Accounting Systems - Problematic Standards - Part 2

Last Tuesday, we identified the two types of accounting system audits/reviews that the Government might perform at a given contractor location (click here to read the posting) - a pre-award audit and a post-award audit. As we mentioned, the post-award accounting system audit is more robust than the pre-award and some contractors who have sailed through the pre-award audit, have been challenged over the adequacy of their accounting system during a post-award audit. There are 18 criteria that accounting systems must meet in order to be considered adequate. Yesterday, we began to look as ones that have been problematical for contractors with Criteria No. 15, accumulating costs that satisfy limitation of costs and limitation of funds.You can read that here.Today we will look at Criteria No. 1 which is vague and highly subjective.

DoD Criterion #1 requires contractor accounting systems to provide for a sound internal control environment and an appropriate accounting framework and organizational structure adequate for producing accounting data that is reliable and cost that are recorded, accumulated, and billed on Government contracts in accordance with contract terms (see DFARS 252.242-7009(c)(1)). Now there's a phrase that only an auditor would appreciate. To most folks, its a bunch of nonsense. What does "control environment" mean? What does "accounting framework" mean? What is an "adequate organizational structure".

Don't feel bad. You get a bunch of auditors in a room to discuss this and they won't even agree on what it means, and very few can articulate the meaning, when asked. Pity the contractor who finds out an auditor is coming to review its control environment. And because the meaning is so vague, trying to apply auditing procedures becomes very subjective and both contractors and auditors become frustrated. So, what is involved in satisfying this criteria? There are several professional resources one could consult but perhaps the most relevant is the DCAA (Defense Contract Audit Agency) guidance on how to audit a contractor's control environment. DCAA has divided its guidance into eight control objectives.

1. Integrity and ethical values: Management must convey the message that integrity and ethical values cannot be compromised, and employees must receive and understand that message through continuous demonstration of word, actions and commitment to high ethical standards (good luck proving that one). Sometimes this is referred to as "setting the tone at the top".
2. External auditor's report: Management should take timely corrective action on any deficiencies noted by the external auditor.
3. Board of directors/audit committee: The BofD and audit committee should be independent from management to constructively challenge management's decisions and act effectively on external audit communications.
4. Basic structural organization: The organization structure provides the overall framework for planning, directing and controlling operations.
5. Assignment of authority and responsibility: Management ensures that appropriate responsibility and delegation of authority is assigned to deal with goals and objectives, operating functions, regulatory requirements, information systems and authorization for changes. 
6. Financial capability: Management must ensure that the contractor has adequate financial resources to perform on Government contracts.
7. Accounting systems and controls: The accounting system is well-designed and is operating effectively to provide reliable accounting data and prevent misstatements that would otherwise occur.
8. Cost allocations: Management ensures that an item of cost or a group of items of cost are assigned to one or more cost objectives in accordance with rules, regulations, and standards for proper distribution of direct cost and allocation of indirect costs.

So, if you can do all this, your meet the first of 18 criteria for an adequate accounting system.