Full Disclosure of Disciplinary Actions Required by CPA Firms Engaged in Government Auditing

Last month, the Defense Department issued a "Class Deviation" that affects contractors performing contract audits for the Department. Contracting officers are now required to use a new clause (described later) when contracting with accounting firms providing financial statement auditing or audit remediation services to the Defense Department in support of audits. Or, in other words, incurred cost audits that were once the sole bailiwick of DCAA (Defense Contract Audit Agency).

Section 1006 of the 2019 National Defense Authorization Act (NDAA) requires that any accounting firm providing financial statement auditing or audit remediation services to the Defense Department in support of audits required under 31 USC 3521 (i.e. incurred cost audits) to provide DoD with a statement setting forth the details of any disciplinary proceedings with respect to the accounting firm or its associated persons before any entity with the authority to enforce compliance with rules or laws applying to audit services offered by the accounting firm.

Most likely, disciplinary proceedings contemplated in this provision would include those administered by individual State Board's of Accountancy in the states where firms are licensed. In California, for example, the State Board of Accountancy's quarterly newsletter details disciplinary actions taken during the quarter. There were about 40 actions listed in that newsletter. A lot of these disciplinary actions resulted from acts discreditable to the profession and resulted in suspension, revocation of licenses, fines, and remedial training.

The Government has a vested interest in ensuring that its contractors, including those that provide professional audit services, adhere to the highest ethical, moral, and professional standards. What is not clear is whether this disclosure requirement applies to on-going or interim review status or whether it applies when the case is closed/finalized. The class deviation also ensures confidentiality if the contractor so-desires.

Comparative and Trend Analyses in Risk Assessments

Happy New Year everyone and welcome to our first blog post of 2019. As we begin this new year, the Government is in the midst of a partial shutdown. However, Defense, Energy, Education, VA, Labor, and Health and Human Services remain fully funded, open and are conducting business as usual. Agencies affected by the shutdown include Justice, Agriculture, Treasury, State, Interior, Transportation, Commerce, and HUD. Companies with contracts with those agencies might be feeling an impact, or soon will. No one is yet predicting how long the partial shutdown will last. If this one is like previous shutdowns however, all those furloughed Government employees will receive their full pay - they just get, what amounts to extra paid vacation.

But since contract auditors are, for the most part, open for business, this is not a time to sit back and let your policies, procedures, practices, and internal controls take a furlough. Those things are important - past, present, and future. They are important for supporting incurred costs, for supporting estimates of future costs, and used by auditors for trend analyses and comparative analyses. How do contract auditors employ trend/comparative analyses in their work and what are the results of those analyses used for? To answer those questions, we'll take a look at a standard audit program for evaluating labor costs using employee interviews. How do auditors decide who from hundreds or thousands of employees to interview? Their's is not a haphazard selection. Auditor's expend a lot of effort into a risk assessment, the results of which lead the auditor to select specific persons (or groups of persons) they need to check on. One of the steps in performing the risk assessment is the trend analysis/comparative analyses steps.

Auditors are free to and expected to exercise their professional judgment as to what kinds of comparative and trend analyses need to be performed. But there are two specific analyses called for in the standard audit program: ratio of direct to indirect labor and trend lines of sensitive accounts.

1. Ratio of direct to indirect. Auditors will perform trend analyses to disclose any significant increases in the ratio of direct to indirect labor accounts. If disclosed, contractors will be requested to explain those fluctuations. If there is no apparent (or satisfactory) explanation, auditors are instructed to further evaluate those fluctuations.

There was a not-so-famous case years ago - back when there were caps on IR&D/B&P expenditures - where such an analysis showed that indirect costs increased significantly in the last couple of months of the fiscal year. Further investigation disclosed that this increase coincided with the contractor reaching its maximum IR&D expenditures. A criminal investigation and subsequent settlement disclosed that employees were instructed to mischarge their time once the IR&D budget was exhausted. The contractor ended up sending a lot of money back to the Government.

2. Comparative analysis of sensitive labor accounts. Auditors are instructed to perform comparative analyses of sensitive labor accounts. What are sensitive labor accounts?  That's not stated but probably includes any labor accounts that are charged directly or indirectly to Government contracts - especially cost-type (or reimbursable) contracts. Again, contractors will need to be able to explain significant fluctuations. Auditors are looking for situations where labor is being excluded from an indirect allocation base or mischarged from the direct labor base to the indirect cost pool. By omitting a project or product line from the indirect allocation base, the resulting rate will be increased and the Government overcharged.

