Just Because You're Bankrupt Doesn't Mean You're Precluded from Government Contracting

Companies that desire Government contracts must meet a number of qualifications including an accounting system suitable for Government Contracting and enough financial resources to perform the contract. From a practical standpoint where a contractor is eligible for progress payments or other interim payments (e.g. public vouchers), a two to three months of working capital is sufficient until the billing/payment pipeline starts producing.

Prior to any contract award, the Government will perform a financial responsibility determination. Often times, the responsibility is assigned to someone in the procurement office. Sometimes it is farmed out to the Administrative Contracting Officer (ACO). Once in awhile, DCAA is requested to perform the review though that Agency is mostly out of the financial capability assessment business. These reviews are typically performed by someone who does not know a debit from a credit and the scope of the reviews are very superficial - never diving into the underlying data that makes up a financial statement.

Earlier this year, the Marine Corps awarded a contract for motorcycle safety training services. The contract was ultimately awarded to a company called Information Sciences Consulting, Inc (ISCI) whereupon a competitor, SaxmanOne, LLC protested the award. The protest alleged a number of deficiencies including an allegation that the Marine Corps improperly determined that ISCI was a responsible offeror. SaxmanOne contended that the contracting officer ignored ISCI's alleged debts and pending bankruptcy litigation.

As a general matter, the GAO (with whom the protest was filed) does not review affirmative determinations of responsibility by a contracting officer. It will, however, review a challenge to an agency's affirmative responsibility determination where the protester presents specific evidence that the contracting officer may have ignored information that, by its nature, would be expected to have a strong bearing on wither the awardee should be found responsible.

In this case, the contracting officer considered ISCI's alleged debts and pending bankruptcy litigation. The contracting officer specifically found that ISCI had adequate financial resources to perform the contract, or the ability to obtain them". The contracting officer specifically mentioned that an involuntary bankruptcy notice was provided to the Government. Further, the Marine Corps inquired with ISCI's current clients and determined that neither its debts nor pending bankruptcy litigation had an impact on its contract performance. Lastly, the Marine Corps checked the Federal Awardee Performance and Integrity Information System (FAPIIS) and identified no information indicating that ISCI had a history of failing to pay its subcontractors.

Given this level of detail, the GAO ruled that the Marine Corps did not ignore either ISCI's alleged debts or any pending bankruptcy litigation and denied the protest.

Installment Payments to Repay Debts to the Government

Yesterday we discussed DFAS's (Defense Finance and Accounting Services) program to accept installment payments in lieu of an immediate payback of overpayments made under Government contracts. The Government will charge interest of course, currently its set at three percent but adjusts each quarter. We mentioned that the approval for installment payments is conditional upon a satisfactory financial capability audit. The whole purpose of an audit is to assess whether a company has the financial resources to repay a debt over time. DFAS is understandably concerned that if a contractor has disclosed that it is experiencing financial difficulty in its inability to repay in lump sum, it may also be unable to repay in installments.

There are four possible outcomes from a DFAS financial capability audit.

1. Acceptable financial condition - contractor can make lump sum payment without adversely affecting acceptable financial condition. DFAS will usually deny the contractor request and demand a lump sum payment.

2. Acceptable financial condition - contractor can make installment payments without adversely affecting acceptable financial condition. DFAS usually grants the installment payment request.

3. Unfavorable financial condition - contractor can make installment payments without further adversely affecting unfavorable financial condition as long as extraordinary actions are taken. Knowing that the contractor may have difficulty making the proposed installment payments, DFAS will have to use its judgment as to whether to grant the installment payment request. Extraordinary actions are not defined but would have to include something more than business as usual. It could mean divestiture of product line, sale and leaseback of facilities, or bringing in additional capital.

4. Adverse financial condition - substantial doubt that contractor can make installment payments. The contractor does not have the financial resources to make the proposed installment payments. In these cases, DFAS will normally request immediate full payment of the debt amount.

Obviously, if your a contractor asking for installment payments to repay a debt, you will want to be in Category 2. If you find yourself in Category 3, there will be a lot of on-going oversight by DFAS until the debt is paid. At a minimum, you will be required to submit future financial statements and cash flow forecasts for the life if the installment agreement.

Owe Money to DFAS? Consider Installment Payments

From time to time, contractors, especially small contractors, find themselves in situations where they owe a significant amount of money back to the Government. Perhaps they were billing at provisional indirect billing rates that were higher than their final rates. Perhaps a contracting officer found unallowable costs in their billings. Or, maybe there was a billing error that resulted in an overpayment. The prospect of paying back the Government can hit a small contractor very hard because of cash flow concerns. Sometimes these contractors are under capitalized. Sometimes these firms forego salaries to their owners to help keep the company afloat or to invest in new capital equipment. If you find yourself in such a situation, don't despair. There is hope.

