Penalties on Unallowable Costs - Part IV

For the past few days, we have been discussing penalties levied by the Government when contractors include unallowable costs in their final incurred cost submissions. These are not inconsequential penalties and contractors should give attention to their internal controls for identifying and excluding unallowable costs. In the first three segments, we have discussed the FAR coverage (FAR 42.709) on penalties. Today, we want to focus on the guidance that DCAA has prepared for its audit staff on what they should do when they encounter unallowable costs during the course of their audits.

The first thing that the audit guidance underscores is the term "expressly unallowable". The FAR coverage uses the term "expressly unallowable" without further explaining or defining what is or is not "expressly unallowable. The DCAA guidance provides a definition that comes out of FAR 31.001. According to that definition, "expressly unallowable" includes only those costs that are expressly unallowable under FAR 31.2. It does not include any costs that are unallowable because they violate any other regulatory requirement or contract term, unless such regulation or contract term is also included in the cost principle. In addition, expressly unallowable costs do not include costs which are unallowable solely because they are unreasonable or unallocable. Later in this series we will provide some examples of costs that are expressly unallowable.

The other aspect of FAR 42.709 that DCAA emphasizes the date that the audit commences. Since the regulations allow the contractor to withdraw an overhead submission before formal initiation of the audit in an effort to avoid penalties, audit guidance requires the auditor to establish verifiable evidence that tthe contractor is aware when the audit begins.

So, what is the responsibilities of the auditor in assessing penalties. In short, the auditor provides an advisory role to the contracting officer. Specifically, the auditor is responsible for

• reporting all unallowable costs subject to penalties identified during the audit, regardless of dollar amount (recall, the penalty can be waived if less than $10,000 but the auditor will report amounts lower than that).
• making recommendations concerning the appropriateness of penalties when the contracting officer specifically requests that assessment, and
• providing assistance in computation of simple interest due the Government.

The auditor has no authority to impose the penalty, recover it against subsequent public vouchers, recommend the supplemental penalty, or waive the penalty. This authority rests solely with the contracting officer.

Flowdowns to subcontractors - the pertinent audit guidance points out that the penalty statutes and implementing regulations do not flow down to subcontracts and reminds auditors to not recommend penalties for subcontracts, even though they might have been passed along to the Government by way of the prime contract.

Inter-company transfers and work orders. Many contractors include allocations from a group office or a home office as part of their indirect rates. These allocations are subject to penalty. The same goes for work performed by an affiliated organization.

Voluntary management reductions. While it doesn't seem quite fair, audit guidance states that a contractor may not avoid a penalty by applying a voluntary management reduction that does not specifically identify the unallowable costs excluded from the final incurred cost proposal. DCAA theorizes that such a reduction is used because the contractor has a poor internal control system for identifying unallowable costs. This provision of the audit guidance seems extra-regulatory to us and should be open to challenge. We are not aware of any appeals of such a position.


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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance