You've Turned in Your Incurred Cost Proposal - What's Next? - Part 1

We're down to about two months before annual incurred cost submissions are due for contractors whose accounting period ends December 31st. If you are one of those and you have not started the process, you need to get started. The due date is contractually mandated as is the content and format (see FAR 52.216-7(d) for a list of required "Schedules"). If you want to ensure that your submission is adequate, download and complete DCAA's Incurred Cost Adequacy Checklist by clicking here. It can't hurt. We use it on those incurred cost submissions that we prepare for clients and its the same checklist that the Agency will use to assess the adequacy of your submission.

Today and for the next few postings, we want to get you thinking about the audit process that will occur subsequent to turning in your submission. A lot depends upon whether the submission will be audited or will be dumped into a low risk pool and administratively closed out. Anything over $250 million is high risk and will automatically be audited. Any low risk submission under $1 million has a zero percent chance of being audited. For more on risk assessments, see this previous posting.

One of the most important steps in preparing an incurred cost submission is to ensure that all expressly unallowable costs have been excluded from claimed direct and indirect costs. Expressly unallowable costs are those that are defined in the FAR (Federal Acquisition Regulations) Part 31 Cost Principles. An "adequate" incurred cost submission does not mean that costs have been scrubbed to eliminate any that are unallowable. An adequate submission may still include unallowable costs - that's why they audit.

There are significant penalties for contractors when auditors find unallowable costs. About a year ago, we published a five part series on penalties. Click here and follow the links to read up on penalties. There are level 1 and level 2 penalties Level 1 penalty is equal to the amount of unallowable costs charged to Government contracts. Level 2 penalties are double that. Level 2 penalties are applied when the cost were determined to be unallowable prior to submitting the incurred cost submission. Penalties can add up real quick and non-negotiable for DCAA. Thankfully, DCAA is only advisory and contracting officers can and do exercise a bit of judgment when it comes to whether penalties are applicable.

Tomorrow - How deep will they audit?

Don't be Bullied

Over the years, there have been many bid protests by companies that were excluded from consideration based merely on the fact that their proposals were not received by the by the time and/or at the place specified in the solicitation. Even a few minutes late has disqualified a proposal. The Comptroller General (a.k.a. GAO or Government Accountability Office) has been very consistent in holding companies responsible for complying with the specific instructions contained in solicitation instructions. If the solicitation requires that a proposal be received by 4:30 PM on such and such date, a proposal received a 4:31 PM will be disqualified. If the solicitation requires that a proposal be received at the contracting officers desk by 4:30 PM, a proposal that shows up at the main gate of a sprawling military base before 4:30 PM but does not find itself on the contracting officer's desk by 4:30 PM will be disqualified. The Government does not allow any leeway nor does the Comptroller General when the case is appealed.

In a recently published bid protest decision involving a late proposal, the Comptroller General sided with the bid protestor for a change. But, the fact situation was a little different than other cases.

In this case (see ICI Services, Inc., B-409231.2: April 23, 2014), the protestor challenged the rejection of its proposal as late, arguing that the Navy's position is based on on "overly rigid interpretation" of the solicitation instruction and a "strained reading" of the undisputed facts. The solicitation required that offeror proposals be submitted through the Navy's electronic portal. When ICI had technical difficulties submitting through that portal, the company asked for and received permission from a contract specialist to submit their proposal via email.

The Navy subsequently rejected ICI's proposal because it wasn't submitted through it electronic portal. In defense, the Navy made some puzzling arguments. The Navy stated that the contracting specialist's acceptance of ICI's proposal by email was invalid because the contract specialist had mistakenly assumed, based on ICI's submission of the proposal via email that ICI had experienced technical difficulties in trying to access or use the Navy's electronic portal system. In fact, the Navy even suggested that the contract specialist was misled by ICI since ICI could not prove that it had experienced technical difficulties.

The Comptroller General (CG) rejected the Navy's arguments stating: "As relevant and dispositive here, the record shows that the Navy installation designated for receipt of proposals was in receipt of ICI's ... proposal by the closing time for receipt of  ... proposals". The record established:

1. the solicitation provided an alternative means for submitting proposals when there were difficulties with the portal
2. several other offerors and the Navy itself, encountered technical difficulties with the portal
3. ICI requested and received permission to submit its proposal by email and dis so before the closing time for receipt of proposals.

The Navy's actions here are very curious and, as former auditors trained to have questioning minds, we suspect there is more to this story that was not part of the CG's decision.

Require Auditors to be Specific when Making Requests

We've used this blog on a number of occasions to advise Government contractors that they have a perfect right to know and understand precisely what a Government auditor's scope of effort entails and how whatever data has been requested will contribute to the satisfaction of the audit objectives. And, it bears repeating. Some auditors do not like to be questioned about their judgment, the data they request or the purpose for which they are requesting it. Some auditors, unless and until pressed, provide vague responses to such questioning.

Contractors and prospective contractors are not obligated to furnish data that does not support the scope of the audit effort nor should they ever feel compelled to provide it out of fear or niceness. If an auditor were conducting an audit of proposed subcontract costs, you would not expect their request to include salaries and wages for engineers. If the nexus between the audit scope and the data requested is not obvious, contractors should require an explanation from the auditor as to the purpose of the request and its intended use. If the auditor's responses are too vague, ask for clarification or for more specificity.

Here are some examples of what we mean.

1. An auditor's statement that he/she is going to verify the hours you billed under Contract so-and-so is too vague. The auditor needs to be specific regarding the subject matter and state what criteria the billed hours will be verified against. For example, "We're going to compare the hours billed on your last billing to the latest labor distribution report and identify any differences.
2. An auditor's statement that he is going to review estimates for escalation is likewise too vague and subject. It does not provide the subject matter and criteria. A statement to the effect that he is going to compare proposed escalation rates for direct labor costs with the most recent forecasts from Global Insights would be more appropriate.
3. An auditor's statement that she is going to compare proposed and actual rates for past years is not specific regarding the subject matter or the criteria against which it will be measured. A statement to the effect that she will compare the proposed indirect rates for fringe benefits, overhead, and G&A to historical rates for fiscal years 2012 and 2013 contained in actual year end cost reports, would be more specific.