The DoD (Department of Defense) Financial Management Regulation, Volume 10, Chapter 18 may provide some relief. When a debtor to the U.S. Government can establish sufficient justification, a series of installment payments may be approved by DFAS (Defense Finance and Accounting Services) to liquidate the debt within a reasonable time frame.

When contractors anticipate having financial difficulty repaying the debt, the contractor may approach DFAS for a repayment installment plan. Prior to approving the installment agreement, DFAS may request the contracting officer to perform a financial capability audit taking into consideration the proposed installment payments to ensure that the contractor has the financial capability to repay the installments.

Here's the process set up by DFAS:

1. The contractor submits a request to DFAS for an installment agreement on debt owed of $50 thousand or more.
2. DFAS provides the contractor with a proposed monthly payment amount.
3. DFAS informs the contractor of a pending audit and request the contractor to provide its financial statements for the past three years and a twelve month cash flow forecast reflecting the proposed monthly installment amount.
4. DFAS submits a request for a financial capability audit to the contracting officer. The contracting officer may decide to perform the financial capability audit in-house or request a more formal audit from DCAA (Defense Contract Audit Agency).
5. DFAS uses the information from the financial capability audit to make a determination whether the proposed installment agreement amount is acceptable.
6. DFAS coordinates their decision on the installment agreement with the contractor.

Tomorrow we will discuss the four possible outcomes of a financial capability audit.Two are good and two, not so good.

What Do Progress Payments Have To Do With Financial Capability Assessments?

The purpose of the Government's financial capability reviews of contractors and prospective contractors is to determine whether the contractor's finances are adequate to perform the contract. Financial capability reviews are performed by either a price analyst situated in one of the many procurement organizations, by DCMA (Defense Contract Management Agency) price analysts or, to a much lesser degree these days, by DCAA (Defense Contract Audit Agency) auditors. Many of the price analysts performing financial capability reviews these days are poorly trained and do not understand the nuances of cash flow projections. Most of them are not accountants and could not tell you the difference between a debit and a credit or explain the fundamental double-entry accounting equation. Yet they are reviewing and analyzing financial statements and rendering judgments on whether contractors have sufficient resources to perform whatever contract they are bidding on.

Lets face it. Many small contractors have very limited financial resources. They are out scrounging for capital. They worry about meeting payroll. Their financial statements, if they even have financial statements, will not paint a rosy financial picture. Start-ups will not have any financial history upon which a financial capability determination can be based. An analyst or an auditor will have a difficult time trying to ascertain whether such companies have sufficient financial resources to perform the work.

The key to understanding the sufficiency of financial resources is the cash flow forecast. A cash-flow forecast, simply put, is a schedule of incomes and expenses, detailed by source of revenue or category of expense. And here is where progress payments and cost reimbursements come it. Both progress payments (fixed price contracts) and cost reimbursements under cost-type contracts represent a form of contract financing and should enter into cash flow projections. So, for example, a contractor works for a month after which it can submit a progress payment request for the costs incurred. That progress payment is normally paid within 30 days (sometimes sooner). So a contractor needs only two to three months of working capital to perform the contract. We know of several instances where Government analysts failed to consider available contract financing in their financial capability determinations. Of course it didn't help that the contractor failed to bring it up. In one case, it was equally unhelpful that the contractor did not even know what a cash-flow forecast was or what it was for.

Contractors (and prospective contractors) expecting a financial capability review should prepare a cash-flow forecast prior to the audit. There are plenty of examples on the web. It is not necessary however to spend a lot of money for a slick model. Just show on a spreadsheet, by month, here's where I'm going to get cash and here's where I'm going to need cash. If at the end of each month expenses exceed income and there is not sufficient cash in the bank to cover the deficit, contractors will need to be prepared to disclose to the auditor its plans for covering the shortfall.

Responsibility for Financial Capability Reviews Shifted to DCMA

On May 20th, the Defense Contract Audit Agency (DCAA) formally instructed its auditors to discontinue any self-initiated financial condition risk assessments and financial capability audits of Government contractors and prospective Government contractors.

From now on, DCAA will perform financial capability audits when specifically requested by the Contracting Officer and only when there are unique circumstances that require technical skills that only DCAA possesses. The guidance does not provide any explanation or examples of what those unique circumstance might be. Perhaps it will become evident in time.

