Business System Deficiency Reports

Contractors might never see it coming. The auditors are there evaluating a price proposal, reviewing the annual incurred cost proposal, or performing a labor floorcheck when it hits - a Business System deficiency report. What's going on? The auditors were not auditing one of the six DFARS (DoD FAR Supplement) business systems. How can they issue a deficiency audit report?

This month, DCAA released a new audit program that requires auditors to issue audit reports on deficiencies/instances of noncompliance with the DFARS business system criteria when such deficiencies are identified during any routine audit. No longer must the auditors wait until they get around to a full-up audit of a business system. They can now issue reports at any time.

According to guidance,

... the objective is not to evaluate the contractor's compliance with all aspects of the applicable DFARS criterion or criteria but only to establish whether the noncompliance identified in the originating audit represents a significant deficiency/material weakness or is less severe than a significant deficiency/material weakness, yet important enough to warrant the attention of responsible contractor management officials.

According to GAGAS (Generally Accepted Government Auditing Standards), auditors are required to report certain findings identified during an attestation examination engagement even when those findings are related to areas outside the specific objective of the examination. This would include deficiencies in a contractor business system identified during audits of incurred cost, price proposals, or any other non-business system audits.

Be forewarned and be prepared.

Trade Discounts

The cost of materials under Government contracts seems pretty straight-forward. Contractors purchase raw materials, parts, sub-assemblies, components, and manufacturing supplies. Sometimes these costs are charged to inventory and other times, directly to the contract. The "reasonableness" of the prices are assured through the contractor's purchasing policies, procedures, and practices. There is, however, one little provision found in FAR 31.205-26 (Material Costs) that contractors often overlook. That provision states that contractors must adjust the cost of material for income and other credits including, among other things, available trade discounts.

Trade discounts are offered by vendors to encourage customers to pay early. They can be found on vendor invoices under the "Terms" section. For example, the term "2/10, N30" means that the customer may deduct two percent off the invoice if payment is made in 10 days. Otherwise, the full amount is due in 30 days.

Contractors are required by FAR to deduct available trade discounts from the cost of materials whether they take the discount or not. Many contractors do not take available discounts and charge their Government contracts the full amount of the invoice. Auditors are well aware of this practice and often spend a fair amount of time reviewing invoices for material costs, looking for lost discounts.

There is some relief available when the discounts are lost "without fault or neglect on the part of the Contractor, or lost through fault of the Government." If one of those events happen, the payment clauses require that contractors notify the Contracting Officer and give the reasons (see, for example, FAR 52.232-7). We heard of a case where the Contracting Officer excused the contractor from adjusting material costs for lost discounts because the vendor invoice did not arrive at the Contractor in sufficient time for it to take the discount.

Contractors should review their policies and procedures to ensure compliance with this FAR cost principle.

Justification and Approval (J&A)

Earlier this week, we reported on the final rule that prohibits the Government from awarding any contract greater than $20 million under the SBA's 8(a) Business Development Program without first obtaining written justification. This written justification, known as J&As (Justification and Approval) in the trade, must be made publicly available for at least 30 days. The Government has chosen to post these J&As on FedBizOpps. Actually, this final rule replaces an interim rule from nearly year ago so these J&As have been available for some time. We decided to take a look at some of them and here are a few observations.

While there are dozens of J&As posted to FedBizOps, we were unable to locate any that were for $20 million plus awards to 8(a) firms. Perhaps there are not that many.

The key to a sole source justification is to demonstrate that the contractor has some kind of unique qualification. Many J&As were for spare parts that only the manufacturer of the full product can deliver. Those justifications are fairly obvious. However, the documentation for many seemed vague. "Expediency" was often used as justification.

Even in sole source procurement, the Government must determine that the price or cost is fair and reasonable. Since these justifications are prospective, the contracting officer has usually not yet determined price reasonableness. So, the J&A typically states that the contracting officer will determine, though various available means, analyses, and comparisons, that the price is reasonable.

The "quality" of J&As varies by Agency. Some are bereft of information and details while others go to great lengths to justify their decision and action. In either case, we were often left wondering about the sufficiency of the justification.

Most of the J&As we looked at included a section describing the Government's planned actions to remove barriers to future competition. In most cases, the Agency offered no substantive plans to further competition for the products being purchased.

