Thursday, July 31, 2014

Senate Bill to Rescind the Davis-Bacon Act

Every Government contractor is probably aware of the Davis-Bacon Act (DBA) and the Service Contracting Act (SCA). The Davis-Bacon Act (DBA) applies to contractors and subcontractors performing on federally funded contracts for the construction, alteration, or repair of public buildings or public works projects. DBA requires that contractors (and subcontractors) pay their laborers and mechanics employed under the contract no less than the locally prevailing wages and fringe benefits for corresponding work on similar projects in the area. The prevailing wage rates are determined by the Department of Labor and updated frequently. The Service Contracting Act (SCA) is very similar but applies to contractors and subcontractors providing "services" to the Government.

Earlier this month, Senator Mike Lee (Utah) introduced a bill that would repeal the Davis-Bacon Act (its called the Davis-Bacon Repeal Act). According to the Senator, the bill will
... drive down the inflated costs of federally funded construction projects on our nation's infrastructure and make it easier for federal contractors to train and employ workers of all skill levels. The ... Act would also save the American people billions of dollars in wasted taxpayer money and diminish the power of the cronyist alliance between big government and big labor unions.
Continuing on, Senator Lee's press release states:
The Davis-Bacon Act exemplifies how big government hurts the people it purports to help, gives unfair advantages to favored special interests, and squeezes the middle class. It crowds out low-skilled workers in the construction industry, preventing them from getting a fair shot at a job, and funnels taxpayer money to prop up big labor unions, which accrue windfall profits as Davis-Bacon removes the incentive for federal contractors to hire unskilled, non-unionized workers.
Forcing the American citizens to subsidize labor unions in this way artificially inflates the costs of construction projects to repair and improve our national infrastructure. This is unfair, and unsustainable, and costing taxpayers billions of dollars every year.
Davis-Bacon certainly increases costs to the Government. We've witnessed situations where workers have walked off a non-DBA (and non-union) job to take a DBA job in the same area where in one case, a worker told us he would be making three times what he was currently making. We suspect that this new bill has little chance of passing.

Wednesday, July 30, 2014

DCAA Revises its Procedures for Auditing CAS Compliance

Late last month, DCAA (Defense Contract Audit Agency) issued guidance which effectively changes the way in which it audits contractor compliance with CAS (Cost Accounting Standards). The new guidance can be accessed here. Actually, this revised guidance is a little confusing so stay with us.

Heretofore, there have been two aspects to auditing CAS Disclosure Statements (DS); adequacy and compliance. The adequacy review focused on whether the DS adequately describes the contractor's current cost accounting practices. The compliance review deals with whether those cost accounting practices are consistent and compliant with applicable CAS standards.

Under the new guidance, auditors will review Disclosure Statements for adequacy prior to deciding whether to accept an engagement to audit for compliance. The "adequacy" review is no longer considered an audit (which is a good thing, in our opinion) so that fact alone improves the chances that reports on adequacy can be issued in a timely manner.

According to the guidance, there are three steps to determining adequacy.

  1. Determine whether the contractor followed the Disclosure Statement form instructions. DCAA has a "tool" for this task that is not available to the public).
  2. Determine whether contractor disclosures are consistent (evidently DCAA has another "tool" for this task.
  3. Gain a thorough understanding of the basis of the described practices, usually during the contractor's walk through of the submission (DCAA is really big on "walk-throughs" these days).

Based on this information, the auditor will assess whether the disclosed practices are current, complete, and accurate (this is a new use of the term "current, complete, and accurate". In FAR, it is used in the context of cost or pricing data). DCAA's definition of current, complete and accurate is as follows:

  • Current - disclosed practices are consistent with the contractor's intended practice described during the walk through.
  • Complete - contractor completed all items on the form in accordance with the instructions
  • Accurate - disclosed practices are consistent with the policies and procedures provided during the walk through.

Once this assessment is complete, the auditor advises the contracting officer who is responsible for making a decision on adequacy. If the contracting officer agrees with the auditor and issues a determination to that effect, the auditor can go ahead and audit the Disclosure Statement for "compliance".

Tuesday, July 29, 2014

Provisional Billing Rates - Recent Audit Guidance

Reasonably accurate provisional billing rates are important for both the Government and contractors. Rates that are too high harm the Government. Rates that are too low, negatively impact a contractors cash flow. Whether too high or too low, its difficult to derive an accurate projection of costs and to comply with other contractual provisions such as limitation of costs or limitation of payments.

FAR 42.704 lays out the requirement for establishing provisional billing rates. It states, in part, that the contracting officer or auditor shall establish billing rates on the basis of information from recent reviews, previous rate audits or experience, or similar reliable data or experience of other contracting activities. Additionally, those rates should be as close as possible to the final indirect cost rates anticipated for the fiscal year.

The key point from FAR 42.704 is that the Government is going to establish provisional billing rates, with or without contractor input. It is almost a certainty that if the Government establishes the rates, it will include some form of decrement to reflect potential unallowable costs. It is always better for the contractor to propose provisional billing rates because the contractor will have the best information on factors that will affect future rates.

DCAA (Defense Contract Audit Agency) recently issued new audit guidance for reviewing provisional billing rates. First of all, the Agency states that the development of provisional billing rates is not an audit. That should help expedite DCAA's role in establishing rates and/or reviewing contractor provisional rate proposals. Further, the steps to reviewing rates consist of the following:

  1. Notify the contractor and ask whether the contractor wishes to provide any input.
  2. Review past audit files for relevant information.
  3. Review incurred cost audits and ascertain trends. Although not stated in the guidance, the audit should review unaudited incurred cost submissions as well.
  4. Compare prior year billing rates with actual year end rates to see how close the contractors' estimates compare to actuals.
  5. Ask for a walk-through of any data submitted by the contractor.
  6. Summarize and come up with an estimate.

These are fairly straight-forward tasks and should not cause any undue grief. From the Government's standpoint, provisional billing rates are low risk because the rates will be trued-up at the end of the year after contractors submit their final indirect rate proposals.

