect the work by any of its officers or agents before the execution of this contract, unless that understanding or representation is expressly stated in this contract.

The existence of this clause makes it very difficult for contractors to submit equitable adjustment claims when project costs increase because of conditions that were knowable, but unknown to the contractor, at the time of contract award. It makes it especially critical for bidders to conduct comprehensive site investigations in the process of estimating costs (and performance periods).

Constructive Changes - Verify Critical Information

A decision that was recently handed down by the Armed Services Board of Contract Appeals (ASBCA) illustrates the importance of both contracting parties, the Government and the prospective contractor, to verify critical information in a solicitation (Appeal of BECO Construction Co., Inc., ASBCA No 57483).

The Government issued a Request for Quotation (RFQ) that called for reclamation work on approximately 2.7 acres. The appellant submitted its bid based on that estimate. After contract award, the contractor discovered that the site to be reclaimed was more than 4 acres and asked the Government for an increase in contract price. The Government refused, the contractor completed the work, and filed a claim for additional compensation. The Government again refused so the contractor appealed.

The appellant argued that there was a constructive change that entitled it to a price adjustment. The ASBCA agreed that the appellant was misled and ordered the Government to pay for the extra work. In its decision, the ASBCA cited the well-established rule that where the government makes positive statements in the specifications or drawings for the guidance of bidders, a contractor has the right to rely on them regardless of contractual provisions requiring the contractor to make investigations. Additionally, the Government knew that the reclamation project was greater than that specified in the solicitation. It had information in its files that it did not disclose estimating the site to be about 5 acres. The Government should have known that the description of the area in the contract was misleading and that potential contractors would rely on it.

Monday Morning Humor - Different Perspectives

How auditors see themselves as the first line of defense against contractor fraud, waste, and abuse.

How Government contractors view auditors.

How contracting officers view audit reports.

Revised Procedures for Submitting Interim Vouchers

Last month, we reported on DoD's proposal to streamline the process of submitting interim vouchers. Interim vouchers are used by contractors to bill for costs under cost-type contracts. For background, you can read the original post here.

Last week, DoD published a Federal Register "clarification" of its proposed rule. It states:

Interim vouchers that are selected using risk-based sampling methodologies will be reviewed and approved by the contract auditors for provisional payment and sent to the disbursing office after the pre-payment review. Interim vouchers not selected for a pre-payment review will be considered acceptable for payment and will be sent directly to the disbursing office. All interim vouchers are subject to an audit of actual costs incurred after payment. The sampling process will be accomplished largely within the Wide Area WorkFlow system.

The rule proposes to revise the requirements for approving interim vouchers by replacing the direct submission process ... with a risk-based sampling process. The proposed risk-based sampling process is a more effective and efficient approach. It allows for the evaluation of selected interim vouchers on a pre-payment basis in lieu of the current direct submission authorization, which does not allow for the pre-payment evaluation of higher risk interim vouchers. It is anticipated that the revised process will provide a more comprehensive samle of all vouchers and an enhanced oversight of higher risk vouchers, while allowing a more efficient processing of the vouchers not selected for pre-payment review.

This proposed rule represents a significant change to process of approving interim vouchers. Under the current rules, the contract auditor is the authorized representative of the contracting officer for authorizing direct submission of interim vouchers for provisional payment to the disbursing office for contractors with approved billing systems (DFARS 242.803(b)(i)(C)). That section will be eliminated under the new rule and replaced with a provision that states: "Interim vouchers not selcted for a pre-payment review will be considered to be provisionally approved and will be sent directly to the disbursing office".

This proposed rule is good news for small contractors. Any contractor who has tried to have its billing system approved for direct submission of interim vouchers can attest to the the fact that DCAA makes it very difficult to "pass". DCAA has effectively encumbered the process by setting a very high standard. The criteria include, adequate accounting system, reconciling billed costs to cost accounting records, establish billing rates with copious supporting data and rationale, maintaining cumulative allowable costs by contract, adjusting billing rates, briefing contracts, and submitting timely annual incurred cost submissions. Many small contractors simply "gave up" and factored extra time for DCAA review into their cash flow projections.