Be wary of the words "verify", "check", and "prove". They are vague and ambiguous and provide no insight into the audit procedure being performed.

What are Novation Agreements?

Contractors are precluded by law from selling off, transferring, or otherwise disposing of their Government contracts. Every once in awhile however, Government contractors are acquired by another company through acquisition or merger or a Government contractor decides to divest itself of a division that is performing a Government contract.  In those situations, the Government may, but is not required to, recognize a third party as a "successor in interest" to a Government contract. These situations are generally limited to cases where there has been a transfer of all of the original contractor's assets (or the entire portion of the contractor's operations involved in the performance of the contract) to a third party.

When the Government recognizes a successor in interest, there must be a novation agreement. Novation agreements are generally discussed in FAR (Federal Acquisition Regulations) 42.12 and is defined in FAR 2.101 as follows:

Novation agreement” means a legal instrument
    (1) Executed by the--
        (i) Contractor (transferor);
        (ii) Successor in interest (transferee); and
        (iii) Government; and
    (2) By which, among other things, the transferor guarantees performance of the contract, the transferee assumes all obligations under the contract, and the Government recognizes the transfer of the contract and related assets.

To begin the process of novating a contract, the contractor must submit a written request to the contracting officer. The request must include the following information:

1. Three signed copies of the novation agreement (sample wording for such an agreement is contained in FAR 42.1204(i)).
2. A description of the proposed transaction.
3. A detailed listing of all affected contracts.
4. Evidence of the transferee's capability to perform the contract (sometimes this can be a stumbling block).
5. Any other relevant information requested by the contracting officer.

Additional, as the following information becomes available, the contractor must supplement the initial request with the following:

1. An authenticated copy of the instrument effecting the transfer of assets.
2. A certified copy of each resolution of the corporate parties' boards of directors authorizing the transfer of assets.
3. A certified copy of the minutes of each corporate party's stockholder meeting necessary to approve the transfer of assets.
4. An authenticated copy of the new entity's certificate and articles of incorporation.
5. Opinions of legal counsel for the transferor and transferee stating that the transfer was properly effected under applicable law and the effective date of transfer.
6. Balance sheets for the transferor and the transferee as of the dates immediately before and after the transfer of assets.

If the Government does not accept the novation agreement, the original contracting party is still on the hook for performance. Failure to do so will most likely lead to a termination for default.

DCAA's Third Annual Report to Congress

DCAA's (Defense Contract Audit Agency) Third Annual Report to Congress, dated March 24, 2014 was recently posted on DCAA's website. This annual report is required under the National Defense Authorization Act (NDAA) for Fiscal Year 2012 and provides an overview of DCAA's mission, audit performance and recommendations to address significant deficiencies identified by DCAA during the conduct of its audits. The first and second annual reports are also available on DCAA's public website.

Sections 1 and 2 are boilerplate background information on what the Agency does and the staffing structure (did you know that almost 27 percent of the audit staff are CPAs (Certified Public Accountants)? These sections haven't changed much from earlier reports. Section 3 recaps the Agency's audit performance during the year (fiscal year ended September 30, 2013) and shows some evidence the the Agency is reducing the backlog of incurred cost audits that have piled up in recent years. And, while there was marginal improvement in the time it took to complete an audit of a price proposal, the average of 97 days is far too long for contracting officers' needs.

Section 4 is probably the most interesting part of the report from a contractor's perspective. In this section, Significant Deficiencies and Recommended Actions to Improve the Audit Process, DCAA tells Congress what statutes or regulations need changing in order for them to do their job better. Following is a recap of some of those issues. Many are carried over from the previous year which illustrates how slowly things move in the Government.

1. DCAA believes that there needs to be additional clarification to the regulations concerning commercial pricing at the subcontract level that outlines prime contractor management responsibilities related to its subcontracts. Without changes, documentation supporting commercial prices at the subcontract level will continue to be inconsistent and, in many cases, insufficient.
2. A carryover from the prior year is a recommendation that Congress expand DCAA's subpoena authority to include "data other than certified cost or pricing data." Currently, DCAA's subpoena authority (which has never been used successfully to our knowledge) is limited to cost or pricing data. DCAA noted that DoD has submitted a legislative proposal to that effect.
3. The lack of access to contractor internal audit reports continue to befuddle DCAA's ability to audit. Reading between the lines, DCAA is not pleased with the current state of affairs where justification and documentation and training and limiting access is the norm.
4. The lack of access to contractor online data is another area of significant concern. Read-only access would greatly assist DCAA in effectively planning and performing its audits. Last year, DCAA stated that it was contemplating a legislative proposal that would require contractors to provide online access to electronic data.  This year, DCAA downgraded its action plan and will now merely seek regulatory clarification.
5. Finally, DCAA submitted a legislative proposal for FY15 to support DCAA's right of access to contractor employees and to avoid any future confusion on DCAA's ability to interview employees. This legislative change will ensure DCAA has access to employees, which will allow DCAA to conduct audits in accordance with professional standards. 

It is fairly obvious from the foregoing that DCAA wants more and more access to contractor data, information, and employees.

Got Ideas on How to Improve the Federal Acquisition Process? Here's an Opportunity to Get Your Two Cents In.

From now through May 5th, the Chief Acquisition Officers Council (CAOC), in coordination with the Federal Acquisition Regulatory Council, the Chief Information Officers Council, and the Office of Management and Budget's (OMB) Office of Federal Procurement Policy (OFPP) is conducting a notional dialogue to discuss burdens and barriers associated with the federal acquisition process and ways to address them. According to the CAOC, this dialogue is part of an effort to improve the economy and efficiency of the federal acquisition system by identifying "impactful" steps that can be taken to make it easier for agencies to do business with the best companies and enter into contracts that allow these companies to provide their best solution for the taxpayer.