Monday, July 28, 2014

Independent Audits of Contractor Business Systems - Part 6

We've been discussing DoD's recent proposal to require contractors to perform annual self-assessments of certain of their business systems and to have those systems audited by a CPA firm every three years. If you haven't been with us for the entire series, it would be a good idea to start at the beginning:

     Part 1
     Part 2
     Part 3
     Part 4
     Part 5

The proposed rule, according to DoD, will have no impact on small businesses. That's because the Department has set the applicability at a pretty high level. For estimating systems, the criteria applies to contractors that had negotiated contracts of $50 million or more in their previous fiscal year. That doesn't necessarily exclude small businesses as we've seen contracts awarded to small businesses that exceed that amount. But, that threshold would certainly exclude most small businesses. For MMAS (Material Management Accounting Systems), the annual assessment and audit requirements specifically excludes small businesses and applies to contractors with qualifying sales to the Government of $50 million or more and an affirmative determination by the ACO that an MMAS review is needed (based on various risk factors). For Accounting Systems, the requirement applies to CAS-covered contractors (Cost Accounting Standards). (For CAS coverage requirements, click here).

The system criteria for these business systems are not changed by this proposed regulation nor are the penalties (billing withholds) for having a system that does not comply with the stated criteria.

There are several aspects of this new regulation that we believe will become problematic during implementation.

  • Cost - these self-assessments and independent audits will cost contractors dollars that they wouldn't have otherwise incurred.
  • Cost allocation - the cost will need to be allocated somewhere. Contractors will make the case that since these costs are required by contract, they are allocable to those contracts and not to commercial work. The Government will probably try to make the case that these internal control systems benefit all the work of the contractor and should be allocated broadly.
  • Timeliness - there doesn't seem to be any penalty for failing to meet the annual assessments or triennial audit requirements. 
  • Timeliness of Government Involvement - The proposed regulations require that the Government be afforded the opportunity to review the CPA risk assessment and audit planning documents. The Government does not have a good track record of turning out responses in a timely manner. This could impede the efficient and effective accomplishment of the CPA's efforts.
  • Resolving disagreements - while the proposed regulation contains processes to resolve deficiencies raised as a result of assessments and audits, it does not cover disagreements that might arise between the CPA and the auditor who will be overseeing the CPA effort. This could become a contentious area.

There is more to this proposal than we've covered in these blog posts. The proposal itself takes up nearly 14 Federal Register pages - a laborious read to say the least. Most likely, this will not be a case were the proposed rule is adopted as final, without change. A change of this magnitude will undergo significant revision before adoption - perhaps even a second draft for public comment.

If you care to provide comments to this proposed regulation, you have until September 15th to do so. You can submit those comments electronically to So far, not too many comments have been submitted.

Click here to read Part 7 in this series.

Friday, July 25, 2014

Independent Audits of Contractor Business Systems - Part 5

For the past few days, we've been discussing DoD's proposed rule that would require contractors to perform their own self-assessments of compliance with DoD's business system criteria and a further requirement that contractors commission an audit every three years by an independent CPA to test the contractors compliance with those system criteria. The proposed rule affects three of the six business systems covered in the DFARS (DoD FAR Supplement); estimating, accounting, and material management and accounting systems. It applies primarily to larger contractors, small businesses being exempt. If you're just joining this series, you may want to start at the beginning and read forward.
     Part 1
     Part 2
     Part 3
     Part 4

As discussed, the new rule would require contractors to provide the CPA's audit strategy, risk assessment, and audit plan to the Government auditor for review. Presumably, the Government auditor render his assessment, saying it is adequate or it needs refinement. Once the CPA's audit is finished, the contractor must maintain and make the CPA's working papers available to the Government auditor for review. This will be interesting to watch - it seems to us that a lot of CPA firms will be reluctant to expose their working papers to Government review and oversight (second-guessing). In any event, the way that this new rule works, is that the Government auditor will review the CPA's audit report and working papers and advise the contracting officer on what it thinks.

The contracting officer then must make a decision as to the acceptability of the estimating, accounting, and/or MMAS systems for Government contracting purposes. In evaluating the acceptability of these systems, the contracting officer, in consultation with the Government auditor or functional specialist, shall determine whether the contractor's system complies with the DFARS system criteria. In making that determination , the contracting officer shall consider;

  • the contractor's annual report and the CPA audit.
  • any other findings and recommendations reported by the Government auditor including the assessment of the contractor's CPA audit report and related documentation.

To summarize, the contractor's documentation requirements include:

  1. Documentation to provide reasonable support for its annual assessment. 
  2. Information considered in the selection of a CPA
  3. Arrange for Government access to the working papers supporting the CPA audit reports

Click here to read Part 6 in this series where we discuss a few miscellaneous items included in the proposed regulation.

Thursday, July 24, 2014

Independent Audits of Contractor Business Systems - Part 4

We're in the midst of a discussion on DoD's new proposal that will require contractors to perform their own self-assessments of compliance with the standards for business systems and to have a full CPA audit performed every three years on those systems. This proposed rule was published in the Federal Register on July 15th and applies to large DoD contractors. If you haven't read the previous postings, it would be a good idea to start from the beginning:
     Part 1
     Part 2
     Part 3

Yesterday we discussed the hoops that contractors will have to jump through just to get a CPA firm on board. The contractor is going to have to assess the CPA's independence, objectivity, and qualifications. Not only will the contractor have to make those assessments, but will need to be prepared to turn over its assessments for Government review. But what is to happen after that is perhaps more insidious (in a way).

What follows might seem arcane to non-CPAs but it is a big deal. When undertaking any audit, CPAs must plan out their strategy. They have to understand the objective of the audit, the criteria against which performance is to be assessed, the inherent risks associated with the audit engagement, considerations of fraud, and a step-by-step program for accomplishing the audit. These are often referred to as the planning and risk assessment phases of the audit. Often, hours associated with these activities represent a significant portion of audit engagements. These activities must be completed before field work (e.g. testing) begins.

