IS YOUR FINANCIAL SYSTEM DCAA COMPLIANT?
Written by Peter Lauria

When addressing the issue of DCAA compliance with our clients, we often start by helping them understand that this is much more than a simple technology question. For new or growing government contractors, adopting the perspective of the government is the best way to assess your accounting practices and financial system requirements.

As with any customer, the government expects high quality services/products. Additionally, the government wants to ensure that it is paying no more than its fair share of the costs associated with a given contract or task order. The integrity of a contractor's financial system (i.e., the ability to account for costs and bill the government fairly) is a vital component of the government's assessment.

One standard method used by government auditors when evaluating a contractor is the Pre-award Survey of Prospective Contractor Accounting System, documented in the SF (Standard Form) 1408. Typically, this survey is completed in advance of contract award, but the government may choose to review your financial system immediately after award or as the volume and complexity of contracts/task orders increases.

To accurately assess your own financial system compliance, it is essential to understand the areas that will be evaluated during the review. Your "system" compliance will be a combination of technical software capabilities and the policies and business practices that you follow. The review will specifically consider compliance in the following areas:

• Generally Accepted Accounting Principles (GAAP). The presumption will be that your accounting is in accordance with GAAP as applicable under your specific circumstances. Any deviation will need to be explained, and the government will consider its ability to adequately evaluate your financial position and performance.
• Segregation of Direct Versus Indirect Costs. In a compliant system, you must be able to track direct costs (defined as those that have a final cost objective, e.g., a contract). You also must be able to track indirect costs (those costs NOT identified with a single final cost objective) in a separate cost pool or cost center. Also, a consistent method for segregating which costs are direct versus indirect is required.
• Accumulation of Direct Costs. Is your accounting system able to adequately accumulate the direct costs by contract? This component of your system is often referred to as your job cost system and must allow direct costs by contract to be clearly separated and adequately summarized.
• Identification of Cost by Contract Line Item. In addition to isolating and accumulating direct costs by contract, you will need the ability to track costs by contract line item (CLIN) if called for in the contract.
• Allocation of Indirect Costs. After you have segregated and accumulated your direct versus indirect costs, the government will assess if you and your system have the ability to allocate the indirect costs in a consistent and equitable manner to your "intermediate and final cost objectives" (i.e., your contracts). This area can become quite complex depending on the nature of your business and your specific government contracts. The key is the ability to pool the indirect costs and then use a consistent and approved rationale for distributing them to your contracts.
• Accumulation of Costs under General Ledger Control. In this area, the government wants to ensure that your job cost system can be reconciled to your general ledger and your entire accounting system is governed by the general ledger system controls.
• Timekeeping System that Identifies Employee Effort by Appropriate Activity. One of the most significant areas of review will be around your timekeeping system and related practices. Historically, this has also been one of the greatest areas of non-compliance and abuse by government contractors. A vital component will be your ability to track employees' time by work effort and to establish and maintain a system of policies and internal controls that ensure compliance.
• Labor Distribution System that Charges Direct and Indirect Labor to Appropriate Cost Objectives. A second component of the timekeeping system is the ability to "distribute" labor costs appropriately once effort is tracked by activity. As this area can also become quite complex, it is important to have an effective and approved method for allocating labor cost based on the recorded effort of your employees. It is also critical to ensure that "indirect" activities are clearly segregated from "direct" activities.
• Routine Posting of Books and Records. Another part of the system review is ensuring that you follow a routine process (at least monthly) of posting your transactions so that you can generate regular reports and accountings of your contract and business activities.
• Unallowable Costs. The government has specifically identified certain costs that are expressly unallowable to be charged against a government contract - either as a direct cost or an allocated indirect cost. Examples include bad debts, interest, entertainment, political contributions, excessive compensation and others. Your accounting system must be able to isolate these costs to ensure they are not charged against government contracts or included in indirect cost pools.
• Segregation of Pre-Production Form Production Costs. If applicable, your accounting system will need to segregate these types of costs. This is typically accommodated by establishing separate projects or activities in the job cost system.
• Limitations of Cost or Payment (Billings) as Required by the Contract. Depending upon the type and nature of the contracts you enter into, the government may review your system to ensure that you can support limitations or ceilings on costs incurred and/or government payments (billings).
• Support for Progress Payments (Billings). Your ability to invoice the government fairly and in accordance with the provisions of your contract(s) is critical. This includes the ability to trace and support billed transactions at the appropriate level required by the contract. The billing system will need to correctly bring together all of the above components to accurately bill your government contracts.
• Adequate Data for Pricing Follow-on Acquisitions. A final consideration in evaluating the adequacy of an organization's accounting system is some level of assurance that the system can produce reliable historical data for pricing follow-on work. Typically, when the government enters into a contract with a supplier, they may choose to extend that contract to include additional products or services. Auditors will consider the ability of the system to report accurate and appropriate financial data to support the pricing of such follow-on work.

