Audits of Direct Costs - Labor

The overall objective of audits of contractor annual incurred cost submissions is to render an opinion on the propriety of costs charged to flexibly priced (e.g. CPFF, CPIF, FPI, T&M, etc) Government contracts. The audit procedures include tests of both indirect and direct costs. Many contractors have the mistaken impression that auditors are only reviewing indirect rates during the incurred cost audit. This is understandable because so much of the standard incurred cost submission is focused on the development of indirect cost pools and their allocation bases. But, at the end of the audit, the auditor is expressing an opinion on both direct and indirect costs charged or allocated to contracts. Last Friday, we discussed the primary audit objectives for material costs. Today, we discuss the audit of direct labor costs which is usually, far more significant, in terms of dollars, than are material costs.

A significant part of the audit of labor costs occurs before the incurred cost submission is prepared and submitted. These are the Government's infamous floorchecks (or, observations of work areas). These are unannounced visits to contractor facilities to interview employees and compare timesheet entries with work actually being performed. Floorchecks are a major component of the audit of direct labor costs. Floorchecks are performed in “real-time”, that is, concurrent with the actual work being performed. The purpose of a floorcheck is to verify that contractors have policies and procedures to ensure the propriety of labor costs being charged to Government contracts. Deficiencies disclosed in a floorcheck are often the result of poor internal control systems or compliance issues. Deficiencies could lead to payment withholds, as discussed previously in this blog.

In addition to floorchecks, auditors will perform other procedures as part of the audit of the incurred cost submission. These procedures are developed after a risk assessment of the situation. Larger contractors warrant more attention than smaller ones. Likewise, contractors with a high percentage of flexibly priced contracts are a higher risk than ones with low percentages. Depending on the results of the risk assessment, the auditor might include some or all of the following areas for substantive testing:

• Evaluation of labor cost charging and allocation
• Evaluation of payroll preparation and payment
• Evaluation of compensation levels
• Evaluation of personnel policies and procedures
• Evaluation of overtime, extra-pay shifts, and multi-shirt work (often times, these are limited by contract terms)
• Evaluation of uncompensated overtime
• Evaluation of labor standard cost systems and sole proprietors’ and partners’ salaries
• Evaluation of quantitative and qualitative utilization of labor

Audits of Direct Costs - Material

Most Government contractors are familiar with the FAR (Federal Acquisition Regulations) requirement to submit annual incurred cost submissions. These submissions set forth contractors' calculations of final indirect expense rates (e.g. fringe benefits, overhead, General and Administrative, etc) as well as tabulate direct costs by contract. During the audit of incurred cost submisisons, auditors are testing for allowability, allocability, and reasonableness of both direct and indirect costs. This sometimes surprises contractors, especially because so much of the focus of the submission is on indirect costs. However, at the conclusion of the audit, the auditor is attesting to the propriety of both direct and indirect costs incurred during the fiscal year under audit.

The auditor's examination of transactions and procedures in reviews of material costs charged to cost-reimbursable contracts must be sufficient to support an opinion on the allowability, allocability, and reasonableness of those costs. In performing the overall testing, the auditor will likely consider the following with respect to material costs:

• Was it needed for the contract?
• Was it charged and billed in a reasonable relationship to its use in the manufacturing process.
• Was it considered properly for make or buy
• Was it purchased in reasonable quantity
• Was it purchased at a reasonable price?
• Was it used on the contract?
• If contract subject to CAS (Cost Accounting Standards), were the charges in compliance with CAS.
• Was it accounted for properly as to initial charge, transfer in or out, and residual value.

Additionally, audit guidance also instructs auditors to be alert for purchases from "related" suppliers or subcontractors, preferential treatment, and unwarranted sole-source purchases.

More on Recouping Improper Payments

Four senators have introduced legislation intended to improve the Government's ability to recoup money that it has erroneously to Government contractors. The proposed legislation adds several features to the existing law on recouping improper payments.