More on the New Executive Compensation Cap

Yesterday we reported that the Office of Management and Budget (OMB) had just bumped the Executive Compensation cap for 2011 by 10 percent from $694 thousand per year to $763 thousand per year. The OMB announcement is about a year later than usual. In every other year since it began publishing executive compensation caps, OMB has published the cap in April or May of the year in which the cap applies. This time around, OMB published the cap for 2011 in 2012. It probably would have preferred to delay the announcement even longer except contractors need this information to prepare their annual incurred cost proposals, which for calendar year contractors, are coming due June 30th. (by the way, if you need help completing your annual incurred cost claim, give us a call).

In past years, OMB's executive compensation cap announcements have been rather perfunctory - a simple statement of the new cap. This year was quite different. . OMB was amped up on Red Bull and a mega-dose of B-complex vitamins. It made sure that everyone knows that the current Administration was not behind or responsible for this increase. It proclaimed that the executive compensation cap was based on a formula that was statutorily required and that they were only filling in the numbers. The OMB heralded the President's proposal last fall that would limit executive compensation to $200 thousand (or so)  and bitterly complained that Congress wouldn't go along with the proposal

"...to date, Congress has not adopted the Administration's proposal to replace the existing statutory formula for determining the reimbursement cap."

The OMB further claimed that the underlying considerations behind the statutory formula have no relationship to the type of work that contractors are actually performing under Federal contracts. It is the formula, and not any comparable improvement in contractor performance that resulted in the $70 thousand increase.

This issue is far from dead. Last March, a bipartisan group of senators introduced a bill that would cap the reimbursement rate at the president's salary, currently $400 thousand, and apply it to all contractor employees. A similar bill introduced i the House would lower the cap to $200 thousand and also apply it to all contractors. Although most Government contractors are not affected by the current cap, these lower caps would impact many contractors.

Executive Compensation Limit for 2011

At long last, the Office of Management and Budget has published the executive compensation cap for 2011. The new cap is $763,029, a nearly $70,000 jump (10 percent) from the 2010 cap of $693,951. We do not know why the delay. It is about a year late, when compared to previous years. Its possible this large of an increase will reflect poorly on the current administration. It is a staggering amount. As one pundit put it: "Obviously the system for calculating the benchmark is flawed. There is absolutely no justification for executives to be getting ten percent pay raises when employee pay has stagnated and many have lost their jobs."

For 2011, this cap applies to the top five most highly compensated employees in management positions at each home office and each segment. For 2012, it applies to all employees under DoD, Coast Guard and NASA  contracts and the top five for all other Government contracts. That should confuse things at affected contractors. They will need dual rates, one set of indirect rates for DoD, Coast Guard, and NASA and another set for all other Government contracts.

This cap does not affect the amount of compensation that contractors may pay. It only affects the amount that the Government will reimburse. Compensation for the fiscal year means the total amount of wages, salaries, bonuses, restricted stock, deferred and performance incentive compensation, and other compensation for the year, whether paid, earned, or otherwise accruing, as recorded in the employer's cost accounting records.

Stay tuned. There's going to be congressional pressure to reduce these caps.

Justifying Sole Source Contracts Awarded to 8(a) Firms

The awarding of sole source contracts by the Federal Government has always been a murky area. Except for those contractors who benefit from such awards, most are left in the dark as to how those awards are justified. Accusations and innuendo abound, ranging from kickbacks to political "quid pro quo" and other skulduggery. Congress did not feel like it had sufficient insight into what was going on and, if Congress had a hard time getting information, the public was totally in the dark. So, as part of the National Defense Authorization Act for 2010, Congress added a requirement that prohibited the award of sole-source contracts greater than $20 million awarded under the SBA's 8(a) Business Development Program without first obtaining written justification. Moreover, Congress added a provision that the justification had to be made publicly available prior to contract award.

The legislation and ensuing regulations specified certain criteria that must be present in the justification. These minimum criteria include:

1. A description of the needs of the agency concerned for the matters covered by the contract.
2. A specification of the statutory provision providing the exception from the requirement to use competitive procedures in entering into the contract (see 19.805-1)
3. A determination that the use of a sole-source contract is in the best interest of the agency concerned.
4. A determination that the anticipated cost of the contract will be fair and reasonable.
5. Such other matters as the head of the agency concerned shall specify for purposes of this section.

These justifications should be of more than passing interest to Government contractors and prospective contractors. They might offer some kind of road map on how contractors might position themselves to someday secure some of the (usually) lucrative awards.

The justifications are posted to FedBizOpps for a period of at least 30 days. As of now, there is no requirement to maintain these beyond the 30 days.