What Happens When the Contracting Officer Disagrees with the Contract Auditor?

Contract auditors perform audits and issue reports, sometimes with recommendations or questioned costs, to the contracting officer. The contracting officer, in turn, resolves the audit findings with the contractor. Sometimes, the contracting officer does not agree with the audit findings; more so if the audit relates to pricing proposals than with historical costs. Why? When it comes to pricing proposals, everyone's dealing with estimates of future costs and judgement becomes a big part of estimating. Incurred cost on the other hand deal with historical evidence supporting the incurrence of costs. Contractors either have support or they don't. Judgement is not a major factor on the allowability of costs.

The Defense Department has made it very clear that when it comes to its contracting officers and its contract auditors (namely the Defense Contract Audit Agency), the contracting officer will rule the day. In a 2009 memorandum, the Defense Department states as official policy:

It is neither expected nor necessary that the contracting officer and the contract auditor agree on every issue. They have different, yet complementary, roles in the process. It is expected that the auditor and contracting officer will work together recognizing that it is the contracting officer's ultimate responsibility to determine fair and reasonable contract values.

That particular guidance anticipates that when the contract auditor and contracting officer disagree on particular issues, the matter be elevated  to successively higher levels until there is an agreement. That means one side or the other will need to give in.

Sometimes, auditors become so entrenched in their positions that they seemingly refuse to listen to the contractors' side of an issue or acknowledge that there might be merit to the position. In those cases, it is often better to take the matter up with the contracting officer, knowing that in the end, the final decision rests with them.

Fast Cars, Easy Money - An Update

This is an update to an article we posted last August concerning DCAA's (Defense Contract Audit Agency) questioning of $50 million on an Army contract to mentor and train Afghan National Security Forces (see DCAA Questions $50 Million of a Contractor's Incurred Costs).

Yesterday, Senator McCaskill, as ranking member of the Senate Committee on Homeland Security and Governmental Affairs, released a report that provides considerably more details than was previously publicized, although the original DCAA audit report was not released.

The new report (available here) was issued in conjunction with yesterday's hearing where Senator McCaskill grilled the Secretary of Defense (and other officials) about that particular contract where she stated that "Somebody's head's got to roll on this".

Click HERE to watch McCaskill's questioning at yesterday's hearing and be prepared to be entertained.

McCaskill was not at all pleased that the subject of the audit was still under contract and drawing taxpayer funds to drive around in luxury automobiles and paying family members (and "significant others") exorbitant salaries but performing no work.

The Secretary of Defense acknowledged that there was an ongoing criminal investigation into the matter and he was not at liberty to discuss details in an open forum. That didn't mollify McCaskill however. She questioned why that contractor had not been immediately debarred from Government contracting which is an action independent of any criminal investigation.

McCaskill also demanded that the Pentagon identify the specific individuals responsible for awarding the contract and approving billings under the contract."Someone's head is going to roll".

DCAA to Share Audit Function With Commercial Firms - Part 2

Yesterday we introduced the Section 803 provision in the 2018 NDAA (National Defense Authorization Act) that will require the Defense Department to begin farming out some of its incurred cost audit functions to commercial firms. Though the probable soon-to-be law does not specify a particular percentage or dollar value of audits to be shaved off of DCAA's (Defense Contract Audit Agency's) current workload, the general tenor of the provision sounds like the sharing will be substantial and on-going.

For example, yesterday we reported that the new provisions require that audits be completed within one year from submission of an adequate incurred cost proposal (for information on what constitutes an adequate incurred cost proposal, see Annual Incurred Cost Submissions - Adequacy or DCAA's Checklist for Determining Incurred Cost Proposal Adequacy). But what happens if the audit is not completed within a year? Section 803 contains a provision that states if audit findings are not issued within one year after the date of receipt of a qualified incurred cost submission, the audit shall be considered to be complete and no additional audit work shall be conducted. That would result in significant risk to the Government and will probably necessitate the transfer of a substantial number of audits from DCAA to commercial auditors - particularly since DCAA has not had much success in completing incurred cost audits in a year.