DoD's proposed regulations will require that these preliminary documents be provided to the Government:
The Contractor shall provide the Contractor's CPA's audit strategy, risk assessment, and audit plan (program), upon completion ... to the cognizant contracting officer and Government auditor.
What is the contracting officer and Government auditor supposed to do with the CPA's audit strategy, risk assessment, and audit program? According to the proposed rule, the contracting officer must,
Upon receipt of the contractor's CPA's audit strategy, risk assessment, and audit plan (program), request a review from the Government auditor, and notify the contractor of any potential issues identified by the Government auditor regarding their reasonableness. Early notification of potential issues may decrease the likelihood of the contractor incurring unreasonable costs. However, review of the contractor's CPA's audit strategy, risk assessment, and audit plan (program) does not constitute the contracting officer's approval.
So here you have it. The Government auditor (DCAA), the same organization that cannot find the time and resources to audit contractor compliance with DoD's business systems criteria, and whose abject performance in this area led to this new regulation in the first place, is now tasked with overseeing the strategy,  risk assessment, and audit plans of the contractors' CPAs. What's more, DCAA is expected to turn around its assessment in a timely manner in order to reduce the likelihood that the CPA will become inefficient in its work. We see this as a major stumbling-block to efficient and effective execution of audits and we know of no other instances where such a requirement is imposed on the performance of audits conducted in accordance with GAGAS (Generally Accepted Government Auditing Standards).

Click here to read Part 5 in this series.

Wednesday, July 23, 2014

Independent Audits of Contractor Business Systems - Part 3

For the past two days, we've been discussing the proposed DFARS (DoD FAR Supplement) rule that will require contractors to perform their own annual assessments of compliance with business system criteria and to have an independent CPA audit of those business systems performed every third year. The business systems covered by the new rule include estimating systems, accounting systems, and MMAS (Material Management and Accounting Systems).  This new rule applies primarily to large contractors (small businesses are exempt) and marks a significant departure in the manner in which the Government administers its oversight functions. It will also cost contractors (and the Government) a lot of money.

The cornerstone of the new procedure is the requirement for a triennial audit by independent CPAs. By definition, the CPA must be an independent certified public accountant, in public practice and not directly employed as an employee by the contractor, performing audits for the contractor in accordance with GAGAS (generally accepted government auditing standards). It is the contractor's responsibility to ensure that whatever CPA firm is selected, is independent and qualified. To ensure the CPA firm meets these conditions, the contractor must do a little homework:

First of all, the contractor must reasonably ensure that the CPA firm performing the audit is independent and objective with respect to the audited entity by obtaining and reviewing a written representation from the CPA firm that the firm and the assigned engagement team is:

  1. independent and objective with respect to the audited entity
  2. will remain independent throughout the audit
  3. has not performed any non-audit services for the audited entity that impair the auditors' independence for the subject audit, and
  4. will disclose any independence issues discovered

Next, the contractor must ensure that the CPA firm is qualified to perform the audit by obtaining and reviewing

  1. information about key engagement team members regarding professional qualifications and experience, including valid CPA licenses or certificates in good standing, and current knowledge and experience in the type of work to be done, and
  2. the firm's most recent peer review report, in accordance with the American Institute of Certified Public Accountants (AICPA) Peer Review Program or equivalent.
It is almost a certainty that someone in the Government, most likely the contract auditor (i.e. DCAA) will request information to assess whether the contractor has performed due diligence in assessing their selected CPA firm's independence, objectivity, and qualifications.

Click here for Part 4 of this series where we discuss additional requirements related to the triennial audit including the requirement to furnish interim data to the contracting officer and the auditor.

Tuesday, July 22, 2014

Independent Audits of Contractor Business Systems - Part 2

Big changes may be coming in the way that the Government conducts oversight of its larger contractors. Yesterday we began a series on a proposed rule that will require DoD contractors to hire independent CPAs to conduct compliance reviews of three major business systems; estimating systems, accounting systems, and material management and accounting systems (MMAS). Heretofore, these audits have been conducted, albeit irregularly, by the Defense Contract Audit Agency (DCAA) and/or the Defense Contract Management Agency (DCMA). One thing for certain, this proposal, if it is enacted in its current form, is certain to cost contractors a lot of money. Audits don't come cheap and the process imposed by the new rule, where Government auditors must review planning documents and risk assessments before independent audits can proceed, will certainly impede efficiency and further increase costs to the contractor. And, there is no certainty that these costs can be allocated exclusively to Government contracts. Most likely, the Government will argue that these costs be allocated over a contractor's G&A base.

The stated purpose of this new regulations is to improve efficiency and effectiveness of audit:
To improve the efficiency and effectiveness of auditing contractor business systems, DoD is proposing to amend the DFARS (DoD FAR Supplement) to entrust contractors with the capability to demonstrate compliance with DFARS system criteria for contractors' accounting systems, estimating systems, and material management and accounting systems, based on contractors' self-evaluations and audits b y independent Certified Public Accountants (CPAs) of their choosing. Government auditors will perform overviews of the results of contractor self-evaluations and CPA audits.
The applicability of the standards are not changed. Contractors subject to the business system criteria now will still be subject to those standards under the new regulations. For example, contractors, other than small businesses are subject to the estimating system disclosure and maintenance if they received $50 million in (certified cost or pricing data) DoD prime contracts and subcontracts the previous year. That threshold drops to $10 million if the contracting officer determines it to be in the best interest of the Government.

What does change are added requirements for annual reporting and triennial CPA audits.