Preparing in advance for a system review will simplify the audit process and increase the government's confidence in your ability to fulfill your contractual obligations. For contractors with increasingly complex government work and for those whose volume has increased significantly, an understanding of these compliance requirements will lay a solid foundation for future compliance. While technology is an important component of the equation, it is not the only part. Compliant policies and practices that complement your software capabilities are essential to both a successful accounting system review and your long-term success as a government contractor.

AVOIDING EXCESSIVE PASS-THROUGH CHARGE PENALTIES
Written by Andrew Stowe

Effective April 26, 2007, the Department of Defense ("DoD") issued an interim rule defining and rendering pass-through charges deemed to be excessive as unallowable. This Interim Rule was implemented as a result of Section 852 of the National Defense Authorization Act for Fiscal Year 2007 ("the Act"). The Act required DoD to "prescribe regulations to ensure that pass-through charges on contracts or subcontracts or task orders or delivery orders... are not excessive in relation to the cost of work performed by the relevant contractor or subcontractor."

The Act indicated a frustrated Congressional response to procurements which they believe are analogous to the infamous $2,000 hammers of the 1980's. While the intent of the Act is to save money, the reality may fall short of the expectations. In their well-intentioned attempt to avoid a repeat of previous procurement follies, Congress and DoD have unwittingly created a maze of undefined terms and conflicting guidance. We aim to decipher and navigate this maze so government contractors can manage the associated risks within their organization structures.

The Interim Rule, based upon the Act's vague language, is far-reaching in its scope. It defines excessive pass-through charges as those which "add no, or negligible, value to a contract or subcontract," specifically including overhead and profit in the "no or negligible value" category. It also leaves the definition of "value" as a subjective measurement set forth by the Contracting Officer. In addition, it is:

• Applicable to contracts or task orders where 70 percent of the total cost of work under the contract or task order is to be performed by subcontractors
• Applicable to both proposed and performed work and
• Applicable to all contract types except for Firm Fixed Price, Competitively Awarded contracts

How Will This Impact Your Business

Companies which provide integration, logistical or other services in which their primary expertise is to assemble many disparate parts or services from subcontractors into a coordinated whole may find that the cost of the subcontracted parts or services will exceed the 70 percent threshold. Such companies now have to present a sound, effective and audit-proof argument as to the value added to the subcontracted parts and services in order for their General & Administrative ("G&A") rate to be allowable when applied to the subcontracted parts and services. The significant risk, in these cases, is that the Federal Acquisition Regulation and the Cost Accounting Standards do not define value. Additionally, the Defense Contract Audit Agency does not define value. Whatever value exists must be demonstrated to the Contracting Officer; thus, value is now a subjective judgment rendered by the Contracting Officer.

If you are like most major government contractors, you likely allocate your General and Administrative ("G&A") expenses (e.g., allowable executive salaries, legal expenses) to a Total Cost Input ("TCI") base. This TCI base includes the subcontracts cost. If more than 70 percent task order/delivery order or the contract cost is subcontracted cost and you cannot demonstrate or convince the Contracting Officer of the value that G&A costs add to your subcontracted work, then you stand to lose a proportionate amount of previously allowable G&A cost.

Take Action

There are no Generally Accepted Accounting Principles ("GAAP"), Federal Acquisition Regulation ("FAR") or Cost Accounting Standards ("CAS") provisions to address this. Your first instinct may be to take your subcontract costs out of your G&A base. DCAA has been moving towards a consistent requirement to use a TCI base over the last several years, which includes subcontract costs. While CAS 410 provides for a value-added G&A base, you will likely be found to be CAS non-compliant if you take this route without proceeding through the proper process.

There are other alternatives to avoid unnecessary cost recovery losses - both temporary and permanent in nature. The optimal way to avoid any audit or billing controversy is to obtain an advance agreement where the Contracting Officer agrees to terms or defines the basis for determining whether subcontracted work is value-added. This will enable you to more effectively predict the ultimate allowability of "allowable" G&A costs.