Another Section 803 provision that makes the number of commercialized audits substantial and on-going is the requirement that DoD maintain an appropriate mix of Government and private sector capacity to meet the current and future needs and to ensure that qualified private auditors perform incurred cost audits on an ongoing basis. Sounds to us like the program is to be set up for the long haul.

There are certain qualifications that commercial firms must meet in order to participate in the program. There can be no conflicts of interest, the auditors must be independent, they must sign non-disclosure agreements to protect proprietary or nonpublic data, they cannot use proprietary data for other purposes, and must protect it. Also, and significantly, the firms performing the audits must have a peer review with an "acceptable" rating ("acceptable" is as good as you can get in a peer review).

DCAA To Share Audit Function With Commercial Firms - Part 1

The 2018 NDAA (National Defense Authorization Act) Conference Report has been published. The Conference Report refers to the final version of a bill that is negotiated between the House and the Senate via conference committee. It will still need to be submitted to each Chamber for its consideration for approval or disapproval but in the past, NDAA conference reports are routinely passed by both the House and Senate. So, assuming the President signs the bill, it will become law.

Our coverage of the NDAA focuses on contracting matters - provisions that will affect contractors or prospective contractors. And this year's NDAA is going to change the way many Government contractors are audited. The Department of Defense will be making a major shift toward using commercial audit firms to conduct incurred cost audits instead of exclusively relying upon DCAA (Defense Contract Audit Agency) to perform their incurred cost audits. We can't foresee whether this is good news or not such good news for contractors.

The good news is that audits will be completed much quicker than they presently are. Audits will need to be completed within a year after the Government receives an adequate incurred cost submission from the contractor. More good news includes the fact that the Government and contractors will be able to close out contracts much quicker. The big uncertainty for contractors however is the unknowns that come with a new audit organization. Will the audits be more detailed or less detailed in scope? Will commercial auditors have the same materiality threshold as Government auditors?

We will spend a few days unpacking the content of the new bill. There's a lot to it. But here's the essence: To support the need of the Defense Department for timely and effective incurred cost audits, and to ensure that DCAA (Defense Contract Audit Agency) is able to allocate resources to higher-risk and more complex audits, the Secretary of Defense shall use qualified private auditors to perform a sufficient number of incurred cost audits;

1. To eliminate any backlog of incurred cost audits by October 1, 2020.
2. Ensure that incurred cost audits are completed not later than one year after the date of receipt of a qualified incurred cost submission
3. Maintain an appropriate mix of Government and prive sector capacity to meet the current and future needs of DoD to perform incurred cost audits
4. Ensure that qualified private auditors perform incurred cost audits on an ongoing basis to improve the efficiency and effectiveness of incurred cost audits
5. Limit multi-year auditing (obviously you cannot perform multi-year auditing and achieve one year turn-around)

Privatization of the incurred cost audit function under this bill is not a one-time shot to help DCAA eliminate its backlog. The bill intends privatization to be a permanent, on-going, and substantial part of contract audits.

GSA Drafting Guidance to Assist Civilian Agencies in Procuring Contract Audit Services

The General Services Administration (GSA) is leading an inter-agency working group to develop a guide to assist civilian executive agencies in selecting private firms to perform required contract audits. The inability of DCAA (Defense Contract Audit Agency) to perform timely audits has been reported here and elsewhere and the subject of several GAO (General Accountability Office) and Inspector General reports. Civilian agencies, unlike the Defense Department are not required to utilize DCAA for their contract audit services. Agencies that do utilize DCAA, reimburse DCAA for those services thus there has developed a strong consensus within civilian agencies that they can receive more timely services by contracting with commercial firms rather than relying upon DCAA. Some even contend that the cost for commercial audits are less than the cost for comparable DCAA audits. That contention is difficult to assess. The hourly rates charged by private firms are generally higher than the hourly rates charged by DCAA so the other variable is the number of hours it takes to perform the work. It might be that DCAA, unbound by a profit motive, spends too many hours while a private firm, needing to make a profit, spends too few hours. A number of years ago, the Energy Department moved away from DCAA and contracted with private firms for its contract audit services. Though we have not seen a comprehensive assessment of how that is working, we do know that in some circumstances, the Energy Department has been concerned with the cost growth of these services - especially when contracted firms are called upon to assist "extra-scope" activities such as helping to resolve audit issues that arose from their audits.