To fill the void, DCMA (Defense Contract Management Agency) established its Financial Capability Group to perform all financial analysis for the Department including preaward financial analysis, post award financial surveillance, and monitoring of contracts receiving financing payments. We've seen examples of the data requested by DCMA when performing preaward financial capability reviews and its pretty much the same information that DCAA might have requested. The big difference is that the DCMA group sits in DC and requires the contractor (or prospective contractor) to mail in a boatload of data whereas DCAA required far less in the way of copies because it performed its reviews at the contractor facility. 

DCAA will continue to perform financial capability reviews for non DoD agencies where DCMA has not already performed a review of the particular contractor/prospective contractor.

Installment Payments - Part 2

Yesterday we alerted you to a program within the DoD finance office to allow contractors to refund amounts owed the Government on an installment payment basis. If you missed that, read it here. The only problem with this installment payment program is that it requires contractors to open up the financial records to Government auditors and to have a good story as to why they didn't just repay the amount overpaid right away. If a contractor maintains that it didn't know that it had been overpaid, it sort of implies that their billing system is not up to par. That would open another can of worms. But, if the installment payment approach is the best way to pay down this liability, DoD will first send in its auditors to determine whether the contractor has the "ability to repay" the debt. This is called a financial capability audit. Before the auditors begin the review, here is a likely list of documents that they will request.

• financial statements for the last three years
• a 12 month cash flow forecast reflecting the proposed installment amounts
• written confirmation that the financial statements disclose all off-balance sheet arrangements and related party transactions.
• any inquiries from their IPA (independent public accounting) firm related to off-balance sheet arrangements and related party transactions and their responses.
• the results and reports of any internal audits, reviews or other analyses of off-balance sheet arrangements and related party transactions.
• any analyses it has performed to assess its current and future financial conditions.
• details on prior, current, and forecasted events that have had or are forecasted to have a favorable or unfavorable impact on its financial condition
• written policies and procedures that require
• evaluation of current financial conditions in order to anticipate and avoid unfavorable or adverse conditions
• periodic assessments of accounts payable and accounts receivable, including analysis of accounts payable aging and the collectability of accounts receivable
• periodic assessments to ensure compliance with any loan covenants and debt payment schedules
• preparation of cash flow forecasts, including reasonable and supported assumptions
• monitoring, analyzing and managing its cash flow
• periodic assessments of contract cost performance.

This listing is only the beginning. The auditor will likely spend at least a couple of days analyzing the data and reaching conclusion about the contractors financial viability.

Installment Payments

From time to time, organizations find themselves in situations where they owe the Government money. Most often, this involves income tax and payroll tax liabilities but it can also result from instances where contractors have received overpayments on contracts. Contract overpayments can occur because of billing system inadequacies, payment mistakes (e.g. duplicate payments) or because of contract administration adjustments. Of course, as soon as an overpayment is discovered, contractors should immediately refund the amount of the overpayment back to the Government. Contractors that do not refund overpayments in a timely manner, do so at their own peril. We know of an instance where a Federal Government investigative organization opened a criminal investigation on one such case.

There may be cases however, where contractors are financially strapped and cannot repay the overpayment right away. If the overpayment involves a DoD contract, there may be some relief. The DoD Financial Management Regulation, Volume 10, Chapter 18 allows for a series of installment payments under certain circumstances. When a debtor to the U.S. Government can establish sufficient justification, a series of installment payments may be approved by DFAS (Defense Finance and Accounting Service) in amounts that will ensure liquidation of the debt within a reasonable time frame.

Prior to approving the installment agreement, DFAS will ask the contracting officer to perform a financial capability analysis, taking into consideration the proposed installment payments to ensure that the contractor has the financial capability to make the installment payments. In addition to determining the contractor's ability to repay, the contracting officer will also determine

• what the contractor did with the overpayment and
• why it is not currently in a position to return the overpayment to the Government.

Needless to say, contractors that embark down this road must have strong rationale to support its case and must expect and be prepared to have auditors poking around in their financials. Tomorrow, we will look at some of the specific things that the Government will request when performing its review.