An alternate scenario would be to set up a subcontract Shipping, Material & Handling ("SM&H") rate which you could apply to the subcontracted cost. The SM&H rate should include costs which can be associated with the procurement, shipping, invoicing and quality assurance processes for the subcontracted services or goods. Through you will still be unable to recoup all of your G&A cost because of the disparity between the Interim Rule and DCAA's TCI G&A base requirement, you can recoup a portion by carving them out in this manner. For CAS-covered contractors, this alternate scenario would result in redrafting your Cost Accounting Standards Board disclosure statement and changing the mechanism by which you account for and allocate G&A costs.

For further clarification on how to react to this rule, it is always best to seek the advice of a government contracts specialist. These matters are complex and new to the government contract industry. As such, they frequently have more than one "right answer." One thing is certain, however - the consequences of coming to the wrong answer could be financially damaging to your business.

HOW TO SUCCESSFULLY MANAGE YOUR DCAA RELATIONSHIP
Written by Brigitta Scott

For contractors doing business with the federal government, a visit from the Defense Contract Audit Agency ("DCAA") is inevitable. Along with a notice requesting an upcoming visit from DCAA, you can also expect the anxiety that is likely to ensue. By following these simple steps towards improving and maintaining a positive relationship with DCAA, you will increase your chances of a successful outcome.

DCAA was formally organized in 1965 to provide contract audit and other services surrounding contract related activities for the Department of Defense. Over time, DCAA has evolved into providing contract audit services to other government agencies. Government procurement dollars have been increasing over the years, and even though DCAA personnel staffing is on the decline, the reported audit results are stronger than ever. In FY 2006, DCAA audited $121.1 billion of costs incurred on contracts and reviewed 9,015 forward pricing proposals amounting to $182.3 billion. Approximately $2.3 billion in net savings were reported as a result of the audit findings associated with these audits. When compared to the $448 million expended for the Agency's operations, the return on taxpayers' investment in DCAA was approximately $5.20 for each dollar invested. Given these facts, your organization's strategy should be to minimize audit findings