First, it would prevent agencies from relying only on voluntary disclosure of improper payments by contractors. In various hearings, these senators concluded that the government's estimates of improper payments were anemic and superficial.

Secondly, it would mandate that each agency set up an audit coordinator for recovery audits.

Thirdly, it would require a nationwide "do not pay" list.

And finally, it would require agencies to produce documentation to prove a payment was correct.

Many contractors have already been subjected to one or more "payment recapture audits". From our limited perspective, it does not seem like the Government is getting "bang for the buck" in these audits. No contractor that we know of has had to refund erroneous payments.

DoD Says Acquisition Reform is Nearing its Goals

DoD announced last week that it is 18 to 24 months away from completing the implementation of changes in the way it procures goods and services. The DoD initiative, (aka the Better Buying Power Initiative) arose from a mandate to deliver better value to taxpayers and war fighters. The initiative targeted five areas;

1. affordability (the No. 1 priority), 
2. incentivizing productivity in industry (e.g. use more FPI contracts), 
3. promote competition, 
4. improve trade craft, and 
5. reduce bureaucracy.

According to Shay D. Assad, the Director of Defense Pricing, most of the policy and execution plans are already in place and although progress is being made toward achieving those goals, it will take 18 to 24 months to implement the plans among 26,000 contractors and three million contract actions.

We'll just have to take their word for it.
  

New Regulation Proposed for Payments under Commercial Time-and-Material Contracts

Back in 2006, FAR was revised to expressly authorize the use of time-and-materials (T&M) and labor-hour contracts for commercial services under specified conditions as well as policies regarding payments under those contracts. The proposed change affects payments under T&M contracts that are terminated for cause.

Commercial T&M contracts include a termination for cause clause (FAR 42.212-4) that gives the Government the right to terminate commercial contracts. If the Government terminates the contract for the Government's convenience, the Government pays the contractor for work performed prior to the termination, plus reasonable charges resulting from the termination. If the Government terminates the contract for cause, the Government only pays for supplies and services ``accepted by the Government.''

The proposed change will, for contracts terminated for cause, allow the contractor to be paid for work performed prior to the termination for cause, including work not delivered or accepted by the Government, less applicable profit. 

When supplies or services do not conform to contract requirements, the Government generally rejects the supplies or services. The Government ordinarily provides contractors an opportunity to correct or replace nonconforming supplies or services when correction or replacement can be accomplished within the required delivery schedule. Correction or replacement is generally made without additional cost to the Government. However, certain contract types, including T&M contracts, generally require the Government to pay additional costs for replacement or correction, but no additional fee is paid. Payment for replacement or re-performance is consistent with the ``best efforts'' nature of T&M contracts. The Government generally pays for replacement and re-performance on both commercial and noncommercial T&M contracts.

  

Suspension and Debarment - Part V

We've come to the last part of our short series on suspension and debarment. The Government's decision to suspension or debarment depends primarily on the sufficiency of the evidence. Suspension requires adequate evidence while debarment requires the preponderance of evidence. A suspension lasts up to 18 months while debarment lasts up to three years. Either one can be extended if litigation is going on that is related to the activity causing the action. Both suspension and debarment actions can be mitigated if a contractor takes remedial action and seems contrite.

The most effective steps a contractor can take to avoid or protect against suspension and debarment are actions that demonstrate they are responsible contractors. Here are a few rules for guarding against a future suspension or debarment.

• Develop and maintain effective standards of conduct and an effective internal control system.
• Take appropriate disciplinary action against individuals in your organization that are responsible for wrongdoing.
• Implement correct actions following the discovery of wrongdoing.
• Continuously review internal control procedures and revise when necessary.
• Implement an ethics training program (now contractually required in many contracts).
• Develop an internal program that illustrates management's commitment to ethical behavior. Set the proper tone at the top.

Establishing these rules is no guarantee that a contractor can avoid a suspension or debarment. Because of this fact and because the financial effect of either action can be devastating, contractors should involve legal counsel in any matter that could lead to a suspension or debarment.