Annual reporting. Each year, within six months after the end of the contractor's fiscal year, the contractor must provide the contracting officer and the Government auditor, a report regarding compliance with the system criteria. The report is to be signed by an individual at a level no lower than VP or CFO. The report for each of the three business systems covered by this proposed regulation varies slightly in content depending on the system covered. For estimating systems, the report must include:

  1. a statement that the contractor has evaluated the estimating system's compliance with the system criteria contained in the DFARS.
  2. the contractor's assessment of the estimating system's compliance with the system criteria, including a statement as to whether or not the system complies in all material respects, and disclosure of any significant deficiencies with sufficient information for the Government to understand the deficiencies; and
  3. the status of any significant deficiencies disclosed as part of the contractor's assessment, or, if applicable, in the CPA's triennial audit. This mus include a corrective action plan with milestones and actions to eliminate any significant deficiencies that have not bee corrected as of the date of the report.

Click here for Part 3 of this series where we discuss the triennial CPA audit requirements.

Monday, July 21, 2014

Independent CPA Audits of Contractor Business Systems - New DoD Proposal

Last March, we alerted readers to the impending DoD proposal that would require contractors to go out and get their own independent audits of their business systems. At that time, we didn't know the extent of the new rule or when that proposal would be published. We do now -a proposed rule was published last week in the Federal Register.

This proposed rule is rather lengthy but we'll do our best to summarize the key points over the next few days. Small businesses can rest easy on this one - they are exempt for the most part. The proposed rule includes provisions for the contracting officer to flow the requirements down to small businesses in some limited situations but it seems unlikely to us that contracting officers would do so. Additionally, the proposed rule applies only to three of the six DoD designated contractor business systems; Estimating Systems, MMAS (Material Management Accounting Systems), and Accounting Systems.

According to DoD, contractor business systems and internal controls are the first line of defense against waste, fraud, and abuse. We don't know about the "first line of defense" argument but we do agree that weak control systems increase the risk of unallowable and unreasonable costs on Government contracts. In response to a 2011 GAO report, DoD agreed to consider alternative approaches to audit contractor business systems. At that time, GAO noted that audits of contractor business systems were not being conducted in a timely manner and laid the blame squarely on DCAA's (Defense Contract Audit Agency). The GAO reported:
Several factors may affect DCMA’s ability to meet its missions going forward. One significant source of external risk stems from DCMA’s reliance on the Defense Contract Audit Agency (DCAA) to conduct audits of certain contractor business systems. Business systems—such as accounting and estimating systems—are the government’s first line of defense against fraud, waste, and abuse. Because of its own workforce struggles, DCAA has lagged in completing a number of such audits and is currently focusing on other high priority areas.  
GAO found, however, that DCMA contracting officers maintained their determination of many contractor business systems as adequate despite the fact that the systems had not been audited in a number of years—in many cases well beyond the time frames outlined in DCAA guidance. Further, based on a recent DOD policy change, DCAA is no longer auditing contractor proposals below certain cost thresholds, and DCMA will need to use newly-hired contract cost/price analysts to help pick up this increased workload. Internal risks are also present, such as uncertainty on the part of CMOs about whether funding will be available to retain personnel hired using the Defense Acquisition Workforce Development Fund.
So, neither the GAO nor DoD had any confidence that DCAA could ever deliver audits of contractor business systems in a timely manner. The alternatives were to augment the audit staff or make contractors hire independent CPA firms to perform the reviews. This proposed regulation requires the latter - make contractors responsible for securing (and paying for) independent audits.

DCAA is not left out of the process however. Under the proposed regulations, DCAA will be reviewing the independent CPA firms plans and risk assessments as well as assessing their reports for adequacy. That process, we suspect, will generate a lot of concerns and negative comments to the proposed rule.

Click here for Part 2 of this series.

Friday, July 18, 2014

Accelerated Payments to Small Business Subcontractors - Program Extension

The Office of Management and Budget (OMB) announced last week the good news that its program for encouraging accelerated payments to small business subcontractors by Government prime contractors has been extended to December 31, 2016. It was set to expire on July 11, 2014.

Here's the way it works. Agencies, to the full extent permitted by law, will accelerate payments to prime contractors - with a goal of paying them within 15 days of the receipt of a proper invoice. This will allow the prime contractor to provide accelerated payments to their small business subcontractors.

Whether this policy is working effectively is anyone's guess. We have anecdotal evidence that it has not had a marked improvement in reducing the lapsed days for some small business subcontractors to receive payment from their primes. It could be that some prime contractors are sitting on the money until such time as subcontractor billings become due in the normal course of business. We do not know of any Government oversight agencies with programs to review for compliance with the accelerated payment policy. DCMA (Defense Contract Management Agency) might include coverage in a billing review but those reviews are performed very infrequently.

If you are a small-business subcontractor, you should inquire of your prime contractors whether their customers are participating in the program (almost all Agencies are participants, by the way). If so, you should also benefit from the program.

You can read OMB's extension letter here.

Thursday, July 17, 2014

Accounting for Leases - Part 5

Today we intend to conclude our discussion on capital leases. So far we've discussed the criteria (or tests) that contractors must apply in order to determine whether a lease should be classified as an operating lease or a capital lease, some of the techniques for applying the tests and some of the warnings and considerations that the Government thinks about anytime it sees lease costs. From the Government's perspective, capital leases are less expensive than operating leases based primarily on the imputed interest that is unallowable on Government contracts. That is why we often see auditors trying to reclassify rental payments to capital lease payments. Today we're going to discuss additional considerations concerning amortization periods.

According to DoD, the proper classification of a lease according to FAS-13 (now ASC 840) does not automatically result in acceptable contract costs. For capital leases, auditors are instructed to consider the acceptability of the amortization period and that requires a definition of "Lease Terms".

According to FAS, the lease term is the fixed noncnacellable term of the lease plus

  • all periods covered by bargain renewal options
  • all periods for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured,
  • all periods covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt related to the leased property is expected to be in effect
  • all periods covered by ordinary renewal options preceeding the date as of which a barghain purchase option is exersiable, and
  • all periods representing renewals or extensions of the lease at the leessor's option.

However, in no case shall the lease term extend beyond the date a bargain purchase option becomes exercisable.

