Annual Incurred Cost Submissions - Schedule M

Schedule M of the annual incurred cost submissions required of contractors holding flexibly priced contracts is a "Listing of decisions/agreements/approvals and description of accounting/organizational changes" See FAR 52.216-7(d)(2)(iii)(M).

DCAA's adequacy checklist for incurred cost proposals contains the following items relative to Schedule M.

• Ensure completion of this schedule.
• Negative responses are required.

Note here that DCAA has added the second bullet - negative responses are required. That is not a requirement of the referenced FAR and should not be a criteria for determining the adequacy of a submission. Nevertheless, if a contractor has not made any accounting or organizational changes during the year, it really takes no time to state that fact in a Schedule M. We recommend contractors do so and include negative responses, where appropriate, in submissions we prepare on behalf of clients.

The purpose of this requirement is to help identify changes in cost accounting practices that might affect how costs are accumulated and allocated to Government contracts. For example, moving a department from an overhead pool to a G&A pool will affect both rates. Adding a material handling rate where there was none previously, will most likely affect multiple rates. Certainly, acquiring another company or selling off part of an existing company will affect rates. The Government auditors need to know these things in order to effectively and efficiently conduct its audit. Its likely that such events will be identified during the audit anyway so its better that the information be provided up-front.

A number of years ago, we discussed the Minimum Annual Audit Requirements (MAARs) that contract auditors need to satisfy in each and every incurred cost audit that they perform. MAAR #7 requires that auditors evaluate any identified significant changes in practices for charging direct/indirect costs for consistency with generally accepted accounting principles, the applicable cost principles per contracts, and any applicable CAS requirements. The purpose of this requirement is to verify that changes in charging do not have the effect of improperly shifting costs among cost objectives, circumventing cost targets or ceilings of certain contracts, or other significant cost categories.

Schedule M from the annual incurred cost submission will help the auditor accomplish its MAAR #7 audit requirements.

Purchase, Existence, and Consumption

Material costs are usually significant for any production type contract. Contract auditors have a special review they perform annually whenever material costs are significant on cost-type contracts. This is a mandatory review as well, meaning that the auditor must perform the review before approving final costs on a contract. It is also required to be performed annually. The purpose of the special evaluation is to verify that purchased direct materials were in fact received and ascertain that they were

• needed for the contract
• purchased in reasonable quantities
• purchased at prudent prices
• used on the contract, and
• properly accounted for as to initial charge, transfer in or out, and residual value.

These reviews are a bit different from traditional audits in that the auditor will draw a sample of materials charged to Government contracts and then physically locate all items in the sample. The auditors will also obtain purchase orders for the sampled items and trace those purchase orders to receiving reports. Contractors that cannot physically locate sampled material items are at risk for internal control deficiencies and perhaps having some billings temporarily suspended.

To determine whether the item was needed for the contract, the auditor will compare purchase requisitions or purchase orders to contract requirements and/or bills of materials. Good internal controls would have all three of these documents (purchase requisitions, purchase orders, and receiving reports) prepared by different personnel.

Purchases should be made at optimum quantity levels. Contractors should not buy too few at a time and lose out on quantity discounts. On the other hand, sometimes, buying too many of a quantity will result in lower prices based on available quantity discounts.

When materials used on a contract come from inventory (as differentiated from purchasing directly for the contract) the auditor will be very interested in inventory valuation methodologies.

Mandatory Annual Audit Requirements (MAARs) - Part VI

Today we conclude our discussion (at least for awhile) on MAARs, Mandatory Annual Audit Requirements. MAARs are minimum audit procedures that must be applied to reviews of contractors' annual incurred cost submissions in order for the review to be considered compliant with GAGAS (Generally Accepted Government Auditing Standards). Audit working papers usually contain checklists to ensure that each and every applicable MAAR was covered, either in that particular review or in another audit. The first five parts in this series can be read here:

• Part I - Introduction
• Part II - Timing
• Part III - MAARs #1 - 4
• Part IV - MAARs #5 - 8
• Part V - MAARs #9 - 13

MAAR #14 - Pools/Base Reconciliation to Books. The purpose of this procedure is to determine that the claimed indirect cost pools and allocation bases under Government contracts reconcile to amounts in the contractor's official books and records. This is why auditors will often request the "trail balance" when determining adequacy of an annual submission.

MAAR #15 - Indirect cost comparison with prior years and budgets. The purpose of this procedure is to identify changes in cost accounting practices, reclassification of costs, and areas with substantial increases or decreases in costs that require further audit analysis and/or explanation. Auditors will often ask contractors to prepare a comparison showing current year and prior year's costs by account. Significant changes either up or down will prompt at least a query.

MAAR #16 - Indirect account analysis. This is likely the area that an auditor will spend the most time during an audit of incurred costs. The auditor needs to obtain sufficient evidence to support an opinion on the allowability, allocability, and reasonableness of the costs. The auditor will concentrate on sensitive accounts, new accounts and accounts with large variances.

MAAR #17 - Reserved. Initially, this MAAR involved IR&D/B&P computations. At one time, there were limits to how much a contractor could claim on Government contracts and this involved formulas and comparisons with prior years. After those limits were eliminated in the FAR cost principles, this MAAR was dropped.

MAAR #18 - Indirect allocation bases. The purpose of this MAAR is to assure that allocation bases are equitable for allocation of indirect costs to intermediate and final cost objectives. The focus here is on whether indirect costs are allocated to cost objectives on a "causal and beneficial" basis.

MAAR #19 - Indirect rate computations. The purpose here is to confirm that the contractor's rate computations are accurate for distributing indirect costs to Government contracts. Most contractors use Excel-based models to submit their annual incurred cost claims. These models are moderately complex and errors commonly occur.

MAAR #20 - Reserved. At one time, this MAAR required auditors to review adjusting journal entries that involve indirect expenses. It has now been merged into MAAR #10 which requires auditors to review all adjusting journal entries.

The MAARs provide auditors a kind of road map on how to approach their audits of incurred costs. Knowing the various MAARs should aid contractors in preparing for an audit.

Mandatory Annual Audit Requirements (MAARs) - Part V

Today we continue our discussion on MAARs, Mandatory Annual Audit Requirements. MAARs are minimum audit procedures that must be applied to reviews of contractors' annual incurred cost submissions. Anything short of these would render the audit non compliant with GAGAS (Generally Accepted Government Auditing Standards). If you missed any of the first four parts, you can read them here:

• Part I - Introduction
• Part II - Timing
• Part III - MAARs #1 - 4
• Part IV - MAARs #5 - 8

MAAR #9 - Payroll/Labor Distribution Reconciliation and Tracing. The purpose of this MAAR is to test the overall integrity of labor cost records at the general ledger and cost ledger levels, and to reconcile payroll accruals and disbursements to ensure that distribution entries trace to and from the cost accumulation records. Or, to put it another way, how does an hour charged on a timesheet, convert to dollars on a bill to the Government.

MAAR #10 - Adjusting entries and exception reports. The purpose of this MAAR is to identify adjustments and/or exceptions that require further audit analysis and explanation. The audit will evaluate the propriety of adjusting journal entries and exception reports for both direct and indirect costs.

MAAR #11 - Reserved. (At one time, MAAR #10 pertained to labor adjusting journal entries and MAAR #11 pertained to materials adjusting journal entries. These were combined into a single MAAR.

MAAR #12 - Auditable subcontracts/assist audits. The purpose of this procedure is to identify and request assist audits on "auditable" subcontracts. "Auditable" subcontracts are flexibly priced subcontracts awarded under flexibly priced prime contracts. It is the prime contractor's responsibility to perform subcontract audits but its the auditor's responsibility to ensure that those audits are adequately performed.

MAAR #13 - Purchases existence and consumption. The purpose of this MAAR is to test that materials were in fact received (exist or were consumed) and that services were in fact performed. The auditor will make physical observations and/or inquiries on a concurrent basis in addition to documentation verification of contract charges for purchased materials and services.

Tomorrow we will conclude this series by discussing the remaining MAARs.

Mandatory Annual Audit Requirements (MAARs) - Part IV

We're continuing our discussion on Mandatory Annual Audit Requirements (MAARs): minimum audit procedures before completing reviews of contractor incurred cost proposals. If you're jumping into this discussion for the first time, you might want to go back and read the first three posts in this series:

• Part I
• Part II
• Part III

Today we will be discussing MAARs 5 through 8.

MAARs #5 - General ledger, trial balance, income and/or credit adjustments. The purpose of this procedure is to help identify any income and credits which the Government may be entitled to obtain or share, and to evaluate the exclusion of any adjustments not reflected by the contractor in Government contract costs. It is not uncommon nor is it contrary to generally accepted accounting principles (GAAS) to book miscellaneous income "below the line" to an income statement section reserved for non-operating income and expenses. However, sometimes the Government is entitled to share in these non-operating transactions (e.g. rebates). Additionally, contractors have been known to hide expenses in these sections in order to reduce their indirect expense rate allocation bases thereby increasing their indirect rates (hint: don't do that).

MAARs #6 - Labor floorchecks or interviews - We've covered this area extensively in our blog. The purpose of this procedure is to test the reliability of employee time records, that employees are actually at work (difficult for "work-at-home" employees), that they are performing in assigned job classifications, and that time is charged to the proper cost objective. This is one of the two MAARs that must be performed in the year the costs are incurred (the other is MAAR #13). After the fact, there is no way to determine that time charges correspond to the work actually being performed.

MAARs #7 - Changes in charging direct/indirect costs. The purpose of this procedure is to verify that changes in charging direct/indirect cost do not have the effect of improperly shifting costs among cost objectives or circumventing costs targets or ceilings of certain contracts or other significant cost categories. The auditor will evaluate changes in procedures and practices for charging direct/indirect cost for consistency with generally accepted accounting principles, the applicable cost principles per contracts, and any applicable CAS requirements.

MAARs #8 - Comparative analysis -sensitive labor accounts. The purpose of this procedure is to identify for further examination any sensitive labor charges (for example, indirect charging by direct labor employees) that vary significantly from the prior period and/or budgetary estimates. Lately, DCAA has been requesting contractors to prepare two or three year comparisons of costs by account. It saves time for the auditor however there is no contractual requirement that contractors do so.

Mandatory Annual Audit Requirements (MAARs) - Part III

Mandatory Annual Audit Requirements (MAARs) are procedures that auditors apply when auditing contractor annual incurred cost proposals. These procedures are considered absolutely essential in order to comply with generally accepted government auditing standards when performing the audit. Contractors submitting incurred cost proposals can expect auditors to delve into these areas at some point before issuing an audit report on the results of their review. There are seventeen of them and beginning today, we will begin a discussion on the objectives and purpose of each MAARs. This will take several posts to cover them all.

MAAR #1 - Internal Control Audit Planning and/or Internal Control Questionnaire: The purpose of this requirement is to determine the extent of reliance that can be placed on the internal controls for contract costs and the need for and extent of substantive testing that may be required based on the observed strengths or weaknesses of contractor systems. Essentially, the better a contractors internal control systems, the less auditing will be required. If the auditor can relay on internal control systems to "catch" potentially unallowable costs, he/she can reduce audit testing.

MAAR #2 - Contract Cost Analysis and Reconciliation to Books: This provides the auditor (i) an overview and order-of-magnitude frame of reference for direction of audit effort and other audit planning/performance considerations, and (ii) to verify that the auditable costs claimed or to be claimed on Government contracts tie in to the amounts produced by the accounting system in the contractor's official books and records. Auditors will evaluate summaries of the contractor's total annual contract costs by major cost element (material, subcontracts, intra-company charges, and credits,etc), and verify that the auditable contract costs reconcile to contractor accounting records by cost element.

MAAR #3 - Permanent Files: Permanent files provide an efficient and effective repository of current audit information. Permanent file maintenance should help identify the need for further audit and analysis, and help in determining the accounting methods that influence the nature, level, and extent of further testing required in specific cost accounts, functions, operations, and departments. Permanent files are updated for new or changed contractor organizations, operations, policies, procedures, internal controls, software programs, and accounting methods that influence the nature, level, and accounting treatment of costs being charged to Government contracts.

MAAR #4 - Tax Returns and Financial Statements. The purpose of this step is to highlight possible areas to reduce the extent of audit effort that might otherwise be required. The evaluation of a contractor's financial statements, corporate minutes, tax returns, reports filed with regulatory bodies (e.g. SEC) and data available on the corporate web site will assist the auditor in planning the audit more effectively. Generally, greater weight is placed on corporate reports to regulatory bodies with reporting requirements.

Mandatory Annual Audit Requirements (MAARs) - Part II

Yesterday we began a discussion on mandatory annual audit procedures that auditors must apply during audits of contractors' incurred cost submissions in order to comply with GAGAS (generally accepted government auditing standards). We did not list the seventeen MAARs so here they are:

MAARs are performed before, during, and after the fiscal year when the costs are incurred. Ultimately, the auditor must cover each "applicable" MAARs before issuing his/her audit report.

• MAARs 1, 3, and 7 are typically accomplished on a continuous basis as audits are performed and are not necessarily associated with a single contractor fiscal year or exclusively with the incurred cost audit. 
• MAARs 2, 4, 9, 14, 15, and 19 are "reconciliation" procedures and are usually performed as preliminary steps in the audit of incurred costs.
• MAARs 10 and 16 are historical transaction testing and performed during the incurred cost audit.
• MAARs 6 and 13 are concurrent procedures and must be performed during the fiscal year being audited.
• Finally MAARs 5, 8, 12, and 18 are typically performed during annual incurred cost audits but may also be performed in advance of the fiscal year being audited.

Tomorrow we will begin digging deeper into the purpose and objective of each of these seventeen Mandatory Annual Audit Requirements.

Mandatory Annual Audit Requirements (MAARs) - Part I

Today we start a series that goes into more detail that we usually include in this blog. Often we are asked about the propriety of a particular request from an auditor. Most of the time, we know and understand what the auditor is intending to accomplish by the request. Sometimes, the requests are a bit obscure. When it comes to audits of incurred costs, auditors must comply with Mandatory Annual Audit Requirements (MAARs). MAARs are minimum audit procedures necessary to comply with generally accepted government auditing standards (GAGAS) when performing incurred cost audits. We thought it would be useful and educational to describe each of the MAARs to help you appreciate why auditors ask what they ask and do what they do.

The MAARs vary greatly in purpose, type of transaction being evaluated, and time frame of accomplishment. MAARs are performed at all major contractors (those with $100 million or more in costs booked to flexibly-priced contracts such as CPFF, CPIF, FPI, and T&M) unless such work would fulfill no useful current or future need or the contractor has no costs claimed in one or more cost elements related to a specific MAAR.

Some MAARs must be performed during the fiscal year under audit. MAAR #6 for example requires auditors to review compliance with timekeeping policies and procedures (i.e. floorchecks). Other MAARs are performed during the incurred cost audit, even if that is several years after the fact. Some are accomplished on a continuous basis.

Currently, there are seventeen MAARs. These requirements are tweaked periodically and some have actually been dropped. At one time there were twenty MAARs.

Over the next few days, we will be describing the purpose and objective of each of the seventeen MAARs. Although, as we mentioned above, they are applicable to "major" contractors, the essence of these audit requirements are performed at non-major contractors as well. So this series should be useful to contractors of all sizes who desire to gain some insight on why auditors do what they do.