The purpose of this dialogue is to discuss improvements to the Federal contracting process. Through this "discussion" based platform, CAOC will gather ideas and proposed improvements that can be accomplished through executive (regulatory, administrative, or management) action, as well as potential legislative proposals (new laws). The open dialogue is focused around three topics (OICC calls them "campaigns). These topics include:

• Reporting and compliance requirements - Currently the Government requires businesses to fill out a lot of complicated paperwork. OICC wants to know how it can reengineer paperwork and systems, eliminate duplicative reporting, reduce the frequency of reporting, and change outdated requirements.
• Procurement rules and practices - Companies doing business in the private sector have best practices and the Government would like to learn about and replicate those in the Federal Government wherever possible. 
• Participation by small and minority businesses, new entrants, and non-traditional Government contractors - Many businesses lack the resources and expertise to participate in the Federal marketplace. CAOC is looking for feedback to understand what steps can be taken to increase participation among entities not currently participating in Federal contracting.

Everyone is welcome to share thoughts, ideas, suggestions, and comment on other suggestions.  Here's an example of a comment recently posted to the site.

To participate in this forum, click here. Go back often. At the end of the process, CAOC will publish a summary document that highlights the key concepts, themes, and the ideas that emerged in the dialogue.

GSA Schedule Contracts - Audits

Yesterday we discussed GSA rights to access a contractor's or prospective contractor's books and records for the purpose of performing post-award audits; that is audits for over-billings and compliance with the price reduction and industrial funding fee clauses. These are loosely termed under the heading of post-award audits. The probability that GSA will perform a post-award audit on a particular contract however, is not high. Some contracts are selected at random while others are selected based on some form of audit lead or perhaps a phone call through GSA's fraud hotline. Far more likely is the chance that contractors will undergo "pre-award" audits.

Contractors that submit proposals in response to a GSA solicitation give GSA the right to poke around their books and record even if there is no contract. One of the standard solicitation clauses states:

By submission of an offer in response to this solicitation, the Offeror grants the contracting Officer or an authorized representative the right to examine, at any time before initial award, books, records, documents, papers, and other directly pertinent records to verify the pricing, sales and other data related to the supplies or services proposed in order to determine the reasonableness of prices(s). 

The "authorized representative" in this case is usually GSA's Office of Inspector General however, DCAA (Defense Contract Audit Agency) has been called upon from time to time to perform these pre-award audits, particularly if that Agency is already in resident at a particular contractor location.

Any data submitted in response to a solicitation is fair game for a pre-award audit. The audit will focus on the propriety of contractor representations: commercial customers and prices charged,, discounts, quantity/volume, FOB terms, concessions, deviations, and sales data. Validation of those key elements will be the auditor's primary focus.

Some experts believe that pre-award audits are not necessarily bad events. Any findings during a pre-award audit that can be corrected, may prevent the Government from being harmed after contract award. Over billings carry their own set of problems and contractors definitely want to avoid those.

GSA Schedule Contracts - Access to Records

We're going to keep with our major theme of the past few weeks - GSA Schedule Contracts (or MAS Contracts) by discussing GSA's access to contractor books and records. Its nice to get a GSA contract, sit back and watch the orders start flowing in (okay, it would be nice but it doesn't happen that quite that easily). What a lot of companies don't realize when they get into the GSA program is the degree to which they must open up their books and records to the GSA contract auditors and the length of time for which they must be maintained and made available.

The basic access to records clause is found in GSAR (GSA FAR Supplement) 552.215-71 included in every GSA contract. That clause states:

The Contractor agrees that the Administrator of General Services or any duly authorized representative shall have access to and the right to examine any books, documents, papers and records of the Contractor involving transactions related to this contract for over billings, billing errors, compliance with the Price Reduction clause and compliance with the Industrial Funding Fee clause of this contract. This authority shall expire  three years after final payment. The basic contract and each option shall be treated as separate contracts for purposes of applying this clause.

The GSA auditors have interpreted this clause very broadly and believe that it gives them the authority to ask for any documents related to the contract, not just those enumerated in the clause. This causes friction when contractors start objecting to or questioning auditors' requests for documents that do not specifically relate to billing and compliance issues. But, because of the fear that auditors will dig deeper into contractors that dig in their heals, the auditors probably get more leeway in the documents they are able to solicit.

Failure to provide relevant information during contract negotiations can lead to charges of overbilling. In that regard, Contractors must ensure that they have properly classified sales to the proper category of customers. Otherwise, GSA may try to make a case that all sales are considered related to the contract.

Note also the clause allows GSA to come in and perform their audits for a period of three years after final payment. Sometimes "final payment" does not occur until long after the period of performance which serves to extend the length of time during which the Government can come back and perform their audits.

What are Industrial Funding Fees (IFF)?

Contractors offering products or services to the Government through GSA's (General Services Administration) MAS (Multiple Award Schedule) program must pay to GSA an Industrial Funding Fee (IFF). The IFF is added to the cost of the product or service and therefore paid by the customer. Contractor's in turn, must remit the IFF back to GSA on a quarterly basis. The IFF is a fee to cover GSA's cost of operating the Federal Supply Schedules program (e.g. MAS) but can also be used to cover other expenses of the Administration. The fee is 0.75 percent of sales and is included in the price that Government agencies pay the GSA contractor when they purchase items from a MAS contract.

Government agencies who buy goods and services have the option of buying off the GSA schedule or they can also buy directly. Buying off the GSA schedule is usually more cost-effective because the agency then does not need to incur the cost (i.e. labor costs) of soliciting, awarding, and administering separate contract actions. To help offset the cost of administering the MAS program, GSA adds the IFF to the negotiated price of the goods and services and the MAS contractors must, in turn, remit the money back to GSA. Using this mechanism, the various agencies are in effect, reimbursing GSA for the cost to administer the MAS program, using contractors as middle-men in the transaction.