So, one can see why it is necessary to carefully read and fully understand all the terms of the lease agreement. Some lease agreements are very complex and verbose documents. In fact, many contractors that enter into leases have never read the fine print - kind of like buying a house and signing documents at closing without fully understanding what they say or mean.

When a capital lease is to be amortized over the lease term, renewal periods will be included if they meet the criteria specified above. From an auditor perspective, this would be an important audit consideration when the renewal is assured through substantial penalties for nonrenewal or a guarantee by the lessee of the lessor's debt. Failure to review the lease term for renewal clauses could significantly distory the amortization charges to current contracts.

There is far more to FAS-13 (now ASC 840) than can be explained in brief blog posts. If you have leases, it would be very beneficial to have someone in your company knowledgeable of the fundamental requirements. Failure to properly classify a lease will definitely lead to questioned costs, and possibly penalties.

Wednesday, July 16, 2014

Accounting for Leases - Part 4

Today, as we continue our discussion on capital leases, we will be focusing on audit guidance - the section in DCAA's (Defense Contract Audit Agency's) Contract Audit Manual (CAM) that instructs auditors on what to look out for, the risk areas to be cognizant of, when auditing lease costs.  This section can be found in CAM 7-203.

Considerations for ensuring that contractors properly classify their leases.

Auditors are instructed to be alert to instances where, to avoid reporting liabilities on their financial statements, contractors may structure their leases, or include assumptions in testing against the FAS-13 (now ASC 840) criteria, that result in those lease being classified as operating. Based on this guidance, contractors can expect auditors to test the assumptions used for classifying leases as operating vs. capital.

Leases improperly classified as operating leases will fail to recognize the imputed interest component of the lease payment. Therefore, lease payments under leases improperly classified as operating leases may contain an unallowable component associated with the interest.

Mitigating circumstances involving materiality determinations may exist. For example, leases reclassified as capital leases may result in depreciation during the early years of the leases at amounts higher than the lease payments due to use of accelerated depreciation methods and applied cost of money. The total depreciation and cost of money under a capital lease may be greater than the total leasing costs. On the other hand, it may be advantageous to the contractor to treat it as an operating lease for Government contract cost purposes to avoid recognition of the imputed interest component of lease payments. In other words, if the proper classification of leases will cost the Government more money, don't pursue it.

Considerations for Determining Unreasonable Lease Costs

From the Government's perspective, there is a risk whenever the lease term is substantially shorter than the asset's useful life. When this happens, the recovery of a high percentage of the fair market value of the asset over the lease term would be indicative of unreasonable rental costs. In this situation , the auditor is instructed to determine if the lessor considered and provided adequate residual value at the end of the lease term. As defined in FAS-13, the estimated residual value is the estimated fair value of the leased property at the end of the leas term. A reasonable residual value must be considered in computing minimum lease payments in order to attain reasonable lease costs.

Contractors can expect auditors to query them about how they establish useful lives for assets in general and capitalized leases in particular.

Tuesday, July 15, 2014

Accounting for Leases - Part 3

This is the third part in our series on how to account for lease costs. We are primarily focusing on capital leases because that is where disputes congregate. If a lease must be capitalized, there are many other factors that affect the propriety of lease costs charged to Government contracts. If the lease is not a capital lease, that is, it is an operating lease, the lease payments, so long as they are reasonable, are simply period expenses. Today we pick up two more considerations, useful lives and lease renewals/extensions.

Useful lives

Capitalized leases are amortized in a manner consistent with the lessee's (i.e. the contractor's) normal depreciation policy for owned assets. So, if the contractor uses straight-line depreciation on its own assets, it must use straight-line on capital lease assets. The useful life determination gets a bit trickier. These assets must be amortized over a useful life as follows:

  • If the leased property reverts to the lessee at the end of the lease or if the lessee is able to purchase the property at a bargain purchase price, then the asset life will be that normally used by the contractor for similar assets.
  • If the property is leased for a term which is 75 percent or more of the economic life of the asset, then the asset should be amortized over the life of the lease to the value of the lessee, if any, at the end of the lease. This could be shorter or longer than the contractor's normal useful life practices.

Capital lease renewals, extensions, and terminations

Here are some miscellaneous provisions from FAS-13 (now ASC 840) when leases are renewed, extended, or terminated.

If a capital lease is renewed or extended and the renewal is also classified as a capital lease, the carrying value of the asset may require adjustment. When the capitalized value under the revised lease and the present balance of the obligation differ, the asset and liability account is adjusted upward or downward to reflect the difference.

If a capital lease is renewed or extended and the renewal is classified as an operating lease, the existing lease shall continue to be accounted for as a capital lease to the end of the original term, and the renewal or extension period shall be accounted for as an operating lease.

A termination of a capital lease shall be accounted for by removing the asset and obligation with gain or loss recognized for the difference.

The exercise of a lease renewal option contained in a current lease other than those already included in the lease term, is classified as a new agreement and not a renewal or extension.

Monday, July 14, 2014

Accounting for Leases - Part 2

This is the second part of a series we began a couple of weeks ago. To read Part 1, Click here. As we mentioned back on July 2nd, there are two kinds of leases; operating leases and capital leases. Leases that meet any one of four tests (transfer bargain purchase economic life, or fair market) are classified as capital leases. Capital leases are capitalized and depreciated over the assets' useful lives. FAR 31.205-11(h) requires contractors to account for leases in accordance with FAS-13 (now referred to as ASC 840).

Now just because a contractor properly classifies a lease, it does not follow that the Government, the contract audit groups, will like the results. There is a bit more to the capitalization and depreciation equation as we will explain today and throughout the rest of this series.

The first thing to think about is the value to capitalize. In a typical lease, you know the monthly lease cost and the number of months. FAS-13 (ASC 840) requires that the present value of lease payments be capitalized. To determine present value, you need an interest rate. And that rate makes a difference. Consider a piece of equipment with the sum of lease payments over five years totaling $50 thousand. The present value assuming a 5 percent rate is $39 thousand. The present value assuming a 4 percent rate is $41 thousand. What rate should be used?