Depreciation using ACRS/MACRS

The Economic Recovery Tax Act of 1981 established the Accelerated Cost Recovery System (ACRS) for property placed in service after 1980 and the Tax Reform Act of 1986 established the Modified Accelerated Cost Recovery System (MACRS) for property placed in service after 1986. Under ACRS and MACRS, the cost of most tangible, depreciable property are recovered over predetermined periods generally unrelated to and shorter than useful lives. The recovery deduction for each year is determined by applying a percentage specified in the law to the unadjusted basis of the property. By now, there are probably not too many assets around that predate the MACRS methodology.

Contractors need to keep in mind that ACRS/MACRS was created for income tax purposes and not financial reporting purposes. It would be very unusual to find ACRS/MACRS depreciation methods used in any audited financial statements. FAR 31.205-11(c) ties the allowability of depreciation for Government contract costing purposes to "financial reporting" purposes. It provides that ACRS/MACRS is acceptable for contract costing if the method is used for financial accounting purposes.

Many small Government contractors do not prepare audited financial statements and therefore have no benchmark for determining the depreciation method applicable to their contract(s). Some simply pluck the amount from the most convenient source and that source is the tax return. The tax return however is focused on minimizing tax liability and not the realistic useful lives of assets.

In reviewing forcasted or actual indirect expense rates, auditors will usually make inquiries into the depreciation methodology used, if depreciation expense is a significant element of the indirect cost pool being reviewed. Contractors who are using ACRS/MACRS for Government contract costing purposes need to adjust their practices to comply with FAR 31.205-11.

DCAA to Establish Milestone Plans for Audit Performance

A few years ago in the wake of the whistle-blower scandal and ensuing Congressional hearings that ultimately toppled its Director, the Defense Contract Audit Agency jettisoned most of the metrics it used to manage audits. The fallout from this was absolutely brutal. The Agency lost most of its credibility and goodwill. The number of audit reports issued dropped precipitously as the Agency no longer seemed to care what the "customer" wanted or needed. In some cases, Judge's orders were required to make DCAA issue audit reports. PCOs and ACOs (Procurement and Administrative Contracting Officers) were not being served and became vocal in their displeasure. As a result, DoD began transferring to other agencies much of DCAA's traditional workload (most pricing audits, financial capability reviews, purchasing system reviews, EVMS reviews, direct billing authorizations, to name a few. Adding additional auditors to chase fewer and fewer audits did not seem to help the Agency to publish audits any quicker.

DCAA management was not oblivious to this demise but its reaction to accusations from oversight agencies like the GAO (General Accountability Office) or the DoD Office of Inspector General) who found that DCAA's audits were "inadequate"caused the Agency it to add appreciably more internal oversight to the audit process (and correspondingly more audit effort and time). The junkyard dog mentality that once characterized Agency personnel has been replaced with John and Jane Milquetoast. Some of us wonder if the bell is about to toll for this once proud fighter for the taxpayer.

To try and put some sanity back into the audit process, DCAA just announced a new policy that will require its auditors to establish milestone plans for various audits. Milestone plans, according to the policy, " ... are intended to be a useful audit management tool that assist the audit team in successfully accomplishing its audit by a realistic due date. Good milestone plans provide a visual document to manage work flow and assist in meeting common objectives. A well-developed milestone plan also will allow the audit team to recognize when established due dates are no longer achievable or increased staffing is required to meet the due date."

There are a number of criteria that need to be considered by the audit staff when developing milestone plans. One of those criterion that should resonate with the contracting community is a requirement to consider the contracting officer's needs when establishing due dates. There's another requirement to explain, justify, and document when milestone dates are missed, not because some individual messed up but so the "process can be improved" - its always the process, never the individual that is to blame.

We do not hold out hope that this policy is going to expedite the issuance of audit reports. The Agency needs more than just a new policy, a flavor of the month, or more faddish fluff. It needs someone or something that will rebuild auditor confidence, courage, and boldness; confidence in knowing they have the knowledge, skills and abilities to conduct professional audits, courage to not care when some picayune oversight agency finds that it forgot to dot an "i" or cross a "t", and boldness in defending sound audit positions.

You can read the new policy here.

Economic Planning Costs

Economic planning costs are the costs of general long range management planning that is concerned with the future overall development of the contractor's business and that may take into account the eventual possibility of economic dislocations or fundamental alterations in those markets in which the contractor currently does business.