Its not that uncommon to find contractors overpaying their IFF obligations. Primarily, this is a result of poor bookkeeping where contractors include Government sales that were not made off their GSA schedule but via other contracting actions.GSA has a robust audit function to ensure that contractors are remitting the correct amount of IFF. These audits have disclosed numerous instances where contractors have overpaid these fees (as well as underpaid them).

There are a number of compliance issues related to the IFF. First and foremost, once a contractor is on the MAS schedule, it must report quarterly sales, even if there were no sales for the quarter. Many contractors assume that if there were no sales, then a report is not required. That's not the case. Zero dollar reports are required.

If you have any questions concerning IFF compliance and reporting, don't expect much help from GSA. They are not staffed to render such assistance and they will recommend that you consult with MAS contracting professionals.

Claims for Extraordinary Relief

There's a little known and seldom used provision in the United States Code that offers contractors relief when all other avenues of contractual remedies have been exhausted. It is often referred to as "Claims for Extraordinary Relief" and is buried in 50 U.S.C. Sections 1431 through 1435. This provision gives the President power to authorize Government departments and agencies to enter into, amend, or modify contracts, without regard to other laws related to making, performing, amending, or modifying contract, whenever such action would facilitate the national defense. Essentially, if there are no avenues available through the FAR (Federal Acquisition Regulations) to address a financial woe, there might be relief available through "Extraordinary Relief". First however, a company has to be determined to be essential to the national defense. This doesn't apply just to DoD contracts. DOE (Energy) has its share of Extraordinary Relief situations, often related to nonproliferation events and activities.

Here are some examples of situations where Extraordinary Relief has been granted.

• When a loss under a contract impaired the contractor's ability to perform or act as a source of supply under a contract that is essential to the national defense, there may be an amendment without consideration.
• Amendment or modification to correct or mitigate a mistake
• Amendment to formalize informal commitments to a person who took action without a formal contract.

There is an upward limit on recovery - its $25 million unless Congress (the Committees on Armed Services of the Senate and House) have been notified in writing and given 60 days to consider it. Contracting Officers typically have a $50 thousand limit. Anything between that and $25 million must be approved by someone higher than an Assistant Secretary.

A Extraordinary Relief claim is like a financial bailout. A contractor must have exhausted all other avenues for raising working capital. To this end, the Government focuses on aspects of financial capability. For example, in reviewing a contractor's claim for extraordinary relief, the Government will request, review, and consder:

1. The contractor's financial position based on the most current information available, and the potential effect on that position if contract performance continued to completion.
2. Net working capital changes and changes in financial position since startint the contract.
3. A comparative statement of costs experienced under the contract and other similar production.
4. The estimated costs to complete the contract.
5. The compensation paid to the contractor's key personnel.
6. The extent of financial assistance already furnished by the Government.
7. Segregation of the profit and loss statement between commercial and Government business.
8. Any legal proceedings pending against the contractor.
9. Any unusual factors which may impair the contractor's ability (financial or other) to perform the contract.
10. Contract inventories and their value in case of default.

If your contract is to cut grass on a military base, you're probably not going to be determined to be essential to the national defense and you're not going to succeed in getting extraordinary relief. If you go bankrupt, the Government will just find another grass-cutter. However, if your contract is to provide housing for military in a war zone, you might have a shot.

Contractor Pays $1.1 Million to Settle False Claims Allegations

This is a followup to a posting we made just last month discussing the necessity of contractors including T&M (Time and Material) contracts in their Incurred Cost Submissions. You can read that posting by clicking here. One of the points we made was this:

Auditors are also interested in the qualifications of the employees billed under the various skill codes specified in the contract. For example, a T&M contract might spell out rates for Senior Engineer, Junior Engineer, and Technician. The auditor will want to ensure that the contractor is not billing a Junior Engineer at a Senior Engineer rate. That is why auditors sometimes request HR information related to employees charging T&M contracts. It doesn't matter nor will the contractor be able to assert that the Junior Engineer was better qualified than the Senior Engineer for the job. If the Government called for a Senior Engineer and paid the rate for a Senior Engineer, it should get the services of a Senior Engineer. Any evidence that the contractor is using lower priced employees will get referred to the contracting officer.

One company found out the hard way what happens when a contractor bills higher rates for lesser skills. The Department of Justice, in a press release yesterday, announced that it had settled a False Claims allegations with a contractor that did just that - falsifying the qualifications of employees in order to bill for labor charges at rates higher than allowed under its Government contract. It cost the company $1.1 million to resolve the issue. The press release did not state what the damages were to the Government but presumably, this settlement covered the known damages and a little more.

 The press release indicated that the contractor had falsified resumes for employees to qualify them for higher paying positions, thereby falsely increasing the amount of money billed for labor. The problem was uncovered by DCAA (Defense Contract Audit Agency) in the course of reviewing an annual incurred cost submissions, simply by following standard audit guidance and audit program steps. The auditors simply asked to examine the qualifications of the individuals billed under the T&M contracts and then dug a little deeper when the data submitted to them seemed a little "fresh".

If the Government calls out for a civil engineer with a masters degree and six or more years of experience, contractors need to provide employees that meet those qualifications. Don't provide someone who doesn't meet those qualifications, even if you know that they can perform the work effectively. Buoyed by these results, you just know that every auditor is going to start asking the penetrating questions concerning labor billed under T&M contracts.

Personal Conflict of Interest Rules to Apply to More Contractor Employees

Back in 2010, a section was added to FAR that addressed PCIs or Personal Conflicts of Interest. At the time, we wrote fairly extensive analysis of the new provision. See for example, here and here and here. Government employees engaged in the acquisition process are bound by all kinds of regulations to help prevent personal conflicts of interest. There was great concern however that since existing regulations didn't extend to contractor personnel performing the same or similar acquisition functions, there existed an internal control weakness that might allow personal conflicts of interest to influence Government acquisitions.