The GSA is now requesting feedback on their draft "Civilian Contract Audit Services Ordering Guide". One of the problems facing Civilian Agencies is to determine what contract audit services are required. Heretofore, those agencies have relied upon DCAA to tell them what audit services are needed. So the guide lays out the different audit services that may be needed including (i) audits of final indirect cost rate proposals, (ii) evaluation of provisional billing rate proposals, (iii) audits of forward pricing rate proposals, (iv) business system audits including accounting systems, (v) floorchecks, and more. The guide identifies best practices among Government agencies that have used or are currently using commercial auditors for their contract audit needs. The draft guide includes considerations for what makes for a quality audit, sample documents to attach to RFQs (Requests for Quotations), recommendations for evaluating contractor responses, and pricing considerations. It also includes examples of helpful non-price evaluation factors.

The time for submitting comments to the draft guidance ends October 27th. Instructions for submitting comments can be found under FedBizOps. The draft guide can be downloaded there as well.

DCAA Questions $50 Million of a Contractor's Incurred Costs

About a year ago, DCAA (Defense Contract Audit Agency) issued an audit report on costs incurred by Legacy East, New Century Consulting (NCC) questioning more than $50 million in costs billed to the Army between 2008 and 2013. This audit report just came to light after Senator McCaskill (MO) publicized the findings in a letter to the Secretary of Defense.

According to McCaskill's letter, DCAA questioned costs related to seven luxury cars including Porsches, Alfa romeos, a Bentley, an Aston Martin, and a Land Rover. Although NCC claimed the vehicles were available to all employees, the audit found that the vehicles were used exclusively by the CEO, the COO, the CFO, and their "significant others". NCC was unable to provide adequate documentation to justify the need for luxury automobiles or show that their usage was in accordance with contract requirements. NCC admitted to using the cars during non-working hours but kept no records of non-work use.

NCC employed the "significant others" of the CEO and CFO as executive assistants even though these assistants worked from home and never traveled to customer locations. NCC was unable to provide evidence that these executive assistants actually performed any work at all. NCC could not even provide a single email from these assistants. Despite the lack of documentation of proof of their work, in 2012, their average salary exceeded an astounding $400 thousand per year.

The auditors disclosed that together, the CEO and CFO earned more than $2 million in 2013 which was $680 thousand more than similar executive earned elsewhere. The audit disclosed other compensation-related issues including compensation paid to consultants that exceeded their consulting agreements.

The auditors also questioned costs for alcoholic beverages, automatic weapons, severance payment, rent, unnecessary licensing fees, extensive austerity pay, and other personal expenses.

The Senator expressed concern that despite all of these findings, the Army continues to utilize this contractor and has requested the Army respond to a series of questions (see McCaskill's letter).

The contractor has disputed the DCAA findings. The Army reports that its contracting officer will make a final decision on the disposition of audit findings.

16,000,000 Miles and What Do You Get?

The Department of Justice Office of Inspector General (OIG) recently released an audit of the FBI's (Federal Bureau of Investigation's) contracts for bulk fuel purchases. The FBI spends about $2 million per year on bulk fuel purchases. That, by the way, is enough gas to take 33 round trips to the moon or 2,800 round trips from Los Angeles to New York. Indeed, $2 million buys a lot of gas.

The purpose of the audit was to determine whether the FBI adhered to federal regulations during the contract award and administration process, had adequate contract oversight, and was properly invoiced by vendors. If the FBI cannot award contracts following the FAR, what business does it have investigating FAR deviations by other agencies. Did they pass the audit? No, they did not.

The OIG audit disclosed several deficiencies including (i) no assurances that the Bureau received the best fuel prices, (ii) received the proper amount of fuel at the agreed upon price, and (iii) used fuel in the most efficient manner. What did the OIG find? The OIG found that the FBI did not award one of the  two fuel contracts under audit to a FAR specified mandatory source. Also, they bought premium grade fuel when only regular grade was needed.

Additionally, FBI contracting officers did not comply with FAR requirements for reviewing invoices or ensuring that the Bureau made timely payments to vendors, did not maintain complete contract files and made numerous errors in inputting information into the Federal Procurement Data System.