Proposed Legislation to Provide More Opportunities for Small Businesses

Earlier this year, the Small Business Committee of the House of Representatives introduced a series of contracting reform bills that are designed to increase opportunities for small business, create protections to fight fraud and abuse, and empower advocates who fight for small business during the federal acquisition process. The legislation is the result of the findings of 10 contracting hearings during 2011.

Last Tuesday, the Chairman of the House Committee on Small Business, Sam Graves, testified before the House Armed Services Committee about including the Committee's contracting legislation in the National Defense Authorization Act of 2013.


The proposed legislation includes the following eight proposals:


1. GET Small Business Contracting (Government Efficiency Through Small Business Contracting) Act of 2012 (HR 3850)

The GET Small Business Contracting Act raises the small business contracting goal from 23% to 25%. Raising the goal by 2% means a substantial amount of new business for small businesses – about $11 billion worth. The Act also holds top agencies accountable for meeting the small business goals by withholding the senior agency officials’ bonuses if the small business goals aren’t met.  Finally, the Act ensures opportunities for small businesses as subcontractors, with a goal of awarding 40% of all subcontracted dollars to small businesses – an increase from the current goal of 35.9%.

2. Small Business Advocate (SBAA) Act of 2012 (HR 3851): 

The Small Business Advocate Act makes it easier for the Office of Small and Disadvantaged Business Utilization (OSDBU) to advocate for small business contracts, focus on acquisition assistance, and fight insourcing and unjustified contract bundling. Acting as the OSDBU Director is often simply another assigned duty for a senior official that lacks the authority to challenge decisions made by the Chief Acquisition Officer or Senior Procurement Executive. The Small Business Advocate Act elevates their position to a senior acquisition leader in the agency and prohibits them from holding any other position so they can concentrate on their advocacy responsibilities. 


3. Subcontracting Transparency And Reliability (STAR) Act of 2012 (HR 3893): 

The STAR Act makes it easier to crack down on deceptive large businesses hiding behind small businesses, and simultaneously makes it easier for legitimate small businesses to comply with limitations by tracking price rather than cost. It also allows for more small businesses to team with other small businesses to compete for federal contracts. Finally, the Act adds transparency to insourcing by requiring agencies to publish their insourcing processes and gives small businesses contractors standing to challenge insourcing decisions in court.   

4. Small Business Opportunity Act of 2012 (HR 3980): 


The Small Business Opportunity Act will help provide more opportunities for small business contractors by requiring small business advocates to be part of federal procurement and acquisition planning processes. Offices of Small and Disadvantaged Business Utilization (OSDBUs) and Procurement Center Representatives (PCRs) are advocates for small business contractors, but are not included in the acquisition process until just before a Request for Proposal or Quotation is to be released.  The Small Business Opportunity Act would provide the OSDBUs and PCRs with access to those acquisition plans on the front end, and require that acquisition plans address how small businesses will be utilized.  

5 .Building Better Business Partnerships Act of 2012 (HR 3985): 

Mentor-Protégé programs are intended to partner small businesses with established mentors in order improve the small business’ ability to win and perform on contracts and subcontracts, but the 13 federal agency programs are duplicative (creating an unnecessary paperwork burden for participants) and lack standardized measures of success.  The Building Better Business Partnerships Act allows the Small Business Administration (SBA) to oversee civilian agency mentor-protégé programs in order to promote portability of agreements between the agencies, guarantee that the programs benefit the small businesses, and ensure that the mentor-protégé agreement doesn’t inadvertently harm the protégé’s small business status.   

6. Small Business Protection Act of 2012 (HR 3987): 

The Small Business Administration (SBA) is creating new group size standards that will define what businesses qualify as “small.” By the SBA’s own analysis, these proposals that lump different industries together are excluding legitimate small businesses from the SBA contracting programs. The Small Business Protection Act protects legitimate small businesses by requiring that the size standard assigned to each common group is appropriate for each individual North American Industry Classification System (NAICS) code that is put in the new group.

7. Contractor Opportunity Protection (COP) Act of 2012 (HR 4081): 

The Contractor Opportunity Protection Act provides a stronger process to appeal unjustified bundling through clarification of the statutory limits on bundling, the creation of a third party arbiter, and more transparency in the contracting process.  