So, the Government developed some regulations pertaining only to contractor employees that were, in some manner, associated with Government acquisitions. These regulations required covered employees to prepare financial disclosure statements, rules regarding prevention, training, internal audits to test compliance, disciplinary actions, and reporting.

Recently, the FAR committees issued proposed regulations to significantly expand the number of employees covered by the PCI (Personal Conflict of Interest) regulations from those engaged in procurement related activities to anyone engaged in activities that are inherently governmental. Those inherently governmental positions are listed in FAR 7.5 which contains a listing of functions considered to be inherently governmental functions or which shall be treated as such. The regulations warn that the listing is not all inclusive meaning they're giving themselves a bit of wiggle room should they decide that it is in their best interest to call a function inherently governmental. This is an extensive listing, containing 20 functions that are by definition, inherently governmental.

This expansion of an existing regulation will have a significant impact on contractors because it will greatly increase the number of personnel required to prepare financial disclosures and go through indoctrination and training. It will also increase the number of employees that contractors need to monitor though their internal audit processes and other oversight.

Its probably not possible at this point to head off the new regulation as the requirement is statutory (i.e. it is based on the 2013 National Defense Authorization Act). Nevertheless, interested parties, and that's every contractor that is potentially affected by the expansion, have the opportunity to study it and provide comments to rule making authorities.

For more information on the proposed regulation including instructions on how to comment, click here.

Billing Withholds - Now We're Talking About Real Money

We've written a lot about DoD's business system rules that were put into place a couple of years ago - rules that define the attributes for what constitutes adequate business systems and provides for billing withholds when those contractor systems do not measure up.

The six business systems include: accounting, estimating, purchasing, EVMS (earned value management) MMAS (material management and accounting), and Government property management.

In a hearing last week of the Senate Armed Services Committee, the Air Force disclosed that it had withheld $25.7 million through February 2014 (or five percent of payments) to Pratt & Whitney for the jet engines it is building the F-35 (Joint Strike Fighter) program because it failed to meet the criteria for an adequate EVMS system. This money, which will be held back by DCMA (Defense Contract Management Agency) until Pratt and Whitney fixes their internal business system used to track cost and schedule performance.

Pratt and Whitney reported that it had received approval from DCMA on 95 percent of its corrective action plans and expects to receive approval for all corrective action plans "soon". At that time, presumably, DCMA will release the withhold and Pratt and Whitney will get its money back.

We don't know the extent to which the Government is withholding funds for inadequate business systems. As far as we know, this information is not made public. Its only at Congressional hearings such as this one where we get a peak at how the system is working. Twenty-five million is a lot of money, no matter how deep a company's pockets are. A company relying on payments for its working capital will need to find other sources for that capital when the Government withholds funds. Those other sources will cost the company money.

Notice of Intent to Disallow

Some of you may have heard the term "Notice of Intent to Disallow". Hopefully not but perhaps so. It means the Government is about to take away some money. The Notice of Intent to Disallow is not a contracting officer's final decision although it is often a precursor to a final decision regarding the propriety of costs that a contractor has billed the Government or intends to bill the Government.

At any time during the performance of a cost-reimbursement contract, a fixed-price incentive contract, or a contract providing for price re-determination, the contracting officer may issue the contractor a written notice of intent to disallow specified costs incurred or planned to be incurred.

A notice of intent comes after a contractor and the Government cannot reach agreement and the Government is convinced that its position is correct. According to FAR 42.801, before issuing the notice, the contracting officer must make every reasonable effort to reach a satisfactory settlement through discussions with the contractor.

A notice of intent to disallow costs usually results from monitoring contractor costs. The purpose of the notice is to notify the contractor as early as practicable during contract performance that the cost is considered unallowable under the contract terms and to provide for timely resolution of any resulting disagreement. In the event of disagreement, the contractor may submit to the contracting officer a written response. Any such response shall be answered by withdrawal of the notice or by making a written decision within 60 days.

At a minimum, the notice must

1. Refer to the contract's Notice of Intent to Disallow Costs clause (it is 52.242-1)
2. State the contractor's name and list the numbers of the affected contracts.
3. Describe the costs to be disallowed, including estimated dollar value by item and applicable time periods, and state the resons for the intended disallowance.
4. Describe the potential impact on billing rates and formard pricing rate agreement.
5. State the notic's effective date and the date by which written respons must be received
6. List the recipients of copies of the notice; and
7. Request the contractor to acknowledge receipt of the notice.

Many notices do not include the requisite information but don't count on winning the argument based on that technicality. It would strain relationships and in any event, the contracting officer could simply reissue his notice in a compliant form.

If the notice involves elements of indirect cost, it shall not be issued without coordination with the contracting officer or auditor having authority for final indirect cost settlement.

If in the event the contractor submits a response that disagrees with the notice, the contracting officer who issued the notice shall either withdraw the notice or issue his written decision.

Keep in mind, once you receive a Notice of Intent to Disallow, you only have 60 days to file your response. In some cases, upon request, contracting officers may grant extensions to the 60 day rule but there is never a guarantee.

SBA's HUBZone Program

SBA's (Small Business Administration) Historically Underutilized Business Zones (HUBZone) program helps small businesses in urban and rural communities gain preferential access to federal procurement opportunities. If offers a couple of benefits to HUBZone-certified companies. First, some contracting opportunities are set-aside solely for HUBZone contractors. Some of those set-asides are sole-source procurements. Secondly, it offers a 10 percent price evaluation preference in full and open contract competitions as well as subcontracting opportunities. That means a HUBZone contractor's bid can be 10 percent higher than the lowest bid and still be competitive.

The amount of dollars flowing through the HUBZone program is not insignificant. The federal government has a goal of awarding three percent of all dollars for federal prime contracts to HUBZone-certified small business concerns.

Companies must meet four requirements in order to participate in the Government's HUBZone Program.

1. A firm must be classified as a small business.
2. A firm must be controlled and owned at least 51 percent by US citizens.
3. A firm's principal office must be located in designated HUBZone areas.
4. At least 35 percent of the firm's employees must reside in a designated HUBZone area.