Although not specifically a contract compliance issue, the audit also identified that the fuel tanks in Miami were located 12 miles from the FBI office requiring a 30 minute drive to fuel vehicles and a commensurate waste of time. Additionally, the fuel tank was not adequately secured.

In response to the findings, the FBI, of course, promised to fix things promptly. You can read the entire audit report here.

How to Facilitate an Audit

Government contract audits (like audits from DCAA (Defense Contract Audit Agency) or KPMG (if you're a DOE contractor)) are different than tax audits (i.e. income tax, B&O tax, sales tax, unemployment tax, worker's compensation, etc) and definitely different than financial audits (e.g. audits of profit and loss statements and balance sheets). Contract audits arise because of some action that you (the contractor) initiated. You decided to pursue Government contracts and as a result, you've agreed to abide by the terms and conditions of the contractual instrument which, in many instances, requires audits. Contract auditors don't just show up based on some randomization. They show up because the contract and the procurement regulations require that they do so. If you've submitted certified cost or pricing data in support of a bid, the auditors may be requested to audit the proposal. If you have a cost reimbursable contract, the auditors will most likely audit the incurred cost to determine whether claimed costs are allowable, allocable, and reasonable. Its really a simple equation. If you don't want contract auditors poking around, don't pursue the type of work that requires them to delve into your books and records.

As far as the speed at which audits progress, the goals for both the auditor and the contractor are the same - get in and get out as efficiently as possible. For contractors, the presence of auditors disrupt the normal day-to-day routines of the office. Time spent with the auditor is time that cannot be allocated to perform other work. It is to the contractors advantage to facilitate the audit process. For the auditor, there is nothing more frustrating than to sit around waiting for data that should be readily available. Auditors also want to get in and get out and move on to their next assignment.

With this in mind, here are a few tips for facilitating an audit.

• Keep in mind at all times that the auditor is not there by happenstance. He/she has been requested to perform a specific review or is required by regulation to come in and perform an audit. Don't act "put upon".
• Always respond to auditor questions and queries in a timely manner. Also make certain that the answers are responsive, clear, and precise. Auditors will always have questions about documentation provided. It is best to answer all the questions while the auditor is on the premises. Answering them later by phone or email is less efficient and susceptible to misunderstanding.
• Designate a representative that is familiar with the subject of the audit. If the auditor is performing a review of the timekeeping system, the designated interface should be someone intimately familiar with the timekeeping system and the related system of internal controls. Don't choose the project manager of the contract to be the interface.
• Keep all books and records well organized and ensure that they can be readily accessed. It is embarrassing for contractors and frustrating for auditors to wait around while someone searches for a spreadsheet that a former employee put together to document this or that. "So and so prepared that spreadsheet, she's on maternity leave right now, her computer is password protected, we'll have to get hold of her, get her password, and see if she can recall where on her hard drive she might have saved that file".
• If for some reason you cannot provide the requested information during the audit, make certain that before the auditor leaves, you have an agreement as to what information is yet to be provided and the time frame in which it is to be provided. And then, stick to your end of the agreement.

$500 Per Gallon for Gasoline

Remember the procurement horror tales of the early 1980s? We do because we're that old and also because we were unwillingly and unwitting participants in trying to unravel and somehow justify why the Government paid $435 for claw hammers, $640 for toilet seats and $7,600 for coffee makers. Casper Weinberger had us scouring contracts to find purchases with excessive line item prices. It wasn't fun and it certainly wasn't productive.

Its back.

The Special Inspector General for Afghanistan Reconstruction (SIGAR) was looking into a hospital construction project in a remote Afghan province. The project was hopelessly behind schedule and over budget. Construction is being funded by USAID (Agency for International Development) or by us, the U.S. Taxpayer. The SIGAR found a number of alarming issues and cautioned that they were probably indicative of a much larger problem. SIGAR's report on their findings is available on the internet at SIGAR 14-6-IR/Gardez Hospital.

Among the findings were two examples of excessive payments to the Afghan contractor. In one case, the Inspector General  found the contractor paid $300 thousand for 600 gallons of gasoline. That's $500 per gallon (I think our driving habits might change at that rate). In another case, the contractor paid $220 thousand for a temperature control devise that should have cost $2 thousand (or possibly up to $10 thousand for a real fancy unit). To make matters worse, the U.S. Government then reimbursed the contractor for these excessive costs. Where was the Government oversight in this matter?

