Accounting Systems - Problematic Standards - Part 6

Today we conclude our discussion series on accounting system standards that many contractors have found challenging. According the the DoD FAR Supplement (DFARS), there are 18 accounting system criteria and we're only addressing six of those. That doesn't mean the other 12 are less important. It means that they are very basic and fundamentally easy to understand. We are reviewing the ones that, in our experience, cause contractors to trip when being audited or left scratching their heads when trying to understand the meaning and intent of the standard. Today, in conclusion, we are going to take a look at Standard No. 16 -  Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms.

Now obviously, this criteria applies to contracts where billings are based on costs such as cost reimbursable contracts and fixed price with progress payments based on cost. But its also important for T&M contracts where the "materials" costs much trace back to accounting records. Also, more recently, the Government has been checking out progress payments based on milestones to ensure that the amounts received don't exceed actual costs. We spent a great deal of time recently discussion performance based payments. For more on this last point, click here.

There are several problems that come up when contractors bill their actual costs. First, we've seen several cases where contractors bill what they negotiated, not what they've incurred. This usually happens at very small Government contractors who don't understand what kind of contract they've received. Most often, these are non-DoD contracts where billings do not go through the rigors of DCAA oversight. Secondly, some contractors like to include amounts in their billings that are not recorded in their accounting records. We've seen provisions for the business use of privately-owned vehicles and other "soft" costs that may have in some way benefited the contract.

Another problem with billing reconciliations is the capability of some accounting systems to record prior period adjustments. QuickBooks is guilty of this as is other software. These systems have no "hard close" dates so that prior period transactions can be edited at will. If a prior period is edited, suddenly the billings will no longer reconcile to the books. There is no definitive way to reconcile billings to accounting records at this point, other than to guess. Guessing does not typically satisfy auditors.Contractors should avoid editing prior period transactions. If adjustments are required, use journal entries and document the reason for the adjustment.

Reconciliations, in this context, are generally limited to direct costs. Indirect costs are typically billed at an approved provisional billing rate. However, as happens over and over, contractors sometimes try to bill indirect costs as direct. It may be a particular indirect cost that is specifically identifiable to a contract so the contractor rationalizes that it should be billed as direct. Doing so, is usually inappropriate and violates some FAR cost principles on direct and indirect costs.

The last issue we'll bring up today is the one where contractors try to bill certain costs at other than cost. A good example of this is company-owned equipment where a contractor charges the going market rate rather than its actual costs. There are situations where that would be acceptable however, generally, costs to the Government must be limited to the cost of ownership.

Accounting Systems - Problematic Standards - Part 5

We're continuing our series on discussions of accounting system standards that many contractors have some difficulty meeting - or, at least meeting to the satisfaction of a Government auditor. As we began this series, we mentioned that there were two kinds of accounting system audits. There is the pre-award accounting system survey which is basically the SF 1408 (Preaward Survey of Prospective Contractor - Accounting System) and a post-award accounting system audit following the guidelines of DFARS 252.242-7006 (Accounting System Administration). The DFARS standards contain the same criteria found in the SF 1408, and then some. Most contractors naively believe that they have adequate accounting systems. Perhaps so but most auditors can find something wrong with the systems and the DoD standards make it much easier to find deficiencies.

Today we're going to look at Accounting System Criteria No. 8, Management reviews of internal audits of the system to ensure compliance with the contractors established policies, procedures, and accounting practices. Some of you might already be thinking that you don't have an internal audit department so this standard must be "n/a" or not applicable. Not so fast. The presumption here is that in order for an accounting system to be adequate, contractors will have policies, procedures, and practices over their accounting systems and that someone in the organization - it does not have to be a formal internal audit department -is going to conduct reviews (or audits) to ensure employees are complying with those policies and procedures.

Inherent in this standard are seven distinct requirements:

1. Contractors must have written policies and procedures
2. The policies and procedures must be disseminated to affected employees
3. Employees are expected to comply with those policies and procedures
4. There must be some form of oversight to ensure that employees are complying with those policies and procedures.
5. There must be some form of oversight to ensure that the policies are procedures are accomplishing what they were designed to do.
6. Management must be informed of the results of these oversight reviews.
7. Management must take action on any forthcoming recommendations.