8. Contracting Oversight for Small Business Jobs Act of 2012 (HR 4206):

The Contracting Oversight for Small Business Jobs Act addresses contracting fraud by helping small businesses comply with complicated contracting and size rules, and providing a safe harbor for small businesses making a good faith effort to comply with those rules. The bill also ensures that potential cases of fraud are properly and transparently dealt with through the suspension and debarment process, and provides a statutory framework for the Office of Hearings and Appeals – the office that decides who is truly a small business.  

Ask Before You Spend - Avoid Subsequent Disputes

Government contractors, like most businesses and individuals are asked to participate in community service projects. Some projects are regular and recurring while others are one-time events. Generally speaking, the cost of these projects  are allowable under FAR 31.205-1 which states that "allowable public relations costs include  cost of participation in community service activities (e.g. blood bank drives, charity drives, savings bond drives, disaster assistance).

Sometimes however, there is a fine line between allowable public relations activities and activities that are more closely aligned with advertising. Most kinds of advertising is unallowable under Government contracts.

There was a recent case involving a Government contractor who was asked to provide two employees to participate in a local Meals on Wheels program. The employees were to deliver meals for two to three hours every other week for one year. The contractor would pay their regular salaries and also reimburse them for their mileage. Before agreeing to take this project on, the contractor asked the contracting officer for advice on whether the costs would be allowable.

Requesting guidance on matters that could be controversial, or better yet, entering into an advance agreement with the Government on the allowability of such costs is a wise move. It precludes disputes later on. In this case, the contracting officer ruled that the cost of the Meals on Wheels project would be allowable as long as the costs were reasonable. The contracting officer also specified that the costs be charged indirect such as to a General and Administrative (G&A) account.

Subcontract Reporting Requirements

This is a reporting requirement reminder that for those of you with the FAR 52.204-10 clause in your contract or subcontract (which should be everyone with contracts greater than $25 thousand). This clause, Reporting Executive Compensation and First-Tier Subcontract Awards, requires prime contractors to report first-tier subcontract award data (e.g., name, amount, address, etc.) for subcontract awards over $25 thousand.  It also requires contractors and first-tier subcontractors with more than $25 million in Federal sales to report certain executive compensation information.

The Government is known to use this data when planning audits and performing other oversight reviews. Discrepancies between the information contained in the reporting databases and what the Government expects to find in those sources are noncompliance with contract terms and conditions and is met with varying degrees of gruffness.

 When this requirement first became a regulation in 2010, the FAR councils estimated the cost of compliance to be around $21 million. This estimate was laughably low according to many public commentators. As a result of these comments the Government this week revised its estimate of compliance. The Government's new estimate is set at $31 million per year. For most contractors, this reporting requirement is onerous, meaning that it takes a lot of time to compile the data, ensure its accuracy, and populate the Government databases. Larger contractors have developed systems to help make the process efficient but smaller contractors do not have the volume of subcontract awards to enjoy a learning curve or to justify the costs of specialized systems. The Government's estimate of 2 hours per subcontract reported is not even close to accurate for contractors that report only a few subcontract awards per year.

Information collected so far is publicly available at http://www.usaspending.gov/.

Special Tooling and Test Equipment

Disagreements between contractors and the Government arise from time to time over whether tooling and test equipment is "special" or "general". The distinction makes a big difference on the amount of tooling and test equipment costs that can be charged to one or more Government contracts. Generally, the costs of special tooling and special test equipment used in performing one or more Government contracts is allowable and shall be allocated to the specific Government contract or contracts for which acquired (see FAR 31.205-40). If tooling and test equipment does not meet the definition of "special", then the costs are normally dumped into an indirect expense pool and allocated across a broad allocation base that represents the contractors entire business.

FAR 2.202 definitions of special tooling and special test equipment

Special tooling means jigs, dies, fixtures, molds, patterns, taps, gauges, and all components of these items including foundations and similar improvements necessary for installing special tooling, and which are of such a specialized nature that without substantial modification or alteration their use is limited to the development or production of particular supplies or parts thereof or to the performance of particular services. Special tooling does not include material, special test equipment, real property, equipment, machine tools, or similar capital items.

Special test equipment means either single or multipurpose integrated test units engineered, designed, fabricated, or modified to accomplish special purpose testing in performing a contract. It consists of items or assemblies of equipment including foundations and similar improvements necessary for installing special test equipment, and standard or general purpose items or components that are interconnected and interdependent so as to become a new functional entity for special testing purposes. Special test equipment does not include material, special tooling, real property and equipment items used for general testing purposes or property that with relatively minor expenses can be made suitable for general purpose use.