We probably haven't heard the end of this story.

Operations Audits

One type of audit that DCAA performs occasionally but gets little discussion is audits of contractor efficiency, effectiveness, and economy or commonly referred to as “operations audits”. The rationale for these audits lies with the presumption that by eliminating inefficiencies in operations and improving the effectiveness of programs and departments the Government contractor and therefore the Government will save money. These audits are typically performed at large contractor locations with significant percentage of flexibly priced contracts (e.g. CPFF, CPIF, T&M, etc). For contractors engaged primarily in commercial work and fixed price contracts, the “competitive influences” (profit motive) kick in and provide ample incentive to become as efficient as possible.

Most of the time, these audits turn out to be duds. Contracting officer who have to adjudicate the audit results don’t like them and often dispose of them with prejudice. One reason is that auditors tend not to look at the larger picture when making recommendations. For example, one time, a Government auditor issued a report stating that the contractor could save a ton of facilities costs by letting their employees work from home. It didn’t matter that the contractor had already tried a work at home program but scrapped it for various reasons. And then there was the recommendation to save electricity by replacing existing lighting with more energy efficient lighting. In his analysis, the auditor did not consider the sunk costs or the cost of the remaining useful life of the current lighting. Had the contractor followed the auditor’s recommendation, it and the Government would have ended up spending more money than less.

There have been a few notable exceptions to the dismal track record of operations audits. One auditor noticed that ship repair crews were spending a significant amount of time to use the land-based restroom facilities. The auditor calculated that the contractor could save significant labor hours by placing portable toilet facilities on the ship. The contractor agreed and everyone saved money. One auditor visiting a remote contractor facility witnessed that contractor employees were sleeping, playing ping pong and other games, reading newspapers, and taking very long lunches. Their first line supervisor was 35 miles away and rarely visited the remote site. The auditor recommended closer, more frequent supervision. The contractor agreed and ultimately was able to reduce the site staff by half while accomplishing the same amount of work.

Auditors will sometimes attempt to impact forward pricing rates for the results of operations audits. It is important for contractors to know that without contracting officer concurrence and determination, such a position is unwarranted and inappropriate.

Communications with Auditors - The Exit Conference

Interaction with auditors is unavoidable if you have any kind of Government contract. There are many audits that need to be performed, especially pertaining to cost-reimbursement contracts. Before contract award, there might be a preaward accounting system audit, a financial capability audit and of course, evaluation of the proposal you submitted. During contract performance, there could be floorchecks, billing rate, public voucher, progress payment, and EVMS-type audits. After contract completion, there is likely an incurred cost audit and final closing audit. Peppered throughout these periodic reviews might be a defective pricing review, other internal control adequacy reviews, and CAS compliance reviews.

When auditors perform these audits, they are required by Generally Accepted Government Auditing Standards (GAGAS) to communicate throughout the review with the contractor. Yesterday we discussed communications that occur during the entrance conference and throughout the fieldwork stages. Today we will discuss the communication that occurs once the audit is complete. This is called the exit conference.

Upon completion of the field work, the auditor will discuss the audit results and obtain the contractor’s views concerning the findings, conclusions, and recommendations for inclusion in the audit report as required by GAGAS. For other than audits involving forecasted costs subject to negotiations, the auditor will provide the contractor a copy of the draft report, or at a minimum, the results of audit section of the draft report (including the opinion and any exhibits and notes, or statement of conditions and recommendations). To facilitate the discussion of the audit results and obtaining the contractor’s views of the results, this information is sometimes provided prior to the exit conference.

If the audit report includes forecasted costs that are subject to negotiations, such as forward pricing audits the auditor will not provide the contractor a copy of the draft report or results and will limit the discussion to factual matters/differences. Auditors should not disclose conclusions or recommendations on projected costs or rates. For example, the auditor would discuss with the contractor why a proposed raw material factor was based on history from the development phase of a particular contract when the contractor has more current and relevant history from follow-on production contracts. In this case, the auditor would not disclose the audit conclusion (e.g., that audit results were based on the history for the follow-on productions contracts) or the overall questioned cost, the questioned cost by cost element, or how much of a specific rate/factor was questioned unless specifically directed to do so by the requestor.