According to FAR 31.205-12, economic planning costs are allowable under Government contracts. However, FAR cautions that allowable economic planning costs do not include organization or reorganization costs which are generally unallowable under FAR 31.205-38. Often times, the distinction between allowable economic planning costs and unallowable planning for the organization or reorganization of the corporate structure of a business (including mergers and acquisitions) is not very clear making this area a frequent source of dispute between contractors and Government auditors.

There are a couple of things contractors can do to minimize disputes. Contractors anticipating to incur significant economic planning costs can pursue an advance agreement with the contracting officer prior to incurring the costs. Whether the contracting officer is amenable to an advance agreement or not, documentation is very important to the process. The activities covered by this cost principle should be tied back to the definition of economic planning costs thereby leaving little room for "interpretation".

H.R. 1540 - Employee Compensation

Last December 31st, President Obama signed into law, H.R. Bill 1540, the National Defense Appropriations Act for Fiscal Year 2012. With respect to compensation, the salary cap that was heretofore applied to the five most highly compensated employees in management positions at each home office and each segment of the contractor (see FAR 31.205-6(p)), was broadened to cover "any contractor employee" The cap is set annually by the Office of Federal Procurement Policy (OFPP). The current cap is $ 693,951. This cap covers the total amount of wages, salary, bonuses, deferred compensation and employer contributions to defined contribution pension plans.

The new law includes an escape clause for certain targeted positions. It states that the Secretary of Defense may establish one or more narrowly targeted exceptions for scientists and engineers upon a determination that such exceptions are needed to ensure that the Department of Defense has continued access to needed skills and capabilities. Look for upcoming guidance in the DoD FAR Supplement (DFARS) on how to make such requests.

The effective date for this section of the law is January 1, 2012 and applies to all " ... contracts entered into before, on, or after the date of the enactment of this Act."

In making this change, Congress was swayed by the fact that DCAA (Defense Contract Audit Agency) had shown that there are lower-level executives not subject to the cap and non-executive employees who receive compensation in excess of the benchmark compensation amount. Congress believes that this section would reduce the risk of excessive individual compensation charged to defense contracts.

Most contractors - especially small contractors - will be unaffected by this cap. $694 thousand is a lot of money. That would not have been the case if other proposals had won out. One would have limited compensation to $200 thousand and another to $400 thousand. Contractors who are affected by this cap need to be sure to record excess amounts to an unallowable account to avoid penalties for claiming unallowable costs.

Happy Valentine's Day.

Contingency due to Currency Exchange Rate Fluctuations

A contractor recently included escalation based on forecasted changes in the currency exchange rate between the country in which the work was going to be performed and the US Dollar. In other words, the contractor would be incurring costs in a foreign currency but reimbursed by the Government in US Dollars. In order to protect itself against a potential increase in the foreign currency relative to the US Dollar, the contractor added costs based on projected changes in the foreign exchange rate. DCAA (Defense Contract Audit Agency) questioned this forecast as an unallowable contingency under FAR 31.205-7. DCAA was correct in its application of this cost principle, in our opinion.

FAR 31.205-7 defines contingencies as a possible future event or condition arising from presently known or unknown causes, the outcome of which is indeterminable at the present time. Contingencies with estimates of future costs fall into two categories:

Costs that may arise from presently known and existing conditions, the effects of which are foreseeable within reasonable limits of accuracy. These are typically allowable.

Costs that may arise from presently know or unknown conditions, the effect of which cannot be measured so precisely as to provide equitable results to the contractor and to the Government. These should be be excluded from cost estimates.

Foreign exchange rates definitely fall into the later category and should not be included in a proposal. (If a Government contractor was able to forecast exchange rate fluctuations with reasonable accuracy, they are definitely in the wrong business). However, there are other contracting vehicles available to protect contractors in such situations. Contracting officers are able to develop a special clause that would address currency exchange adjustments. Usually such clauses swing both ways, protecting the Government's interests as well as the contractor's, depending on which way the currency fluctuates. If you encounter a situation such as this, be sure to discuss the possibility of including such a clause in your contract.