Before a firm can participate in this program and bid on designated government contracts, it must seek and obtain a certification from the Small Business Administration (SBA) verifying that the firm was HUBZone Program eligible. The SBA relies on information that is provided by applicant firms to determine and certify eligibility. It may or may not "audit" these applications.

Firms that win a contract because of their HUBZone status often come under extra scrutiny, not by the SBA or another Governmental agency but by unsuccessful bidders. It is not uncommon for contract awards to be challenged and one the first things that attorneys will look at is the winning bidder's 'standing'. It doesn't take a skilled gumshoe to figure out whether a firm meets the criteria for the HUBZone program.

You can read more about SBA's HUBZone program here including maps of the current HUBZone areas. Who knows. Maybe your firm qualifies.

Another "Don't Discriminate Based On ...." Edict

The President made news yesterday by issuing an executive order aimed at Government contractors. This new executive order prohibits Government contractors from discriminating against employees from disclosing or discussing their compensation levels with co-workers. The President believes that contractors are prohibiting employees from discussing their compensation levels with one another and thereby using that silence to circumvent equal pay laws for women. Senior White House Adviser Valerie Jarrett was quoted as saying "It's very difficult for women to know they are being discriminated against if they can't talk to one another about compensation".

The exact wording of the Executive Order states:

The contractor will not discharge or in any other manner discriminate against any employee or applicant for employment because such employee or applicant has inquired about, discussed, or disclosed the compensation of the employee or applicant or another employee or applicant. This provision shall not apply to instances in which an employee who has access to the compensation information or other employees or applicants as part of such employee's essential job functions discloses the compensation of such other employees or applicants to individuals who do not otherwise have access to such information, unless such disclosure is in response to a formal complaint or charge, in furtherance of an investigation, proceeding, hearing, or action, including an investigation conducted by the employer, or is consistent with the contractor's legal duty to furnish information.

Well, first of all, we don't know of any Government contractor that explicitly prohibits employees from discussing their compensation among themselves though that's not to say there are none. If there are, its a very small minority. Second, anyone who's been in the workplace knows that everyone knows what their peers and co-workers make. You cannot keep that a secret. The largest contractors, representing perhaps 80 percent of all workers on Government contracts, have published pay scales. They're just like the Government - anyone can look up what a GS-12, Step 5, in the Chicago metropolitan area makes - and its the same amount for both men and women.

The President also issued a "presidential memorandum" requiring that the Secretary of Labor establish new regulations requiring Government contractors to start sending copious amounts of data to the Department of Labor so that the Department can compile and study it and do whatever it is that Government agencies do with piles of data. Expect new regulations to appear soon requiring data by sex. And don't expect that it will be a simple compilation. These data requests are never simple.

 

Auditor Access to Contractor Internal Audit Reporting

Its been some time since we've discussed the Government's access to contractor internal audit reports. It was a big deal about a year and a half ago during the legislative process leading up to the 2013 National Defense Authorization Act (NDAA). Ultimately, Congress did not give Government auditors unfettered access to internal audit reports. Not knowing whether this was an issue worthy of legislation, Congress asked for more information. Congress asked DCAA to begin compiling data on requests for access to defense contractor internal audit reports. That data includes

• Written determination that access is necessary to complete a required evaluation of one or more contractor business systems
• Copy of the request from DCAA to the contractor
• A record of the response received from the contractor including its rationale if access is denied.

Once there is a couple of years of history here, Congress will look at the matter again to see if there is a reason for further legislation.

There is nothing in the law that compels a contractor to provide access to internal audit reports though a contractor can certainly choose to voluntarily do so (and most do so when there is a legitimate nexus between the audit being performed by the Government and the subject of the internal audit).

With this background, we were reading recent DCAA guidance on access to contractor internal audit reports and we came across the following (see CAM 4-202.c):

The 2013 National Defense Authorization Act (NDAA) states that DCAA can use the internal audit reports for evaluating and testing the efficacy of contractor internal controls and the reliability of associated contractor business systems. The law not only allows the use of internal audits to assess the contractor’s business systems; it also allows the use of internal audits to understand the efficiency of the contractor’s internal control which we do as part of our risk assessment in every audit. However, it is important to remember that requests for internal audit reports will only occur when the auditor/supervisor can demonstrate how the report may support the risk assessment or audit procedures in a current, on-going audit (i.e., there must be a nexus to your current audit effort).

One might get the impression from the foregoing that the 2013 NDAA gives DCAA the right to access internal audit reports. That would be an inaccurate impression. The guidance should state something to the effect that if a contractor chooses to provide DCAA access to its internal audit reports, the 2013 NDAA limits the use of those reports for evaluating and testing the efficacy of contractor internal controls and the reliability of associated business systems.

Contractors should know that they are still free to withhold internal audit reports from Government auditors. We don't necessarily think that's a good idea but there could be compelling reasons for doing so. In theory, if DCAA can rely on the work performed by the contractor's internal audit staff, they, in turn, will be able to reduce the level of their own oversight. That would be a good thing for everyone.

DCAA Issues Its Annual Performance Report

The Defense Contract Audit Agency (DCAA)* recently issued its third annual Year in Review report. This report highlights DCAA's activities during the year from its own unique perspective. This year's report, which can be downloaded and/or read here , provides the following summary of last year's activities.

In Fiscal Year 2013 (the 12-month period ended September 30, 2013), DCAA (Defense Contract Audit Agency) examined $160 billion in contractor costs, conducted 13,600 reviews, and produced over 6,200 audit reports. Overall, DCAA's efforts resulted in $4.4 billion in net savings to the government - the highest in Agency history and nearly 75 percent higher than the average savings achieved during Fiscal Years 2003 - 2009. Based on these net savings, the return on taxpayers' investment in DCAA was approximately $7.30 for each dollar invested.