Communications with Auditors - What to Expect

Generally Accepted Government Auditing Standards (GAGAS) require auditors to communicate with the entity under audit. If your company is about to undergo an audit by a Governmental audit organization, you can expect communication at the entrance conference, during the audit, and the exit conference. We will discuss communications during the entrance conference and during the audit today, while reserving exit conference communications for tomorrow.

Entrance Conference


The auditor should explain the purpose and overall plan for performance of the audit at the entrance conference while also discussing the types of books, records, and other data the auditor will need. The auditor should also ascertain the nature and location of supporting data. It is also appropriate to discuss other matters during the entrance conference. For example, the auditor may need to follow-up on items discussed at a separate walk-through meeting or arrange for temporary space at the contractor’s facility in close proximity to the contractor’s representatives with whom he/she will be working so that those representatives are readily available.
Communication with the Contractor During the Audit

Through-out the audit, the auditor should discuss matters with the contractor as needed to obtain a full understanding of the contractor’s basis for each item in the submission, or each aspect of the area subject to audit. The auditor should discuss preliminary audit findings (e.g., potential system deficiencies, potential FAR/CAS noncompliances, etc.) with the contractor to ensure conclusions are based on a complete understanding of all pertinent facts. These types of discussions do not impair auditor independence and are generally necessary to obtain sufficient evidence to support audit conclusions. Discussions of the preliminary audit issues should be limited to factual matters when the audit is of forecasted costs that will be subject to negotiations.

Resolving Disputes between the Auditor and Contracting Officer

Back on December 10th, we reported on guidance issued by DoD concerning the resolution of significant audit report recommendations when the contracting officer does not agree with the findings and recommendations of the auditor. To read that post, go here.
DCAA has now issued its own guidance on implementing the DoD policy. You can read that guidance in its entirety by going here. Essentially, this guidance deals with internal processes for elevating disagreements to higher and higher levels withing DoD, until it gets to an undersecretary of Defense. It also includes related correspondence from the Army, Navy, Air Force, DLA, and DCMA. These organizations, in turn, issued their own guidance to implement the DoD guidance.

A couple of notes:

1. The guidance applies only to pricing proposals over $10 million where the contracting officer does not sustain at least 75% of the audit findings in a pre-negotiation objective. A pre-negotiation objective is documentation of what the Government hopes to achieve during negotiation. There is usually a difference between the negotiation objective and the final negotiated price. A contracting officer can easily include the audit findings in his/her negotiation objective with little hope or intent of trying to sustain the finding during negotiations, just to appease the auditor and get around this requirement (we've seen this happen).
2. The policy does not apply to all of the other kinds of audits that DCAA performs; internal control reviews, incurred cost reviews, defective pricing, CAS compliance, progress payment reviews, paid voucher reviews, and a host of others. The policy is not clear with respect to terminations and claims since those are often referred to as "proposals".
3. Elevating matters does not necessarily mean that a disagreement will be adjudicated fairly. Ultimately there is a final authority/decision maker and his/her decisions might be influenced by matters not evident to those with vested interests in the outcome (like, "I don't care what it cost, just get that plane up in the air").
4. This could be a response to a problem that doesn't exist. Recalling our days in the Government, contracting officers were always looking for data that could help them achieve fair and reasonable contract pricing, be it from DCAA or technical reviews. We can't think of many cases where audit findings related to pricing proposal were not incorporated into the pre-negotiation objective. Significant disagreements between the auditor and contracting officer do arise in less quantitative audits like internal control reviews. Internal control reviews are very difficult to resolve because its not easy to show a nexus between the internal control deficiency and risk to the Government. For example, how does one show that failing to have a written policy to cover an event that has never occurred but could conceivably occur at some unspecified future point in time, constitute undue risk to the Government. Yet, that is the position that some auditors have taken. What's a contracting officer to do in that situation? Withhold funds? Disqualify the contractor from future contracts? Or, disposition the audit finding without taking action? 

How to Avoid a DCAA Audit

Would you like to perform U.S. Government contracts without worrying about the Defense Contract Audit Agency coming in to audit your company - ever? All you need to do is incorporate in Canada, United Kingdom, France, Netherlands, or Germany.