Go to Part 2

Financial Capability Risk Indicators

Government auditors, contracting officers, price/cost analysts, and most people involved in procurement are trained to be on the lookout for signs that contractors are in financial distress. Aside from the normal financial capability reviews that they perform (upon request), procurement folks are told to be cognizant of the events and conditions that can significantly affect a contractor's ability to perform on Government contracts. These indicators include, but are not limited to the following:

• Defaults on loan/line of credit agreements
• Defaults on usual trade credit from supplies
• Restructuring of debt where the contractor is charged a higher interest rate above the prime rate than the prior rate charged by lending institutions. (The increase in the rate charged above the prime could be attributable to perceived contractor financial distress.
• Denial of usual trade credit from suppliers
• Noncompliance with loan/line of credit covenants
• Contracts in significant loss position
• Legal proceedings/pending claims
• Loss of principal customer/supplier
• Uninsured or under insured catastrophic events
• Labor strikes
• Unpaid state, local and federal tax liabilities
• Contingent liabilities
• Deteriorating bond ratings
• Significant dollar amount of accounts receivable
• Significant post award or suspected irregularity conduct audit findings and other significant questioned costs that are unresolved
• Contract termination for default
• Deferral of payments to suppliers
• Failure to fund pension plans
• Loans from employees or issuing stock to employees in lieu of salary
• Environmental clean-up impact
• Significant unpaid contractor debts
• Unusual progress payments or other billing concerns
• Poor physical conditions of the work facilities
• Unpaid insurance liabilities

These are only indicators and, if noted, might generate an inquiry. Or, more likely, the risk indicator would be documented and added to a permanent file somewhere to followup at another time or when the number of indicators becomes sufficiently large where the Government must look deeper into a contractors financial viability.

What To Do When Your Finances Aren't Too Great

A couple of days ago, we discussed the Government's interest in assuring that its contractors (and potential contractors) have the financial resources necessary to see the contract through to fruition. Go here to read that post. The key here is to have plenty of cash on hand and/or a revenue stream from other work to finance the Government work. The amount of money needed will vary depending upon the size of the contract of course. The duration of the financing will depend on the type of contract. For the typical cost-reimbursable contract where contractors can bill monthly, three months of working capital is necessary. In the first month, contractors incurr the cost. After month end, its takes a week or two to post the accounting records and prepare billings. The Government takes up to 30 days to pay. Allowing time for requisite approvals by the auditor and contracting officer, a contractor is looking at about three months from contract start to when payments begin coming in. For fixed price contracts, the time will depend upon payment methods - cost, milestones, or deliveries. For fixed price, three months is also a minimum but it could be significantly more.

So how is a contractor with limited cash and backlog going to demonstrate financial capability to skeptical financial analysts from Defense Contract Management Agency or auditors from Defense Contract Audit Agency? Here are some ideas.

• Go to your bank and secure a line of credit. Even if you do not use it, having one increase the analyst/auditor's confidence that you have sufficient financial resources to perform under the contract.
• Secure personal loans or promises/commitments from Stockholders. The downside to this is that the Stockholder will need to be prepared to open his/her personal finances to the Government to prove the existence of those resources.
• Secure equity financing. Usually a last resort.
• Liquidate assests - especially those that are idle, underutilized or obsolete. 
• Defer or reduce discretionary expenses.
• Defer salaries to owner(s). Don't forget the payroll tax implications on deferred compensation.
• Consider leasing over buying. This is sometimes more costly in the long-run but it does even out cash flow.
• Restructure your debt to reduce debt service cost.  

Financial Capability Reviews

Contractor financial difficulties may disrupt production schedules, cause inefficient use of resources, and result in contract nonperformance. These conditions may also result in monetary loss to the Government on progress payments.

Prior to the award of any contract, the Government will assess whether a potential contractor has the financial resources needed to perform the contract. These are called Financial Capability Reviews and are usually conducted by DCMA's (Defense Contract Management Agency) Financial Analysis Center at the request of a contracting officer. The authority to conduct these reviews is found in FAR 9.104-1.

The review begins when DCMA sends a request for documentation. This request is no small matter. Contractors will be required to respond to 20 or more items and furnish the Government a significant amount of proprietary financial information. Click here to see a sample of the request letter. Among the items requested are

• Certified financial statements with footnotes
• Interim financial statements not over 90 days old
• Accounts payable and accounts receivable aging reports
• Cash flow forecasts signed by a financial officer
• Names, addresses, phone and fax for banks and other lending institutions
• Number of customers comprising your overall business base
• Gross profit margins
• Sales backlog
• Sales forecast
• Inventory methods
• Outstanding lawsuits, liens, and judgments including current status
• And many others

The Financial Analysis Center performs these reviews in their own office. Rarely will they visit a contractor's office as an auditor might and it is also unusual for the analysts to call and ask questions or request clarification. Their assessments will be based entirely on the data submitted. Therefore it is essential that contractors' exercise due diligence when providing the requested information - ensuring completeness and clarity.