SBA to Increase Size Standards for Many Small Business Classification

The Small Business Administration (SBA) has increased small business size standards for 37 small business NAICS (North American Industry Classification System) Codes, some of them significantly so; offices of attorneys increased from $7 million to $10 million in sales and offices of certified public accountants increased from $8.5 million to $19 million in sales. These new standards are all receipts based (as opposed to number of employees).

If you have been teetering on the brink between small business and non-small business because of your company sales, you should periodically review SBA's size standards because they do change from time to time. The newly revised standards, which become effective March 12th, can be viewed here.

Significant Deficiencies - Contractor Business Systems

DoD Contractors receiving cost-reimbursement, incentive type, time-and-materials, or labor-hour contracts or contracts which provide for progress payments based on costs or on a percentage or stage of completion, must maintain adequate accounting systems.

"Accounting system" means the contractor's system or systems for accounting methods, procedures, and controls established to gather, record, classify, analyze, smmarize, interpret, and present accurate and timely financial data for reporting in compliance with applicable laws, regulations, and management decisions.

The contracting officer, in consultation with the auditor (or functional specialist) determines the acceptability of a contractor's accounting system and approves or disapproves the system and, if necessary, pursues correction of any deficiencies.

In evaluating the acceptability of a contractor's accounting system, the contracting officer, in consultation with the auditor shall determine whether the contractor's accounting system complies with the system criteria for an acceptable accounting system as prescribed in DFARS (DoD FAR Supplement) 252.242-7006.

An acceptable accounting system is one that complies with eighteen different criteria listed in the aforementioned DFARS reference and provides reasonable assurance that applicable laws and regulations are complied with, is reliable, minimizes risk of misallocations and mischarges and consistent with billing procedures.

A "significant deficiency" in the case of a contractor business system means a shortcoming in the system that materially affects the ability of officials of the Department of Defense to rely upon information produced by the system that is needed for management purposes.

Failure to maintain an acceptable accounting system could result in withholding of payments for CAS covered contractors but might also result in disapproval of the system. A disapproved accounting system will likely prevent companies from winning competitive bids.

Adequate Accounting System

A company in Florida protested the award of an Army contract to a competitor based on a number of factors including the notion that the competitor did not have an "approved" accounting system, as required by the terms of the solicitation. The protest claimed that although DCAA (Defense Contract Audit Agency) had performed a limited scope survey in 2009, the competitor had subsequently and fundamentally changed its accounting system and DCAA had not yet completed its audit of the new accounting system.

Concerning the new accounting system, the administrative contracting officer (DCMA or Defense Contract Management Agency) had "approved" it pending DCAA verification that the company had implemented some corrective actions and that those actions were effective. In awarding the contract, the Army relied on the contracting officer's approval of the new accounting system.

The Comptroller General's office that adjudicated the protest, found that the Army reasonably concluded that the winning bidders accounting system was adequate for determining costs in a cost-type contract. The determination of a prospective contractor's responsibility rests within the broad discretion of the contracting officer, who, in making that decision, must necessarily rely on his or her business judgment. The Comptroller General found no basis to question the Army's judgment and denied the protest.

You can read the entire case here.

The basics for an adequate accounting system are laid out in DFARS (DoD FAR Supplement) 252.242-7006.

Performance and Payment Bonds

Yesterday we discussed the general allowability criteria for Bonding Costs (FAR 31.205-4). Today we want to dig a little deeper into the purpose of performance and payments bonds as well and when such bonds are required.

For construction contracts over $150 thousand, contractors must provide performance and payment bonds before it can begin work. For contracts under $150 thousand but greater than $30 thousand, there is added flexibility in what contracting officers can accept to ensure that a contractor pays its subcontractors and suppliers. Note, the Miller Act set a threshold of $100 thousand but the Federal Acquisition Regulations have a higher threshold (see FAR 28.102-1.a).

Performance bonds protect the Government. The penal amount of these bonds is usually 100 percent of the original contract price but the contracting officer may require additional protection if the contract price is subsequently increased.

Payment bonds protect subcontractors and suppliers. Like performance bonds, the penal amount is typically 100 percent of the original contract price unless the contracting officer determines, in writing, that a payment bond in that amount is impractical. Without payment bonds, subcontractors and material suppliers would otherwise be reluctant to work on Government construction projects, knowing that sovereign immunity prevents the establishment of a mechanic's lien.

