Accounting System, Cost And Accounting, DCAA Relations, Running Your Business

Part Two – Early Childhood or “How DCAA, Contractor, and Consultant Can Ruin an Audit”: Souring the Milk

When the contractor bid on the Air Force contract they had no written policies and procedures, utilized a popular accounting software package, and operated with an alphabetized chart of accounts (not really, but that is what their outside tax CPA claimed). There was an extensive inventory system that ran through cost of goods sold directly (no capitalized inventory).

Back in 2011, a DCAA audit of an accounting system focused, in theory, on two parts: the mechanics of the contractor’s accounting department (usually audited by field work) and the contractor’s policies and procedures (usually provided to DCAA ahead of the fieldwork). Often, DCAA looked at the proposed rates as part of the accounting system audit, effectively combing two audits into one.

Sometimes DCAA gave the impression that the policies and procedures were more of a checkbox than anything else. Often DCAA confirmed policies and procedures during the fieldwork. You would walk through an area such as invoicing, and DCAA would ask if this was reflected in your policies and procedures. You answered yes and moved on to the next subject.

Thus, it was possible to buy a set of policies and procedures, stamp your name on them, and send them to DCAA without realizing that the purchased policies and procedures did not relate to your business and operations at all and sometimes, just sometimes, get away with this.

When our contractor heard that DCAA was on the way, they hired a consulting firm and the consultant recommend they purchase the canned policies and procedures from still another consultant (still not me, (these cost over five times what mine cost)).

Contractor purchased said policies and procedures, but their name on them, and sent them into DCAA. Of course the purchased set of policies and procedures were geared toward a construction company, not a company developing scientific instruments.

The next recommendation the consultant made was based on the conclusion that the contractor’s accounting software set up was adequate. That it was possible to identify direct and indirect costs, claimed and unclaimed costs, plus government and commercial costs. All of the areas identified in the SF 1408 could be demonstrated and defended. The consultant decided on three indirect pools, Fringe, Overhead, and G&A. The consultant’s analysis indicated that the contractor spent $19.43 in indirect costs for every $13.05 in direct costs. The consultant prepared an incurred cost submission, using DCAA’s current ICE model, reflecting these conclusions.

Policies and procedures in place, accounting system compliant with the SF 1408, incurred cost proposals prepared and sent, and rates determined. The contractor felt ready for a DCAA audit.

DCAA came out in the late spring of 2011 and reached several immediate conclusions they promptly passed on to the contractor:

  • The Policies and Procedures provided by the contractor (purchased on recommendation of the consultant) not only had very little to do with the business operations of the contractor but those few areas, such as timekeeping, were not implemented or followed. For example, the policies called for supervisor approval on all timesheets while in practice all of the timesheets went straight to the bookkeeper for entry and processing.
  • The rates and rate structure found in the contractor’s incurred cost submission could not be replicated or tied to the contractor’s actual books of records. Direct and Indirect costs were confused and merged in several accounts. For example, the incurred cost submission reported a little over $90,000 in direct labor while the contractor’s trial balance reported the amount at about $23,000. The contractor and the consultant could not defend either number and there was some evidence the amount was closer to $600,000. Such problems were found throughout the incurred cost submission and the trial balance. This was not an incurred cost submission audit (thank you, thank you, thank you) but DCAA had properly used the concurrent document to try and figure the simple issue of direct and indirect within the contractor’s books.

As DCAA’s questions seem to multiple and answers seemed to generate only further questions. In response to DCAA comments, the contractor began to make rapid changes during the audit that only made things worse. Specifically, all of the costs that DCAA questioned as unallowable were moved to an unallowable G&A account. I do not know if the consultant was aware of the changes.

DCAA poor reaction to the contractor’s preparation and subsequent results raised alarm with the contractor. The contractor felt that the situation was spiraling out of control. Before the contractor received the statement of proposed findings, they terminated their relationship with the current consultant and engaged me as a replacement.

I literally walked into the middle of a bad DCAA audit without any clear idea about what was going on. I was concerned about the relationship with the former consultant but did not make any immediate decisions about either the quality of the previous consultant’s work or the contractor. I focused more on what I figured, wrongly, was DCAA issues.