Government challenges to the cost of special tooling and test equipment typically come from two angles. First, the Government will check to see whether the proposed or incurred tooling and test equipment costs meet the definitions above. If not, the costs may still be allowable indirect costs but moving costs from direct to indirect shifts some of the costs from Governmental to non-Governmental work. Secondly, the Government will assess whether the cost of the special tooling and test equipment is commensurate with the benefits. The purpose for spending money on specialized equipment is to reduce the requirements for production/manufacturing labor hours and costs, to speed up production, or to improve techniques, tolerances, and finished parts. If there is no cost benefit or contractors cannot otherwise build a business case for incurring the costs of special tooling or special test equipment, the Government will challenge the costs.

Fraud Among the Disadvantaged Business Enterprises

The Department of Justice announced last week the conviction of an individual who, over a period of 15 years, was able to obtain contracts that were set aside for Disadvantaged Business Enterprises (DBEs) for his not so disadvantaged firms (SPI and CDS). The Government estimated that he was able to steer about $136 million in Department of Transportation contracts to SPI and CDS by using a "front" firm (Markina, a legitimate DBE) to obtain these contracts. Obviously, this scheme involved co-conspirators.

Although the "front" firm, Marikina, received the contracts on paper, all the work was performed by the SPI and CDS. According to the Department of Justice, SPI and CDS kept all of the profits but did manage to pay small fixed fees to Marikina.

The firms went to great lengths to conceal the scheme. SDI and CDS personnel reutinely pretended to be Marikina employees by using Marikina business cards, email addresses, stationery, and signature stamps, as well as using magnetic placards and ecals bearing the Marikina logo to cover up SPI and CDS logos on their own vehicles.

According to the Department of Transportation, this is the largest DBE fraud case in Department history. The Transportation Inspector General is advising prime and subcontractors to report any suspected DBE fraud and has warned that its agents will continue to "expose and shut down DBE fraud schemes throughout ... the United States.

On a related matter, at least two Congressional committees are continuing to investigate the degree to which contracts awarded to small businesses are actually performed by small business and how much is subcontracted out to large and non-disadvantaged firms. The Alaska Native Corporations (ANCs) are bearing the brunt of these investigations but the committees are not limiting their investigations to that particular group.

These kinds of schemes not only affects the Government and taxpayers but cheats those small minority-owned businesses that the program is intended to help.

Reducing Improper Payments through the "Do Not Pay List"

Regular readers of this blog should be familiar with this Government initiative as we've written about it a few times since it was first introduced in November 2009. See for example:

• More on recouping improper payments
• Payment recapture audits - revisited
• Audits of contractor overpayments
• Payment recapture audits
• A "Do Not Pay" list
• Finding and recapturing improper payments

The basic idea behind this initiative is to ensure that "... the right recipient is receiving the right payment for the right reason at the right time". After a year or so into this program, the Government realized that prevention was just as important, or more so, than detection. That's when they came up with the "Do Not Pay" list. The "Do Not Pay" list is a single point of entry through which agencies would access relevant data before determining eligibility for a payment under a contract, grant, or any other source of federal funding.

Evidently, Government agencies were either not making much headway in this endeavor or were not taking it serious because the OMB (Office of Management and Budget) issued an ultimatum on April 12th giving agencies until June 30th to submit their draft plans for using the "Do Not Pay" solution for pre-payment eligibility reviews.

What this means for government contractors

As envisioned, every time you submit a progress payment request, public voucher, or commercial invoice, the Government will check the "Do Not Pay" list to ensure there are no outstanding monies owed. This would presumably include the IRS. Got a tax dispute going on? The Government will just deduct the amount in dispute from your next invoice. Arguing with NASA about a certain cost? DoE will deduct the disputed amount the next time you bill under one of their contracts.

There are still a lot of questions regarding this system. How are mistakes resolved? What happens when the amount in dispute has been covered by deductions from other billings? Is the contractor then removed from the list. What about inter divisional relationships? Will debts of one division be offset by billings from another? What about personal liabilities? Will the databases be sophisticated enough to associate companies with their owners and go after companies for the personal debts of the owners? Can anyone remove a contractor from the list or only the Agency that put them on the list. How responsive are agencies going to be when errors need to be corrected? Your cash-flow is critical to the ongoing financial capability of your company. Disrupt that and you will need to find other means of financing. Those other means will cost you money in interest or imputed interest.