FAS-13 (now ASC 840) has the answer. Capital leases should be recorded as assets and liabilities at the lower of the present value of the minimum lease payments at the beginning of the lease term or the fair value of the leased property at the inception date. The discount rate used in determining present value is the lower of the lessee's incremental borrowing rate (the rate the lessee would have incurred to borrow the funds necessary to purchase the asset) or the implicit (lessor's) rate in the lease, if the implicit rate can be determined. The minimum lease payments are allocated between a reduction of the liability and interest expense to produce a constant periodic interest rate on the remaining balance.

A lessee may use its secured borrowing rate in calculating the present value of minimum lease payments if the rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.

Now here's where auditors get a bit testy. Many contractors don't have an incremental borrowing rate or a secured borrowing rate. Moreover, the lessor does not have or specify an "implicit" rate in the lease agreement. So what interest rate should be used? The Government likes to come up with a higher rate. That lowers the present value (less depreciation) and increases the interest portion of the lease payments which are unallowable under Government contracts. Contractors on the other hand, strive for a lower rate for just the opposite reason.

Ultimately, both sides have to come to some reasonable agreement. Contractors can best serve their interests if they have thought this through beforehand and have established a defensible method of determining the applicable discount rate.

Friday, July 11, 2014

Capping Your Indirect Expense Rate(s)

Sometimes contractors, especially start-up contractors, have highly volatile indirect rates. We noticed an extreme case not long ago where the G&A (General and Administrative) indirect expense rate went from 24% to 354% to 63% in a three year period. The G&A pool costs did not change significantly but the allocation base swung wildly.

This makes it very difficult for the Government, when contemplating a cost-reimbursable contract, to accurately forecast contract costs and to budget for expenditures accordingly.

To protect against such situations, the Government will sometimes propose to cap a contractor's indirect rates - to negotiate indirect  cost rate ceilings and incorporate those capped rates into the contract. Sometimes the contract auditor will make such a recommendation, sometimes its the contracting officer who makes it during contract negotiations.

Sometimes a contractor will propose to cap its indirect rates. Usually this is an effort to enhance its competitive position in a particular circumstance by basing its proposal on indirect cost rates lower than those that may reasonably be expected to occur during contract performance, thereby causing a cost overrun.

Other situations where it may be prudent to cap indirect rates in a contract include

  • a new or recently reorganized company where there is no past or recent record of incurred indirect costs
  • where a contractor has optimistically forcasted a lot of new work and the Government is skeptical that it will materialize, as scheduled.

Contractors that agree to capped rates need to understand the risks and consequences. Missing the mark on indirect rates can easily and quickly eat up whatever profit is going to be earned. Costs beyond the profit amount will have to be paid by someone else and contractors need to determine the amount of resources it can afford to use to defray unreimbursed costs. Many companies have suffered long-lasting negative financial impact from agreeing to capped rates.

Thursday, July 10, 2014

Government Caused Delays, Disruptions, and Other Encumbrences

Sometimes, not too often but often enough, the Government needs a contractor to temporarily stop working on a contract. Unless these orders to curtail performance are short-lived, these actions almost always end up costing contractors more money. There are two mechanisms available to the Government to stop work; suspension of work (covered in FAR 52.242-14) and a stop-work order (covered in FAR 52.242-17)

A suspension of work usually applies to construction or architect-engineer contracts and may be ordered for a reasonable period of time. If the suspension is unreasonable, the contractor may submit a claim for increases in the cost of performance. No additional profit is allowed on increased costs.

Stop work orders on the other hand are used in negotiated fixed-price or cost-reimbursement supply, research and development, or service contracts if work stoppage is required for reasons such as advancement in the state-of-the-art, production or engineering breakthroughs, or realignment of programs.

Generally, a stop-work order will be issued only if it is advisable to suspend work pending a decision by the Government and a supplemental agreement providing for the suspension is not feasible. Stop-work orders are not be used in place of a termination notice after a decision to terminate has been made.

After issuing the stop-work order, the contracting officer should discuss the stop-work order with the contractor and modify the order, if necessary, in light of the discussion.

As soon as feasible after a stop-work order is issued, but before its expiration, the contracting officer must terminate the contract, cancel the stop-work order, or extend the period of the stop-work order if it is necessary and if the contractor agrees.

The clause at FAR 52.242-17, Government Delay of Work, provides for the administrative settlement of contractor claims that arise from delays and interruptions in the contract work caused by the acts, or failures to act, of the contracting officer. This clause is not applicable if the contract otherwise specifically provides for an equitable adjustment because of the delay or interruption; e.g. when the Changes clause is applicable.

As we indicated earlier, Government-caused delays invariably cause increase costs to the Government. In a construction project, even one day increases costs because idle crews must still be paid. Contractors faced with a suspension of work or stop work order should immediately modify their accounting systems to begin collecting costs incurred during the delay period in order to support subsequent claims or equitable adjustment proposals.

Wednesday, July 9, 2014

What is a "Proper Invoice"?

The term "proper invoice" has very specific meaning in the Federal Acquisition Regulations (FAR). If you perform a search on that term within FAR, you'll find 44 instances where it is used. Here are some examples:
The ordering office shall make payments for supplies or services ... within 30 days after shipment or after receipt of a proper invoice or voucher (FAR 8.709).
Regarding payment due dates, the Government must pay by "The 30th day after the designated billing office receives a proper invoice from the contractor" (FAR 32.904).
For purposes of computing late payment interest penalties that may apply, the due date for making interim payments on cost-reimbursement contracts for services is 30 days after the date of a receipt of a proper invoice (FAR 32.904).
Further, the Government agrees to pay to the Contractor or its assignee, upon presentation of a proper invoice... (FAR 49.603).
It seems like every contractor has had, at some time in their, an invoice rejected because of missing information. The invoice (or voucher, or payment request) was not a "proper invoice". Disbursing offices are not always consistent in their rejections. Some offices might reject invoices that are perfectly acceptable by others. Also, disbursing office personnel are not always consistent in their approach to reviewing invoices. Some will reject out of hand, any invoice that does not have the requisite minimum content. Some disbursing office personnel will call for the missing information and not reject voucher. Sometimes vouchers are rejected as improper and it is left to the contractor to guess or figure out what data is missing. Sometimes, rejected vouchers are annotated to show what additional information needs to be provided.