Failure to provide acceptable bonds justifies terminating the contract for default but the Government can take less drastic actions such as withholding progress payments.

After contract completion, the contracting officer must withhold final payment if the surety provides written notice regarding the contractor's failure to pay its subcontractors and suppliers.

Bonding Costs

A "bond", according to FAR 28.001, is a written instrument executed by a bidder or contractor (the "principal"), and a second party (the "surety") to assure fulfillment of the principal's obligation to a third party (the "obligee" or "Government") identified in the bond. If the principal's obligations are not met, the bond assures payment to the extent stipulated, or any loss sustained by the obligee. The types of bonds are as follows:

• Advance payment bond - secures fulfillment of the contractor's obligation under an advance payment provision.
• Annual bid bond - a single bond furnished by a bidder, in lieu of separate bonds, which secure all bids (on other than construction contracts) requiring bonds submitted during a specific Government fiscal year.
• Annual performance bond - a single bond furnished by a contractor, in lieu of separate performance bonds, to secure fulfillment of the contractor's obligations under contracts (other than construction contracts) requiring bonds entered into during a specific Government fiscal year.
• Patent infringement bond - secures fulfillment of the contractor's obligations under a patent provision.
• Payment bond - assures payments as required by law to all persons supplying labor or material in the prosecution of the work provided for in the contract.
• Performance bond - secures performance and fulfillment of the contractor's obligation under the contract.

Bonding costs arise when the Government requires assurance against financial loss to itself or others by reason of the act or default of the contractor. They arise also in instances where the contractor requires similar assurance. Included are such bonds as bid, performance, payment, advance payment, infringement, and fidelity bonds.

Bonding costs are generally allowable. According to FAR 31.205-4, costs of bonding required pursuant to the terms of the contract are allowable (although the costs must still meet "reasonableness" criteria). Costs of bonding required by the contractor in the general conduct of its business are allowable to the extent that such bonding is in accordance with sound business practice and the rates and premiums are reasonable under the circumstances.

DCAA's Goal to Work Off Incurred Cost Audit Backlog

Although we have not seen anything official, we have heard from a number of sources that DCAA' (Defense Contract Audit Agency) is prioritizing incurred cost audits in Fiscal Year 2012. As many contractors can attest to, the Agency has virtually ignored incurred cost audits at smaller contractors for several years and the backlog has grown accordingly. Many contractors are owed significant sums of money for completed contracts but cannot bill for those costs until the incurred cost audits are completed. DCMA could authorize payment without audit but has been unwilling to do so.

Recently, many contractors have been receiving correspondence from DCAA asking for additional data prior to starting the incurred cost audits. These letters vary according to Region and Field Audit Office but here is a composite of data requests from several of these letters.

1. Comparative analysis of indirect expense pools with prior years
2. Executive compensation information for top five executives
3. List of ACOs and PCOs for each flexibly priced contract
4. Identification of and information on prime contracts under which the contractor performs flexibly priced effort as a subcontractor.
5. List of work sites and the number of employees assigned to each site.
6. Description of accounting system.
7. Procedures for identifying and handling unallowable costs.
8. Certified financial statements or other financial data
9. Management letter from outside CPAs concerning any internal control weaknesses
10. Actions that have been and/or will be implemented to correct the weaknesses described above
11. List of internal audit reports issued in the fiscal year
12. Annual internal audit plan of scheduled audits to be performed in this fiscal year
13. Federal and state income tax returns
14. SEC 10-K report
15. Minutes from Board of Directors meetings
16. Listing of delay and disruption and termination claims submitted which contain costs relating to this fiscal year.
17. Contract briefs

Of course, not all of these items will be applicable to most contractors. If you receive one of these letters and you have reservations about one or more of the items requested, you might seek advice from counsel. At a minimum, you should ask the auditor for his/her authority for requesting a particular item, if not obvious. For example, some companies have refused to provide board of directors meetings as there is no clear nexus between those minutes and costs charged to Government contracts. Other contractors have allowed auditors to review the minutes but not take copies.