• First of all, know your Administrative Contracting Officer ("ACO") and auditor. Your ACO should be directing the audit requirements, so contacting your ACO is always a good starting point. There has been some movement between field offices, so if you are still uncertain about which DCAA office represents you, DCAA publishes their "Audit Office Locator" on their website www.dcaa.mil. Aside from simply identifying the cognizant audit office and supervisory auditor, it is always helpful to know their reputation, the office's reputation, their reporting structure and other similar information. Familiarizing yourself with whom you'll be dealing is the first step towards establishing a successful working relationship with both your ACO and DCAA auditor.
• Now that you know the auditor, be prepared for their visit. Review the notice received and understand the purpose, timing and extent of their visit. In addition to understanding the notice, it is also helpful to know which customer, or in the case of a pre-award audit prospective customer, has requested the visit. Beyond knowing the "who" and the "why," know "what" they will be reviewing, then assess your preparedness for that type of review. We recommend that contractors always request formal entrance conferences designed to cover this information.
• DCAA has numerous audit areas under their purview, including proposals, accounting systems, indirect rate structures, billing and estimating, labor charging and even general compliance and contract close-out. Each area carries with it specialized audits and areas of focus. Major contractors, or contractors with auditable dollars of $90 million or more, are subject to much more scrutiny than non-major contractors. This threshold is just one barometer to watch when working with DCAA. As you approach this level, you should expect the frequency and duration of visits from DCAA to increase. Most major contractors have "resident auditors," DCAA personnel that are physically located full-time at the contractor site.
• Did you know that DCAA publishes their audit guidance? Further information can be found at www.dcaa.mil under published audit guidance. DCAA also publishes an audit manual used by their staff. The DCAA Contract Audit Manual provides insight into the Agency's concerns, internal control recommendations and processes and practices that DCAA expects to see when auditing contractors' accounting systems and compliance areas. This manual is useful to obtain background interpretations of complex issues and provides useful guidance and examples for specific topics addressed in the Federal Acquisition Regulations and Cost Accounting Standards. Once discovered, this resource can provide a wealth of information to contractors and can help you anticipate and be prepared for upcoming audits.
• Now that you understand who is coming to visit and why they are coming to visit, it is time to complete your documentation and support. First, take stock. Is your documentation solid or sloppy, complete or lacking critical elements? Next, reconcile, reconcile, reconcile. Ensure that policies and procedures write-ups and internal control documentation are clear, concise and complete. While you are designing your systems, consider which data will need to be extracted for reporting purposes. This forward thinking will pay dividends in the end when you can efficiently pull information right out of your systems versus the alternative of potentially compromising the data integrity by exporting, manipulating and recasting. Finally, review your CASB Disclosure Statement and ensure that you are in conformity with your disclosed accounting practices. This is a critical element in ensuring the robustness of your documentation.
• Assess your risks, manage your risks. What is your potential exposure? Understanding where DCAA is focusing their efforts and their high priority audit areas will generally help minimize audit risks and outcomes. Currently, DCAA is spending a great deal of effort around how contractors define segments within their organization, compliance with the new Time and Materials/Labor Hour Contract rules, directly associated unallowable costs, training and education costs, lump-sum relocation expenditures, Pension Protection Act results and Executive Compensation. Each of these areas carry with them special nuances that may or may not apply to your organizations. Therefore, staying current with DCAA's areas of focus is imperative when you assess your own risk profile. Even if you believe none of these areas relate to you, this is no time for complacency. Turn a critical eye to other areas to ensure you have considered risks lurking in plain sight.
• Establish appropriate protocol. It is critical to establish an internal point of contact for the DCAA auditors who will act as the company's primary contact. It is wise to limit the interaction with DCAA to one individual for a number of reasons, only one of which is efficiency. The auditors will likely want to speak with different levels of management, including executive management on occasion. Additionally, depending on the type of audit, the auditor interaction could involve areas such as procurement, contracts administration, material handling, pricing and estimating and the billing functions. These functional areas within your company need to understand the purpose of the auditor's requests and may require coaching on how to effectively interact and respond to the auditors in a respectful and cooperative manner.
• If you find that DCAA has scheduled the entrance interview and sent their information request, but you still do not understand what they need, why they're coming and how to effectively deal with the DCAA auditors, know your limitations. If the timing of the DCAA audit could not have come at a worst time, try to request a deference of the audit. If that isn't possible or would compromise other key company initiatives, recognize that you need adequate staff, resources and the capacity to properly prioritize tasks. In the end, there are sometimes circumstances that occur that are beyond your level of comfort and experience and beyond the training provided to your staff. Recognize these and consult with the experts. Subject matter experts are knowledgeable in specific areas and focus on them full-time. They have the breadth and depth of knowledge to provide the right level of support when you need it most. They also have the prior qualifications in dealing with DCAA auditors to understand what they are looking for and how to present the information so that the examination is as pain free as possible.
• If you've gotten the final audit report, and it was not a clean report, correct the mistakes. Whenever possible, negotiate adverse findings, and always include a formal management response to the findings in the final audit report. There is also an escalation process that you should keep in. Do not be afraid to meet with the ACO to discuss the audit findings and vet them with the ACO prior to the report issuance. In the end, if the findings cannot be negotiated, respect the ruling and understand the impact to your business. Then develop a corrective action plan. Consider reviewing the corrective action plan with DCAA to ensure their level of comfort that your proposed steps will cure the problems. If you are unsure how to correct the issue or lack the proper resources, this is another excellent opportunity to contact experts. One example would be that your accounting system is deemed inadequate. An adequate accounting system that fulfills the 15 requirements under the SF 1408 is generally not an off-the-shelf plug-and-play accounting system. A customized accounting system takes expertise to implement properly. Once you understand the corrective actions required, timeliness is key. There is no time like the present to fix what is wrong. The next big opportunity is right around the corner and you do not want to compromise your company's potential windfall with administrative drains.
• While logical, building and managing the relationship may not seem natural. Your DCAA auditor is an auditor at the end of the day, triggering certain professional standards that must be maintained. By building the relationship, there is no expectation that these standards would be compromised. The relationship you should strive to build is one where you have a positive communication channel and there is a level of trust and integrity built and cultivated over time.
• Stay current. You are a government contractor. You live in a world of unique rules and regulations that are embedded in the way the government does business, but these rules are ever-changing. Join advocacy groups and industry associations to reap the benefits of hearing first hand the latest trends and information. Attend seminars and provide the adequate training your personnel need to do their jobs. Cultivate other relationships, such as with your internal or external auditors, consultants, attorneys and bankers. All are tremendous sources of knowledge that will benefit your business.

Integrating these key steps to building and maintaining the proper relationships with DCAA into your company's framework is not only integral to your business but to avoiding the state of anxiety when the DCAA visit request arrives.

 

 

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