Multi-Year Auditing

The Defense Contract Audit Agency (DCAA) is carrying a tremendous backlog of incurred cost proposals that require auditing. It has prioritized these audits in fiscal year 2012. Now that fiscal year 2012 is half way over and DCAA has not made significant progress in reducing the backlog, it will no doubt become a priority for next fiscal year as well.

One of the techniques that DCAA will be using to help reduce the backlog is to conduct multi-year audits. Under the multi-year audit concept, auditors can review from two to five years simultaneously. Savings are achieved by having to prepare a single set of working papers and issue a single audit report. They hope to gain other efficiencies as well but the Agency admits that it is not sure whether additional efficiencies and effectiveness are achievable.

Although multi-year auditing is not new to DCAA, it is now being aggressively encouraged. DCAA introduced new procedures for conducting the audits in guidance issued last month. For starters, multi-year auditing does not apply to contractors with more than $250 million charged to flexibly priced contracts. Second, before entertaining the idea, auditors need to determine and document that the contractor's business and organization structure for the years being audited has been relatively stable and consistent.

Transaction testing must cover all years. The auditor cannot look at transactions in one year and apply the results to other years. However, the auditor can choose to use random sampling, judgmental sampling or a combination as long as they can document that the selection results in adequate audit coverage.

If you company is chosen for a multi-year audit, we would like to hear of your experiences.

On Getting Paid for Work Performed

Ever have one of those days when you just want to smash your head against the wall. We have.

Proposal Preparation Costs - Direct or Indirect? (or Both?)

DCAA recently issued an "alert" to its auditors regarding contractor charging practices for proposal preparation costs. The alert clarifies the point that any proposal preparation costs not funded by a grant or required by contract are by definition indirect and accordingly, proposal and negotiation costs should only be charged directly to a contract when there is a specific contractual requirement for the contractor to submit a proposal.

This is one of those situations where there appears to be an inequity. There may be a contract, for example, with a line item that requires the contractor to prepare and submit a proposal for a follow-on contract or the next phase of the existing contract. Those proposal preparation costs are to be charged direct. Meanwhile, the contract also receives an indirect allocation that includes generic proposal preparation costs. In this case, the contract is being charged for both direct and indirect proposal preparation costs.

CAS 402 addresses this very situation. CAS 402-61(c) states:

... costs incurred in preparing, submitting, and supporting proposals pursuant to a specific requirement of an existing contract are considered to ave been incurred in different circumstances from the circumstances under which costs are incurred in preparing proposals which do not result from such specific requirements. The circumstances are different because the costs of preparing proposals specifically required by the provisions of an existing contract relate only to that contract while other proposal costs related to all work of the contractor.

Evidently there must be some proposal preparation issues out there as auditors are now being advised to carefully examine contractor practices that allow contractors to charge proposal costs directly, absent a specific contractual provision for the effort. Auditors are also being advised to be alert for vague and misleading wording in the disclosure statement that could lead to direct charging proposal costs that are not specifically required by an existing contract.

Contractors should be examining their own policies, procedures, and practices for consistency with the these requirements.

DCAA Issues Guidance on New Contractor Business System Rules

Late last month, DCAA issued audit guidance to its staff on the new DFARS (DoD FAR Supplement) final rule regarding contractors' business systems that became effective on February 24, 2012. We've discussed these new rules quite often in this blog (scroll down and click on the label "business systems" to read past posts on this subject). Essentially, the new business system rules are to improve contractor business systems to ensure that such systems provide timely, reliable information for the management of DoD programs. The rules cover six business systems: accounting, estimating, purchasing, EVMS, MMAS (material management), and property management.

Of these six systems, DCAA is responsible for the performance of the accounting system, the estimating system, and the material management and accounting system (MMAS). DCAA is in the process of revising its standard audit programs align its audits with these new rules. DCAA will also assist in reviewing the purchasing system and the EVMS system when and if requested. However, the responsibility of these latter two systems are the purview of the contract administration office.

These new business system rules apply only to contractors that are also covered by CAS (Cost Accounting Standards). Small businesses are exempt from CAS so the applicability of these rules is significantly limited.

Any shortcomings in  a business system that materially affects the ability of DoD officials to rely upon information produced y the system will be reported to the contracting officer. The contracting officer makes the ultimate decision as to whether it will pursue an issue. Deficiencies not corrected could ultimately lead to payment withholds.