An accounting system that misses the mark on any one of these items, is at risk for being labeled inadequate, or deficient, or needing improvement. Larger contractors are at risk for having some of their billings withheld until corrections are made.

Contractors that do not have internal reviews of internal control system adequacy and compliance should be thinking about ways to implement such a program.

Accounting Systems - Problematic Standards - Part 3

This is the third in our installment of DoD standards for contractor accounting systems that are often problematic for contractors. There are 18 standards in total - most are easily understood and can be implemented without too much pain. There are a few however that are difficult to comprehend or where applicability is not intuitive. In Part 1, we discussed the limitation of cost/limitation of funds clauses where these are compliance with contract terms issues, not accounting system issues. In Part 2, we looked at the control environment and determined what that means in the context of an accounting system. Today we will discuss Criterion No. 4 which requires adequate accounting systems to have a logical and consistent method for the accumulation and allocation of indirect costs to intermediate and final cost objectives.

You have probably already noticed the words "logical and consistent". Logical and consistent according to who? The Government? The contractor. Who's to decide? A method for allocating indirect costs may be logical to you, the contractor, but may seem not so logical to an auditor. We can't begin to count the number of times an auditor has decided based on two minutes of deep analytical thought and computation, that a contractor's rate structure is no good. And often, the pronouncement is made because your way is not what they've seen at other contractors. Or, they get some wild notion that if you use a value-added base for allocating G&A expenses, then you must also have a material handling indirect rate.

Here's what contractors need to know concerning indirect rate pools and allocation bases. It comes from FAR 31.203:

The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs. The Contractor shall determine each grouping so as to permit use of an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping on the basis of the benefits accruing to intermediate and final cost objectives. When substantially the same results can be achieved through less precise methods, the number and composition of cost groupings should be governed by practical considerations and should not unduly complicate the allocation.

There's no hard and fast rules in the foregoing requirement. There is nothing that says you must use a total cost input (TCI) method when such and such is the case. Of course, if you have methods of allocating costs that result in egregious misallocations of indirect costs to final cost objectives (e.g. contracts), you deserve the audit attention.  That's not usually the case however. Disputes generally arise because an auditor usually thinks he/she has a better way.

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.

Accounting Systems - Problematic Standards - Part 1

Yesterday 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). Essentially, you could categorize them as pre-award and post-award. 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. We mentioned yesterday that among the eighteen criteria for an adequate accounting system, some seem to be more problematic than others. We are going to look at a few of those today and in the coming days. These criterion are found in the DoD FAR Supplement (DFARS 252.242-7006) so technically apply only to DoD contractors. However, other Agencies have been know to adopt the same standards for their contractors. While FAR requires contractors to maintain "adequate" accounting systems, only the DoD has attempted to define specific standards for adequacy.

Standard No. 15 requires accounting systems to be able to provide cost accounting information as required by contract clauses concerning limitation of cost (FAR 52.232-20), and limitation of funds (FAR 52.232-22). Essentially, these clauses require contractors to notify the Government whenever it is approaching estimated costs or funds allotted to the contract. In the -20 clause, contractors are required to notify the contracting officer whenever it has reason to believe that the cost it expects to incur under this contract in the next 60 days, when added to all costs previously incurred, will exceed 75 percent of the estimated cost specified in the schedule. In the -22 clause, contractors are required to notify the contracting officer whenever it has reason to believe that the cost it expects to incur under this contract in the next 60 days, when added to all costs previously incurred, will exceed 75 percent of the total amount so far allotted to the contract by the Government.

To meet these requirements, contractors will need to know two things; their historical costs and an estimate of the costs that it will incur in the next 60 days (often referred to as the "burn rate"). An accounting system records historical costs. It doesn't project future costs. Projections of future costs might be included in a budgeting system or some other kind of system but it is not found in a record of historical costs, i.e. an accounting system. Its possible that historical accounting data can be used to project costs to be incurred in the next 60 days, but not necessarily and that is not what accounting systems are designed to do.