Many of these items are documents that the auditor will be requesting during the audit. To that extent, providing them ahead of time might facilitate the audit once it begins. We don't recommend that contractors spend a lot of time creating data. For example, there is no contractual requirement for contractors to prepare a comparative analysis of indirect expense pools with prior years. If a contractor has that information readily available, it should be no problems to provide it. On the other hand, if the data is not readily available, let the auditor perform the analysis - its their job.

Performance-Based Payments - DoD Implementation

DoD is proposing to require the use of its performance-based payments (PBP) analysis tool whenever contracts are awarded using PBPs as a financing mechanism. The PBP analysis tool is a cash-flow model for evaluating alternative financing arrangements.

As with all contract financing, the purpose of PBP is to assist the contractor in the payment of costs incurred during the performance of the contract. Therefore interim payments should never exceed total cost incurred at any point during the contract. The Government has found itself in many situations where PBP to contractors have exceed their costs. It gets really sticky when there is a contract termination or some other contract dispute.

Under DoD's proposed regulations, prior to using PBPs, the contracting officer must agree with the offeror on a price using customary progress payments before negotiation begins on the use of PBPs. Then the contracting officer must analyze the PBP schedule using the PBP analysis tool. This tool is an Excel-based model and is available on the DPAP website. Contractors contemplating a PBP arrangement should download and become familiar with this tool. Contracting officers will need your help to ensure the accuracy of the data needed to accurately populate the model.

If performance-based payments are desired, the contractor must submit a proposed PBP payment schedule which includes all performance-based payments events, completion criteria, and event values, along with the expected expenditure profile. If PBP are deemed practical, the Government will evaluate, and negotiate the details of the PBP schedule.

Here's the incentive for the Government. If, based on the PBP analysis tool, the payment schedule will be more favorable to the contractor than customary progress payments, the Government will expect some consideration in return. This is typically a reduction in the profit percentage that was negotiated without concern for PBP payments. DoD calls this a "win-win" situation. On its previously linked website, DoD states the following:

PBPs offer a unique opportunity for a real "Win-Win" financial arrangement for the Government and the contractor. This opportunity presents itself due to the Government and the contractor having differing views of the time-vale of money. The "Win" for the contractor is better cash flow resulting in a more favorable financial outcome as measured by the IRR (internal rate of return) and the NPV (net present value) of the cash flows at a reduced contract price.

The "Win" for the Government is a lower contract price that more than offsets the additional financing costs of providing a better cash flow to the contract. The PBP Analysis Tool employs a discounted cash flow analysis to help the contracting officer to determine the Win-Win financial solution for any PBP arrangement. The tool provides a unique and simple to use "what if" feature on the timing of PBP event completin and payment that enables both sides to objectively assess the ptential risk of PBPs in determining the Win-Win solution.

Allowability of IR&D Costs Now Contingent Upon Reporting

The Department of Defense has amended its FAR Supplement (DFARS) to require that "major" contractors report their IR&D (Independent Research and Development) projects to the Defense Technical Information Center (DTIC) in order for those costs to be allowable.

Specifically, DFARS 231.205-18(c)(iii)(C) now states:

For a contractor's annual IR&D costs to be allowable, the IR&D projects generating the costs must be reported to the Defense Technical Information Center (DTIC) using the DTIC's on-line input form and instructions at http://www.dtic.mil/ird/dticdb/index.html. The inputs must be updated at least annually and when the project is completed. Copies of the input and updates must be made available for review by the cognizant administrative contracting officer (ACO) and the cognizant Defense Contract Audit Agency (DCAA) auditor to support the allowability of the costs. Contractors that do not meet the threshold as a major contractor are encouraged to use the DTIC on-line input form to report IR&D projects to provide DoD with visibility into the technical content of the contractors' IR&D activities.

Major contractors are defined as contractors (including all segments) that allocated more than $11 million in IR&D/B&P costs to contracts during their previous fiscal year. That threshold should eliminate most small businesses however contractors under the threshold are still encouraged to report.

Making the inputs available to the ACO and DCAA to support the allowability of costs is a mechanism to enforce compliance. DCAA would not necessarily have the expertise to evaluate whether costs are for projects of potential interest to DoD (another requirement of the DFARS cost principle), but they can certainly check to see if the projects for which contractors are claiming costs have been reported to DTIC.

The effective date of this change is January 30, 2012.