Whatever the case, rejected invoices are bad. They negatively impact a contractor's cash flow. They cause the Accounts Receivable department to do additional work which takes time away from their other duties. We read somewhere that it costs companies an average of $27 to produce an invoice but it costs nearly double that to "fix" an invoice. The former is probably an automated process while the latter requires a lot of manual effort.

FAR does not leave anyone guessing what a "proper invoice" needs. In FAR 32.905, lists the items that must be present on an invoice:

  1. Name and address of the contractor
  2. Invoice date and invoice number (contractors should date invoices as close as possible to the date of mailing or transmission).
  3. Contract number or other authorization for supplies delivered or services performed (including order number and contract line item number).
  4. Description, quantity, unit of measure, unit price, and extended price of supplies delivered or services performed.
  5. Shipping and payment items (e.g. shipment number and date of shipment discount for prompt payment terms), bill of lading number and weight of shipment will be shown for shipments on Government bills of lading.
  6. Name and address of contractor official to whom payment is to be sent (must be the same as that in the contract or in a proper notice of assignment).
  7. Name (where practicable), title, phone number, and mailing address of person to notify in the event of a defective invoice.
  8. Taxpayer Identification Number (TIN). The contractor must include its TIN on the invoice only if required by agency procedures.
  9. Electronic funds transfer (EFT) banking information.
  10. Any other information or documentation required by the contract.
A couple of notes. First, EFT banking information is often not required any longer as this information is already included in SAM (System for Award Management). All Government vendors and contractors must be registered in SAM before they're even awarded a contract. Secondly, these minimum requirements for a proper invoice does not apply to interim payments on cost reimbursement contracts for services. Those have different criteria.

Invoices can be rejected for other reasons than the foregoing (e.g. items damaged or didn't meet spec) but they cannot be rejected because as "improper" if they contain the requisite information.

Tuesday, July 8, 2014

Disallowing Costs After Incurrence

Cost-reimbursement contracts (e.g. CPFF, CPIF, CPAF), the cost-reimbursement portion of fixed-price contracts, letter contracts that provide for reimbursement of costs, and time-and-material and labor-hour contracts provide for disallowing costs during the course of performance after the costs have been incurred (see, for example, our write-up on the Notice of Intent to Disallow Costs).

When contracting officers receive vouchers directly from the contractor and, with or without auditor assistance, approve or disapprove them, the process must be conducted in accordance with whatever procedures the individual agency has established for that process. However, for DoD contracts in particular, it is the contract auditor that reviews and approves vouchers (e.g. WAWF or Wide Area Work Flow). Generally, contract auditors are authorized to

  • received reimbursement vouchers directly from contractors,
  • approve for payment those vouchers found acceptable, and
  • suspend payment of questionable costs.

If the examination of a voucher raises a question regarding the allowability of a cost under the contract terms (including FAR cost principles), the auditor, after informal discussion as appropriate, may, where authorized by agency regulations, issue a notice of contract costs suspended and/or disapproved simultaneously to the contractor and the disbursing officer, with a copy to the cognizant contracting officer, for deduction from current payments with respect to costs claimed by not considered reimbursable. This notice of costs suspended and/or disapproved is the infamous DCAA "Form 1".

It is important to note here that the disallowance of costs must be taken against the contract where the costs were incurred. The Government may not offset billings of one contract for potentially unallowable costs incurred and billed under another contract. If the contract where the overbilling allegedly occurred is completed and there are no further costs to bill, the Government cannot disallow costs. It must use other avenues such as making a "demand".

If the contractor disagrees with the deduction, which is almost always the case, the contractor has recourse. The contractor may

  • submit a written request to the cognizant contracting officer to consider whether the unreimbursed costs should be paid and to discuss the findings with the contractor.
  • file a claim under the Disputes clause, which the cognizant contracting officer will process in accordance with agency procedures; or
  • do both of the above.

Monday, July 7, 2014

Abuse in the SBA's Section 8(a) Program

In what appears to be another in a string of crack-downs on companies abusing Government small business programs, the Department of Justice just announced the sentencing of Mr. Smith who fraudulently received $52 million in contracts under the SBA's 8(a) program; a program designed to assist disadvantaged small businesses. The actual loss to the Government was $7 million and that figure, plus the fact that awards to his company prevented legitimate 8(a) companies from receiving contracts under the program, undoubtedly influenced the 42 month prison sentence handed down by the judge. In addition to jail time, Mr. Smith will be required to pay restitution of $7 million.

Mr. Smith formed a roofing company in 1999. Although he exercised complete (but undisclosed) control over the company with his wife maintaining all of the accounting records, he had installed a figurehead - a minority who ostensibly owned 60 percent of the company (with the title of President) and Mr. Smith's son as Vice President with 40 percent ownership  of the company.

From 1999 until 2013, Mr. Smith and his company began picking off Government contracts that were reserved or set-aside for SBA 8(a) contractors. From 2004 through 2010, Mr. Smith also submitted annual updates to the SBA that fell short of full disclosure. These updates did not disclose that Mr. Smith exercised control over the firm, that Mr. Smith owned another company, that he (a non-disadvantaged individual) received more compensation than the "disadvantaged" President, that a relative owned a sizable portion of the company, among other false and misleading information. Based on these fraudulent applications, the company received more than $52 million in contracts from the federal government under the Section 8(a) program to which it was not entitled. The illicit profit from these contracts was estimated at $6.2 million.