Obtaining Indirect Cost Proposals - Part 2

Yesterday, we discussed the Government's process for obtaining annual incurred cost proposals. It starts with a reminder before the due date and progresses to a recommendation to the contracting officer to make a unilateral determination of rates.

The contract auditor does not have the authority to make unilateral determination of rates. The auditor's role in this process is to make recommendations to the contracting officer that will preclude reimbursement of potentially unallowable costs.

Sometimes its very difficult for the auditor to conjure up rates. The auditor has to look to  a variety of sources of information and data and make a best guess.

When recent relevant historical data exists, the auditor can develop recommended rates based on that history. Recent relevant data exists when all the following criteria are met:

• The prior fiscal year has been audited
• All contractor submissions received have been audited and settled.
• The indirect cost pool and base data for the subject fiscal year is readily available in the contractor books and records
• There have been no significant changes in the contractor's business base between last year and this year.
• There has been no significant reorganization of the contractor between last year and this year
• There have been no changes in the indirect cost rate structure between last year and this year.

When recent relevant historical data does not exists, things get brutal. The auditor will recommend a 20 percent decrement to total contract costs (both direct and indirect).

Keep in mind that these are only auditor recommendations and the contracting officer is free to accept, modify, or reject the recommendations. There is usually significant reluctance on the part of the contracting officer to invoke unilateral rates due mostly to the fact that it significantly increases everyone's workload with little, if any, benefit. Once the contractor submits its incurred cost proposal, the Government will have to pay it all back anyway.

There is one other downside for contractors who do not submit their incurred cost submissions in a timely manner. They could have their authority to "direct bill" removed, thereby increasing the length of time for getting paid.

Obtaining Indirect Cost Proposals

Contractors with flexibly priced contracts (e.g. CPFF, CPIF, T&M, etc) are required by FAR 52.216-7 to submit annual incurred cost proposals within six months of the close of their fiscal years. Contracting officers may grant extensions for "exceptional circumstances" but has historically been reluctant to grant extensions. Although its the contracting officer who has the responsibility to obtain these annual submissions, DCAA (Defense Contract Audit Agency) has taken the lead in obtaining them and in determining whether the proposals are adequate.

The process goes something like this:

1. Three months after the end of the contractor's fiscal year, the auditor will remind the contractor of its contractual responsibility to submit an indirect cost rate proposal.
2. When a contractor submission is 30 days overdue (i.e. seven months after the fiscal year end) the auditor will notify the contractor that its submission is past due.
3. When a contractor submission is three months overdue (i.e. nine months after the fiscal year end), the auditor will request the contracting officers assistance in obtaining the submission.
4. When a contractor submission is five months overdue, the auditor will notify the contractor that its submission is past due and advise the contractor that it will unilaterally establish indirect rates.
5. When a contractor submission is six months or more overdue, the auditor will recommend the contracting officer unilaterally establish indirect cost rates. The auditor will provide the contracting officer its recommendation on what those rates should be.

Tomorrow, we will discuss how the auditor (namely DCAA) develops "unilateral" rates.

What is a Subcontract? (Who Knows)

There has always been a lot of confusion over the definition of a subcontract - and with good reason. FAR (Federal Acquisition Regulations) does not contain an overarching definition of "subcontract". Instead, it contains several definitions of those words, each of which has specific application in the context of the rules. Here are some examples:

• FAR 3.502-1 (Subcontractor kickbacks) - "Subcontract" means a contract or contractual action entered into by a prime contractor or subcontractor for the purpose of obtaining supplies, materials, equipment or services of any kind under a prime contract.
• FAR 12.001 (Commercial items) - "Subcontract" as used in this part, includes, but is not limited to, a transfer of commercial items between divisions, subsidiaries, or affiliates of a contractor or subcontractor.
• FAR 15.401 (Contract pricing) - "Subcontract" also includes a transfer of commercial items between divisions, subsidiaries, or affiliates of a contractor or a subcontractor.
• FAR 19.701 (Small business subcontracting program) - "Subcontract" means any agreement entered into by a Government prime contractor or subcontractor calling for supplies and/or services required for performance of the contract, contract modification, or subcontract.
• FAR 22.801 (Equal employment opportunity) - "Subcontract means any agreement or arrangement between a contractor and any person (in which the parties do not stand in the relationship of an employer and an employee) (i) for the purchase, sale, or use of personal property or non personal services that, in whole or in part, are necessary to the performance of any one or more contracts or (ii) under which any portion of the contractor's obligation under any one or more contracts is performed, undertaken, or assumed.
• FAR 44.101 (Notice and consent to subcontract: purchasing system review) - "Subcontract" means any contract as defined in Subpart 2.1 entered into by a subcontractor to furnish supplies or services for performance of a prime contract or a subcontract. It includes but is not limited to purchase orders, and changes and modifications to purchase orders.
• FAR 52.204-10 (Reporting subcontract awards) - "Subcontract" as used in this clause, means any contract as defined in FAR Subpart 2.1 entered into by the Contractor to furnish supplies or services for performance of this contract. It includes, but is not limited to, purchase orders and changes and modifications to purchase orders, but does not include contracts that provide supplies or services benefiting two or more contracts.