The report details nine specific examples of how the savings were achieved. Most of these related to evaluations of price proposals and termination settlement proposals. The report includes a section dealing with reaching out to small businesses. DCAA cannot advise contractors on how to comply with Government rules and regulations nor can they advise them on how to set up their accounting and timekeeping systems. What they can do and have been doing is participating in a series of seminars throughout the US helping to educate those small businesses on the role of DCAA in the acquisition process and helping them understand the importance of implementing adequate estimating, accounting, billing, and timekeeping systems, among others. The Agency also makes available on its website reference material designed to help small businesses understand the basics of accounting for costs under government contracts.

Perhaps the most interesting piece in this report is not what DCAA has done in the past but its priorities for the coming year. The report lists four priorities:

• Increase momentum to reduce the backlog of incurred cost audits
• Increased priority on performing high-risk, time-sensitive labor and material reviews (floorchecks)
• More emphasis on disclosure statements (descriptions of accounting policies, procedures, and practices)
• More responsive to demand work from contracting officers

Reducing the incurred cost backlog is good news for contractors who are waiting to close out old contracts. Increasing the number of floorchecks should be of some concern to contractors - more auditors kicking around taking valuable time by interviewing employees. The disclosure statement emphasis only impacts CAS covered contractors required to maintain CAS Disclosure Statements.
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* The Defense Contract Audit Agency (DCAA) provides audit and financial advisory services to Department of Defense (DoD) and other federal entities responsible for acquisition and contract administration. It helps ensure DoD gets the best value for every dollar spent on defense contracting by conducting contract audits and related financial advisory services. Contract audits are independent, professional reviews of financial representations made by defense contractors. Specifically, DCAA assists in determining whether contract costs are allowable, allocable, and reasonable. The type and extent of DCAA's audit work varies based on the type of contract awarded, but its audit services are generally limited to acquisitions under Federal Acquisition Regulation Part 15 (Contracting by Negotiation). DCAA audits only contractors - it has no internal audit responsibilities in DoD.

Performance Based Payments - Cautions Before Using

This week we've been discussing the new DoD rule regarding performance-based payments (PBPs). We want to wrap up this series with a few miscellaneous comments and observations.

1. PBPs are limited to the lesser of values assigned to PBP events or total costs incurred to date (not to exceed 90 percent of the contract price). That means that PBPs can never include profit. Profit comes when contractors deliver the product.

2. Some contractors will not benefit from PBPs and should continue to use traditional progress payment forms of financing. Contractor efficiency will not be rewarded. Coming in under budget still nets a contractor only its incurred costs. Contractors that understate the value of an event, i.e. they overrun the cost associated with that event, are limited to reimbursement equal to the value of that event. Those contractors cannot recoup their actual costs.

3. The effort involved in establishing and agreeing to PBPs will be significant. The steps include:

• Identifying the PBP events
• Establishing completion criteria for each PBP event
• Obtain and evaluate the contractor's expenditure profile
• Establish PBP event values

4. From the PBP users guide, the Government's intention is to avoid any PBP scenario that would become equivalent to advance payments:

It is important to remember that the fundamental purpose of all contract financing is to assist the contractor in the paying the cost it incurs in the performance of the contract and, per FAR 32.1004(b)(2)(i), to do so “only to the extent actually needed for prompt and efficient performance.” Clearly the contractor can never have a “need” for more than its actual cost incurred at any point in time.

FAR 32.1004(b)(3)(ii) states that the contracting officer must ensure that PBPs “are not expected to result in an unreasonably low or negative level of contractor investment in the contract.” FAR does not define “unreasonably low” level of contractor investment, but it is clear that PBPs are not intended to result in the Government funding all contract costs as they are incurred throughout the contract. The prohibition against “negative level” of contractor investment means that PBPs must not be structured in such a way as to become equivalent to advance payments.

5. Contractors contemplating PBPs should be very careful to weight the potential advantages of higher levels of funding (100 percent vs 80 percent for progress payments) with the cost of foregoing some of their negotiated profit. The higher funding level is only a potential benefit and depends upon the accuracy of subjective elements. The lesser profit amount is certain.

6. Contractors contemplating PBPs should download and study the DoD User's Guide.

7. Contractors contemplating PBPs should not expect to encounter reduced Government oversight as compared to the use of progress payments. The adequacy of the accounting system is paramount under both types of financing arrangements. Under progress payments however, contractors have the added obligation to accurately estimate cost to complete.

Performance Based Payments - DoD's "PBP Analysis Tool"

We've been discussing the new DFARS (DoD FAR Supplement) rule on performance-based payments for the past few days. This new rule provides for a structured approach for determining how PBPs are to be calculated and administered. Its not quite like it used to be. Previously, the Government and contractor established milestones and assigned values to those milestones. When the contractor met that milestone, it gets paid the agreed to amount. Under the new rule, the same applies except now there is a cap on what the Government will pay - no more than the costs incurred. So, if a milestone is worth $100 thousand but the contractor spent $80 thousand, it will only receive $80 thousand. Also, in order for a contractor to obtain PBPs, it must be willing to give up some of its negotiated profit.

The key to determining how much profit a contractor will forgo is calculated using DoD's "PBP Analysis Tool", a spreadsheet model. You can read more about the "tool" and download it here. We don't have any experience in working with this spreadsheet but we have looked at it. And, we can state that its not for the feint of heart. It will take a bit of work to fully understand, comprehend, and use the model. In fact, it the published comments to the draft of the new rule, commentators expressed similar sentiment. DoD, however, responded that the tool "...will be used by trained contracting officers who will be able to walk the contractor through the process, if required." So you can see that even DoD recognizes that this is not something you can pull off the shelf and use. It's going to require some training. The idea that a "trained" contracting officer is going to "walk the contractor through the process" doesn't give us much confidence either. When was the last time your contracting officer returned your phone call?

According to DoD, the benefit of improved cash flow is so significant from a contractor's perspective that a contract with considerably less profit (lwer price) with PBPs can be a better financial deal for the contractor than a higher price for the same contract with progress payments. They call this a "win-win" deal.