Mr. Smith and his wife lived lavishly on these profits. They transferred millions of dollars from company accounts to their own accounts, to credit card companies for personal expenses, for dental work, for veterinarian services, for luxury cruises and limousine rides, for home improvements, and for casinos. Some of the payments to casinos were mischaracterized as subcontractor payments.

To make matters worse for themselves, the Smiths didn't claim these amounts as income on their tax returns. The impact of these omissions totaled $839 thousand in lost income tax revenues for the federal government.

Over the past three years, the Justice Department has filed more than 10,000 financial fraud cases against nearly 15,000 defendants. The Financial Fraud Enforcement Task Force (FFETF) which was created in 2009 to wage an aggressive, coordinated and proactive effort to investigate and prosecute financial crimes includes more than 20 federal agencies and 94 U.S. Attorney's offices as well as state and local partners.

Thursday, July 3, 2014

Post-Award Orientation Conferences

The subject of post-award orientation conferences is covered in FAR (Federal Acquisition Regulations) 42.503. Post-award orientations aids both the Government and the contractor. These conferences help achieve a clear and mutual understanding of all contract requirements and help identify and resolve potential problems. However, FAR warns contractors that post-award conferences are not substitutes for the contractor's full understanding of the work requirement at the time its offer was submitted. FAR also warns that it is not to be used to alter the final agreement arrived at in negotiations.

Post-award orientations are not mandatory. Contractors can request one but  ultimately, it is up to the contracting officer to decide whether a post-award orientation is necessary. Post-award orientations are not always conducted face-to-face either. Many are conducted over the phone. Sometimes, such conferences consist of simply a letter or other form of written communication. Obviously, the sooner the orientation is conducted, the better.

While not mandatory, FAR strongly encourages post-award orientations to assist

  • Small businesses
  • Small disadvantaged business concerns
  • Veteran-owned small business concerns
  • Service-disabled veteran-owned small business concerns
  • HUBZone small business concerns, and
  • Women-owned small business concerns.

When deciding whether a post-award orientation is necessary, the contractor considers a variety of factors including:

  1. Nature and extent of the preaward survey and any other prior discussions with the contractor
  2. Type, value, and complexity of the contract
  3. Complexity and acquisition history of the product or service
  4. Requirements for spare parts and related equipment
  5. Urgency of the delivery schedule and relationship of the product or service to critical programs
  6. Length of the planned production cycle
  7. Extent of subcontracting
  8. Contractor's performance history and experience with the product or service
  9. Contractor's small business, veteran-owned, woman-owned status
  10. Safety precautions required for hazardous materials or operations; and
  11. Complex financing arrangements, such as progress payments, advance payments, or guaranteed loans.
We typically recommend that contractors request a post-award orientation conference if one is not offered. Whether one is offered or not, contractors should prepare questions and topics to be discussed during the conference and provide those to the contracting officer prior to the conference. The Government will have someone prepare a report and this report, according to FAR 42.503 must be made available to the contractor. If the Government does not offer a copy, request it.

Wednesday, July 2, 2014

Accounting for Leases

There are two kinds of leases; capital leases and operating leases. A capital lease is essentially purchasing the asset and therefore, the asset must be capitalized on the balance sheet (and depreciated). An operating lease is what most people typically think of when they hear the term "leasing" - a five year rental agreement on a building, short term leases of equipment, etc. Operating lease payments are expensed in the income statement.

Sometimes it gets a little tricky to classify leases properly, and it makes a difference for Government contractors. Capital leases are covered by FAR 31.205-11(h) (Depreciation), while operating leases are covered by FAR 31.205-36 (Rental Costs). According to FAR 31.205-11(h), contractors must account for leases in accordance with Financial Accounting Standard No. 13 (FAS-13) which is now called ASC 840.

ASC 840 (formerly FAS-13) states that if a lease meets any one of four tests, the lease must be accounted for as a Capital Lease. Those tests include:

  • Transfer test. The lease transfers ownership of the property to the lessee by the end of the lease term.
  • Bargain purchase test. The lease contains a bargain purchase option. A bargain purchase option is a price that is lower than the fair value of the equipment.
  • Economic life test. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, where the lease term begins in the last 25 percent of estimated economic life, this criterion shall not be used to classify the lease.
  • Fair market test. The present value, at the beginning of the lease term, of the minimum lease payments equals or exceeds 90 percent of the excess of the fair value of the lease property. The 90 percent test should be considered a lower limit rather than a guideline. However, where the lease term begins in the last 25 percent of the estimated economic life, this criterion shall not be used to classify the lease.
In the coming days, we are going to be discussing in some detail, the mechanics of setting up capital leases and depreciating them under Government contracts. The classification of leases makes a difference in how much a contractor can recover - especially contractors that do not claim FCCM (Facilities Capital Cost of Money). There have been a lot of disputes between the Government and its contractors over the proper treatment of lease costs and we want to help you avoid potential disputes.

Tuesday, July 1, 2014

The Government is Unilaterally Determining Final Indirect Rates

We recently saw our very first case where a contracting officer applied a 20 percent decrement factor to a contractor's final G&A rate, called it a final decision, demanded a significant refund, and informed the contractor of its appeal rights to the Armed Services Board of Contract Appeals.

What precipitated the action? In late 2013, the contractor informed the Government that it was going out of business and wasn't sure at that time, where its accounting records would be sent? Since DCAA (Defense Contract Audit Agency) had not commenced its audits of 2005 and 2006 costs, the contracting officer was well aware of the impending six year statute of limitations that was about to kick in on those submissions. Not wanting to lose the opportunity to recover monies should an audit disclose unallowable costs, the contracting officer simply made a demand for "potential" disallowances.

This is an interesting twist. The contractors annual incurred cost submissions were determined to be adequate by DCAA - DCAA just never got around to conducting an audit in a reasonable amount of time. The contractor was not denying access to the auditors, it had simply ceased operations and was in the process of deciding where to send the records so that they could be audited.

Stay tuned on this one - its headed for litigation.