Tuesday, January 19, 2010

The Cost of Compliance is About to Increase

The Defense Department has proposed a new regulation that they say is designed to improve the effectiveness of DoD oversight of contractor business systems - Defense is going to withhold funds on cost reimbursable (and other flexibly priced) contracts until contractors fix their inadequate business systems. The withholds begins at 10 percent and could go as high as 100 percent under certain circumstances (though the higher figure seems highly unlikely). Withholds affect cash flow and disrupting cash flow will certainly get contractors' attention.

Over the next few days, we will provide analysis and comment on what this regulation portends for Defense contractors. To state that it will represent a very significant change in the way the Government does business is a huge understatement.

Currently, contractors bear no direct consequences for inadequate business systems. When deficiencies are identified, contractors are allowed time to fix those deficiencies. There is no perscribed timetable for effecting corrections nor does the Government withhold any billings until changes are made. After corrective actions are implemented, the Government (usually the auditor) has no prescribed timeframe for determining whether the actions have been effective in correcting the deficiencies. Many times, these deficiencies are "on the books" for years without any permanent resolution. Under the proposed regulations, there are very tight timetables for implementing corrective actions.

The propsed regulations set forth certain criteria for adequate business systems. Some are very objective while others are highly subjective. For example, there are 17 criteria for an adequate accounting system. One criteria is the system must be capable of segregating preproduction costs from production costs. This functionality is built in to most moden accounting software and is easy ot audit. It is basically a yes/no answer. However, other requirements are very subjective. One such subjective requirement is the contractor must conduct periodic monitoring of the system, as appropriate. What does that mean? How often is "periodic"? What is entailed in the term "monitoring"? What does the term "as appropriate" mean? These are very subjective elements and contractors are going to experience the vagaries of auditor judgement when the auditors come in to test for compliance with this standard.

The ten business systems covered by this new regulation include
  • Accounting systems
  • Estimating systems
  • Purchasing systems
  • Earned Value Management Systems (EVMS)
  • Material Management and Accounting Systems (MMAS)
  • Property management systems (Government property held by contractors)

To read the full text of this proposed regulation, go here.

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