Contractor accounting systems that meet the other adequacy criteria will automatically be able to produce historical costs. But what the auditors are looking for here is additional tracking and analysis apart from the accounting system. Auditors are looking to see if contractors have a system of estimating their burn rate by month, that they add these projections of future costs to historical costs and compare them with contractual cost estimates or fund limitations, and notify the Government when it hits the 75 percent threshold. Most auditors will ask for policies and procedures that apply to this requirement (most Government contractors do not have them). Then, the auditors will test for compliance with those policies and procedures (most Government contractors do not get concerned about these clauses until they get pretty far down the contract performance line). Realistically, its a meaningless exercise until expenditures approach the 75 percent of cost or amount funded levels. Many auditors don't deal in practicalities however - they want to see a system in place and actively monitored on day one.

Many contractors have successfully met this criteria with a simple written policy and Excel.

Two Kinds of Accounting System Audits

There are two types of accounting system reviews conducted by the Government. The first is a pre-award survey that essentially follows the SF 1408, Preaward Survey of Prospective Contractor - Accounting System. We've discussed this one several times and have alluded to it several more times. Its used primarily as a tool to assess whether a prospective contractor has an accounting system capable of meeting contractual requirements. These surveys are conducted by a contracting officer, a contract specialist, by DCMA (Defense Contract Management Agency) or by DCAA (Defense Contract Audit Agency). DCAA, hands down, does the best and most thorough review of anyone in assessing accounting system adequacy.

The other type of review is often referred to as a postaward accounting system review and is largely confined to Defense contractors. The policy is laid out in the DoD FAR Supplement (DFARS) at 242.7502.

Contractors receiving cost-reimbursement, incentive type, time-and-materials, or labor-hour contracts, or contracts which provide for progress payments based on costs or on a percentage or stage of completion, shall maintain an accounting system.

In evaluating the acceptability of a contractor's accounting system, the contracting officer, in consultation with the auditor or functional specialist, shall determine whether the contractor's accounting system complies with the system criteria for an acceptable accounting system as prescribed in ... (DFARS) 252.242-7006, Accounting System Administration.

Many of the same criteria found in the SF 1408 are contained in the DoD criteria, but the DoD criteria has about 5 or 6 additional criteria not contained in the SF 1408. The 18 DoD criteria includes the following. Not every criteria will apply to every contractor.

1. A sound internal control environment, accounting framework, and organizational structure.
2. Proper segregation of direct costs from indirect costs
3. Identification and accumulation of direct costs by contract
4. A logical and consistent method for the accumulation and allocation of indirect costs to intermediate and final cost objectives
5. Accumulation of costs under general ledger control
6. Reconciliation of subsidiary cost ledgers and cost objectives to general ledger
7. Approval and documentation of adjusting journal entries
8. Management reviews of internal audits of the system to ensure compliance with the Contractor's established policies, procedures, and accounting practices
9. A timekeeping system that identifies employees' labor by intermediate or final cost objectives
10. A labor distribution system that charges direct and indirect labor to the appropriate cost objectives
11. Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account
12. Exclusion from costs charged to Government contracts of amounts which are not allowable in terms of FAR Part 31 cost principles and other contract provisions
13. Identification of costs by contract line item and by units (as if each unit or line item were a separate contract), if required by the contract
14. Segregation of pre-production costs from production costs, as applicable
15. Cost accounting information, as required by contract clauses for limitation of cost, limitation of funds, allowable cost and payment, and to readily calculate indirect cost rates from the books of accounts
16. Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms
17. Adequate, reliable data for use in pricing follow-on acquisitions
18. Accounting practices in accordance with standards promulgated by the Cost Accounting Standards Board, if applicable, otherwise, GAAP (Generally Accepted Accounting Principles).

There are several of these criteria that seem to be problematic to a lot of contractors. We will highlight those in tomorrow's post.