We are continuing our series today on risk factors associated with Government contractor labor charging practices. You can read the previous installments by following these links: Part 1 and Part 2. As we indicated, there are a lot of perceived risks in labor charging. Its the one cost element that doesn't have a lot of independent or third party support associated with it. For material costs, contractors can provide purchase requests, purchase orders, invoices, and receiving documents. For subcontracts, contractors can provide copies of subcontract agreements as well as other performance related information. For labor costs however, the only thing a contractor can provide is a timesheet and the veracity of that timesheet depends solely on the internal control policies, procedures, and practices that the contractor employees.
Today we're going to cover three more "risk" areas that auditors are attuned into while designing procedures to test the propriety of labor charges to Government contracts. These are reclassifications, adjusting journal entries, and budgetary controls.
Reorganization/Reclassification of Employees
Auditors are instructed to analyze the organizational structure of the contractor to determine if it permits inconsistent treatment of similar labor. In some instances, reorganizations and reclassifications are implemented to achieve an accounting objective that was not possible under the previous structure. Sufficient review should be performed to determine if the changes will have an impact on Government contract costs.
Adjusting Journal Entries/Exception Reports (Labor Transfers)
Auditors will design tests to determine if there are any unusual labor transfers made via adjusting journal entries. Adequate rationale and supporting documentation should be available for all significant labor transfers. Evaluations in this area require the auditor to be knowledgeable about how adjusting entries are put into the system, either manually and/or by computer. If some significant entries appear to be more than just normal corrections, the Government risk and vulnerability is high and the area should be reviewed.
Many contractors operate management systems that require strict adherence to budgetary controls. If the system is inflexible, labor charges may have a tendency to follow the identical route of the budgeted amounts, especially if managers' bonuses or incentives are determined based on performance against some predetermined budget. Rigid budgetary control systems can result in predetermined labor charges. In our experience, this is one of the highest risk areas for not only auditors, but contractors themselves. Many times, contractor management simply don't know what's going on out in the plant.