Its no wonder then that the Government and contractors often bicker over what constitutes a subcontract. From a purchasing system perspective, it makes a difference. The policies and procedures for subcontracting are significantly different than those for purchasing raw materials or purchased parts.

Plant Protection Costs

There is a FAR cost principle devoted specifically to plant protection costs. FAR 31.205-29 states that the costs of such items as wages, uniforms, and equipment of personnel engaged in plant protection, depreciation on plant protection capital assets, and necessary expenses to comply with military requirements are allowable costs. This provision has been around since 1959. Its surprising to us that a cost principle was needed to address these costs as protecting a contractor's plant has always been considered necessary and therefore allowable.

Whenever a "plant protection" issue arises, it is usually an allocation issue rather than an allowability issue. The Government will often distinguish between general plant protection and that allocable to a specific cost objective. General plant protection would normally be charged through an indirect rate however, if it could be identified to a specific job, contract, product line, etc., the costs would be charged direct to those cost objectives.

For example, the ASBCA ruled that the costs of providing an additional security guard at the plant gate during a strike were not properly chargeable to a ship repair contract because the ships being repaired had their own security guards.

The cost of plant protection is certainly increasing at a rapid pace in this post 9/11 era. It is very likely that as costs become more significant, Government auditors will increase their oversight by looking into how these costs are allocated to Government contracts. Look for more attempts by auditors to push plant protection costs out of indirect cost pools onto non-Governmental cost objectives.

Another Report on Government Auditing

The Center for American Progress issued a report last month entitled "Better Auditing for Better Contracting". In this report, the Center makes a number of recommendations designed to strengthen the federal auditing system. The report is primarily about DCAA (Defense Contract Audit Agency) and chronicles many of its recent problems but its recommendations cover all Governmental audit agencies responsible for contractor oversight. The report states:

In response to the critical GAO report and Congressional hearings, the Defense Contract Audit Agency has attempted difficult shifts in its bureaucratic culture over the past three years. However, many believe that these changes have not been for the better, but have actually lessened oversight of government contractors. In particular, DCAA now seems to be focusing on fewer contracts, and this is clearly not good enough. 

The report goes on to make eight recommendations including:

1. Hiring more qualified auditors at DCAA and other agencies with auditing responsibilities, such as the Department of Energy
2. Giving auditors authority to subpoena contractor records, which they cannot do now.
3. Naming and shaming companies that do not have adequate financial systems.
4. Withholding 10 percent of contractor fees if they do not have adequate business systems in place to create a financial incentive to improve accounting systems.
5. Moving to risk-based audits and random checks rather than excluding certain types of contracts such as limiting proposal audits to fixed-price contracts over $10 million, as is now the practice.
6. Completing pricing reviews within a set number of days so that the contracting agencies can issue contracts in a timely manner
7. Providing the DCAA with its won independent general counsel so that it does not face a conflict of interest by relying on the Pentagon's lawyers.
8. Evaluating whether the DCAA should report directly to Congress rather than to the Pentagon as is presently the case.

There is nothing startling or new in this list except for the recommendation for an evaluation of whether DCAA should report to Congress. That will never happen with an Executive Branch agency and besides, Congress already has the GAO (Government Accountability Audit) with authority to conduct whatever contract audits it chooses to perform.

Some of these recommendations have already been implemented such as the one to hire additional auditors and  paying attention to due dates. The recommendation to withhold 10 percent of fee for contractors with deficient business systems is not as stringent as the regulations already on the books which is 5 percent of all costs, not just the fee.

You can read the entire report at the American Progress website.

April 9, 2012 Update: There have been numerous web news, articles and postings on this report since we published this article. One, representing the view of a government contractors association can be read here.