The Department of Defense has reciprocal audit agreements with certain foreign countries to provide contract audit services and other contract administration services without charge. Under these agreements, DCAA performs audits of U.S. companies performing or bidding on contracts of the foreign country. In return, the auditors of the foreign country perform audits of the foreign companies performing or bidding on U.S. Government contracts. The U.S. currently has reciprocal audit agreements with five countries: Canada, United Kingdom, France, Netherlands, and Germany.

Well, maybe relocating to another country is a bit drastic. And, who knows. The auditors in those far off places might even be tougher than DCAA.

Advice for the Air Force - Don't Rely on DCAA to Ensure Fair Prices

James Hasik (Hasik Analytical, LLC) has some advice for the Air Force now that Northrup has dropped out of the competition for the new air refueling tanker leaving Boeing the only remaining bidder. Asking the question of how to ensure a fair and reasonable price for the planes when there is only one buyer (the 767 is a 30 year old plane and commercial customers have stopped ordering them) and one seller, Hasik warns that the Air Force should not pretend that DCAA (the auditors) will save it. Hasik writes:

One could be tempted to hope  ... that once the legion problems at the Defense Contract Audit Agency (DCAA) are corrected, the watchdog will reclaim its teeth. Sure, it’s a fixed price contract, but Boeing must disclose both its costs and its profit margin, so even without competition from Northrop and EADS, the government will get a good deal, no? Eh, no. The problem is that effective regulatory regimes are generally elusive, and for four reasons:

This is true in the first place because the informational asymmetries in regulation are severe, so the perspectives that regulators develop on their subjects are almost always distorted. In theory, the government needn’t spend too much time and effort trying to gin up should-cost numbers for the 767, as that airplane has been in production for 30 years. However, with a large, technically complex, and sun-setting system like the KC-X, the problem is serious. As relative prices shift, and commercial customers for this plane that no one else wants fall away, what it should cost becomes anyone’s guess.

Further, the appropriate contracting mechanisms are not obvious. Whether contractors are regulated according to price or cost, they, their managers, or their labor forces generally find some way of gaming the system to extract at least a portion of the rents they desire. Auditors and regulators can set rules, but smart people will always find a way around them.

Besides, regulatory capture is a near certainty. Regulators are very frequently observed to go native in the firms they regulate. The problem is particularly severe in technologically intensive industries where the regulators, by virtue of the domain knowledge required to participate in the regulatory process, most frequently hail from the industry itself. Sooner or later, factions within the KC-X program office, the DCAA, and AFCAA, and any other organization with what people on Capitol Hill like to call “oversight” would come to think about Boeing’s interests as synonymous with the Air Force’s interests. It’s an industrial base thing.

Finally, the regulatory burden itself is costly, which contributes to the overall cost of the project, even if no further rents accrue to Boeing. Ultimately, the Air Force has to pay for those squadrons of bean-counters and fact-checkers, and all those clipboards and green eye shades cost money. But more significantly, at a certain point, the managerial cost of the added oversight, through gummed-up processes and drawn-out schedules, exceeds its marginal returns.

To read Hasik's entire article, click here.

Resolving Contract Audit Recommendations

DoD issued guidance concerning the resolution of significant audit report recommendations when the contract auditor and contracting officer disagree on those recommendations. In cases where the contracting officer does not include at least 75 percent of the audit recommendations in his/her negotiation objectives, the issues can be elevated to succesively higher levels until there is agreement. The policy, however, makes it very clear that it is the contracting officer, not the contract auditor, who is responsible for determining fair and reasonable prices:

It is neither expected nor necessary that the contracting officer and the contract auditor agree on every issue. They have different, yet complementary, roles in the process. It is expected that the auditor and contracting officer will work together recognizing that it is the contracting officer's ultimate responsibility to determine fair and reasonable contract values.

This policy only applies to proposals greater than $10 million and does not address many other types of audits where there are significant disagreements between contracting officers and contract auditors. For example, audits citing deficiencies in contractor internal control systems would not fall under these guidelines. Yet, the resolution of systemic deficiencies are often times difficult because of the subjective nature of the audit "findings". Other examples of contract audits not covered by this policy are audits for compliance with TINA (Truth in Negotiations) and audits of incurred costs.