The DoD PBP Analysis Tool allows the contracting officer to identify a "win-win" solution for both the Government and the contractor. It does this by comparing the expected monthly cash flow to the contractor when using PBPs versus progress payments. The tool calculates the final cost to the Government and the financial value to the contractor under both scenarios. The final cost to the Government is calculated by adding the cost of borrowing the financing payments made to the contractor to the contract price. The financial value to the contractor is based on calculating the Internal Rate of Return (IRR) and Net Present Value (NPV) of the cash flows. The tool finds the solution that benefits both parties: Lower final cost to the Government and greater IRR and NPV for the contractor. The tool also allows the user to do "what-ifs" on PBP event timing to see the financial impact to the contract and Government of event slippage or acceleration. This permits the user to make a fact-based assessment of the financial risk and benefits of the PBP arrangement.

Whether PBPs is the way to go for all contractors remains to be seen. We would hesitate giving up a significant portion of our profit for improved cash-flow, especially if we were a company that wasn't experiencing cash-flow issues. If you have cash sitting around earning less than one percent interest, you don't want to use the tool and pretend that your money can get 4 or 5 or 6 percent interest (the IRR). If the model is built of faulty assumptions, contractors are going to suffer. It might be preferable to take the traditional progress payment route.

Performance Based Payments - What are the Alternatives?

According to the Federal Acquisition Regulations (FAR), the first preference for financing a contract is for the contractor to obtain private financing without Government guarantee (see FAR 32.106(a)). Of course, interest is unallowable - its not going to be allowed in the pricing of that contract (or any other Government contract) - so most contractors will opt for the second preference, customary contract financing. Any why not? Why not get the free Government financing as opposed to going out and paying interest for private financing.

There are two kinds of Government financing. There is the traditional progress payment and there is performance-based payments (PBPs). Between the two, FAR prefers the use of PBP (see FAR 32.1001(a)) when the contracting officer finds them to be practical and the contractor agrees to their use. Under customary progress payments, financing cannot exceed 80 percent of costs incurred (or, 85 percent for small businesses). Under PBPs, contractors have the opportunity to receive payments up to 100 percent of costs incurred, so long as they are less than 90 percent of the contract price. So one can readily see that PBPs will generate more cash flow to the contractor than will traditional progress payments.

As we mentioned a couple of days ago, PBPs are linked to certain contract milestones but also to costs incurred. The purpose of all contract financing is to assist the contractor in paying the contract cost incurred during contract performance. According to FAR (see FAR 32.104(a)), contract financing is intended to be provided only to the extent actually needed for prompt and efficient performance. The reason that DoD has linked PBP with cost incurred is to ensure that financing is not provided to a greater extent than intended by FAR.

When a contractor accepts Government-provided financing payments, it must accept some form of requirement for the oversight of business systems that substantiate the incurrence of the costs to support the financing payments and to protect the Government's interests. That's true for both traditional progress payments as well as PBPs. No contractor is under obligation to accept performance-based payments or any other type of contract financing, and thus, avoid any additional economic consequence of the rule for an adequate accounting system. If a contractor doesn't want the Government in its knickers, then it should not expect to receive Government financing.

PBPs, when properly structured, can provide benefits to both the Government and the contractor. The key benefit to the contractor is improved cash flow. However, there is a cost to the Government of providing improved contract financing to the contractor. The time-value of money works both ways. The contractor benefits but the Government pays. That is why the Government will expect some kind of consideration in exchange for granting PBPs. Usually, perhaps always, the PBP analysis tool will calculates a lower profit to ensure that the use of PBPs provides a mutually beneficial financial arrangement for both parties.

Tomorrow we will look at DoD's "PBP Analysis Tool"

Performance Based Payments - The Government will Extract Consideration from Contractors

The idea behind performance-based payments is to improve a contractor's cash flow - to provide contractors a mechanism to obtain more "interim" financing than that afforded by the traditional progress payment rules. In exchange for this "improved cash flow" however, the Government expects some consideration from the contractor. Usually this consideration means a reduction in the negotiated profit percentage. Whether that makes sense from a contractor's perspective will depend upon many factors including how badly the company needs cash. The Government thinks this can be a win-win situation - the Government gets a lower price and the contractor has to borrow less for its working capital needs. For contractors that have no debt, the attractiveness of performance-based payments loses some of its allure.

Historically, one of the attractive features of performance-based payments is that payments are not based on incurred cost but on established milestones. This created the ridiculous situation where contractors established milestones that did not reasonably correspond to the spend rate and some contractors were receiving most of the contract price well before anything was ready for delivery. That is changing. There is a requirement in the new regulations that prevent performance-based payments from exceeding incurred costs (that is why an adequate accounting system is necessary). In fact, with each performance-based payment request, the contractor must provide the following information.

• Negotiated value of all previously completed performance-based payment events
• Negotiated value of the current performance-based payment event
• Cumulative negotiated value of performance-based payment event completed to date
• Total costs incurred to date
• Cumulative amount of payments previously requested
• Payment amount requested for the current performance-based payment event (not to exceed total costs incurred to date).

Prior to using performance-based payments, the contracting officer must agree with the offeror on price using customary progress payments before negotiation begins on the use of performance-based payments. Then, the contracting officer must analyze the performance-based payment (PBP) schedule using the PBP analysis tool on DoD's website. We'll be saying more about this analysis tool later in this series but you can read about it and download it at this link.

To use the PBP analaysis tool, the contracting officer needs information from the contractor. The contracting officer will request the contractor to prepare a proposed PBP schedule that includes all performance-based payments events, completion criteria and event values along with the projected expenditure profile in order to negotiate the value of the performance events.

Then, the contracting officer must negotiate the consideration to be received by the Government if the performance-based payments payment schedule will be more favorable to the contractor than customary progress payments. The contracting officer is required to document in the contract file that the performance-based payment schedule provides a mutually beneficial settlement position that reflects adequate consideration to the Government for the improved contractor cash flow.