I will admit that I have a tendency to blame DCAA in such circumstances, especially during this timeframe. On occasion I had seen DCAA and contractors feed off each other as both tried to figure out just what was going on. I listened to the contractor’s legitimate concerns about DCAA’s claims on rental cars as a classical example of audit confusion.  I just figured the consultant had gotten stuck in the middle and I offered a chance for a reset.

As I looked at it, it became clear that DCAA had done a pretty good job. The proposed findings were actually developed and discussed fully with the contractor before any commitment to writing and there were several proposed findings, nine to be exact. There was some confusion in the proposed findings. For example, one finding confused G&A Base and G&A Pool. Two other findings appeared contradictory until one realized the books were contradictory.

All in all, DCAA proposed nine findings:

  • Inadequate Internal Controls Over Timekeeping
  • Inadequate Segregation of Duties Over Timekeeping
  • Fragmentation of the G&A Base Used To Allocate G&A Costs
  • Failure To Properly Segregate and Accumulate Direct and Indirect Costs
  • Failure To Calculate and Monitor Indirect Rates
  • Improper Recording of Direct Material Costs
  • Noncompliance With FAR 52.232-22(c) Limitation of Funds
  • Use of an Arbitrary Rate to Bill the Government for Indirect Costs
  • Inclusion of Unallowable G&A Costs in the G&A Base

All of the findings were constructed and supported out of references to the Federal Acquisition Regulations (FAR), something the successor auditor failed to do. The last finding was a little confusing, I am sure the auditor meant “Pool” and not “Base”.

Number six, “Improper Recording of Direct Material Costs”, arose out of the contractor utilizing a complicated inventory system but then expensing everything through Cost of Goods Sold. The auditor raised FAR 31.201-2 (a) (3) and pointed to the GAAP Matching principle as the basis for the proposed finding.

Number four, “Failure To Properly Segregate and Accumulate Direct and Indirect Costs”, arose out of the fact that the contractor had hundreds of thousands of dollars in costs (over half a million in labor alone) marked in the job system as commercial contract work but booked to indirect accounts in the general ledger such as “G&A Labor”.

The third proposed finding, “Fragmentation of the G&A Base Used To Allocate G&A Costs”, arose out of the circumstances I described above where DCAA raised the issue early in the audit, the contractor made a change, and DCAA gigged the contractor on the change.

It started when the auditor asserted that the FAR required (and I later confirmed this assertion) that all rental cars had to be compact to be allowable. The contractor found this so unbelievable that the CFO decided to move all rental cars to unallowable G&A. This of course raised another issue and DCAA proposed a finding based on the change. It took me a while to work this through with the CFO. Yes, the auditor was wrong about the rental car position but the issue was now direct versus indirect. It is not just the direct cost of the rental car that is alleged to be unallowable but also the associated G&A costs. That is why the change the contractor made did not work. Since the auditor was careful to support all of the proposed findings with strong regulatory support, it was doubtful the auditor would actually propose a finding asserting that rental cars must be compact, but the auditor had no problem with objecting to the change and creating proposed finding number three.

The first two timekeeping proposed findings, “Inadequate Internal Controls Over Timekeeping” and “Inadequate Segregation of Duties Over Timekeeping” were pretty standard DCAA objections. One, anybody could charge anything. Two, the bookkeeper approved the timesheets.

Findings seven and nine (corrected), “Noncompliance With FAR 52.232-22(c) Limitation of Funds” and “Inclusion of Unallowable G&A Costs in the G&A Base” are pretty standard also. Nine related to using unclaimed costs to calculate the indirect rate for proposing billing rates. The reason why I believe the auditor confused the terms “base” and ‘pool’ is due to the simple fact that unallowable direct costs are required to be included in the G&A base but unallowable G&A costs must be excluded from the G&A pool.

The last two findings, five “Failure To Calculate and Monitor Indirect Rates” and eight “Use of an Arbitrary Rate to Bill the Government for Indirect Costs” relate to the easy conclusion reached by DCAA that the contractor did not employ an accounting system that allowed for consistent, supported, and even clear calculation of rates and management of the associated pools/bases.

How was the consultant involved? Much of this had the consultant’s thumbprints on it. Proposed findings five, eight, and nine arose out of the consultant’s own work and conclusions. The first two findings plus number seven are government contractor compliance 101 and should have been addressed before the audit. As to number four, which the contractor included in the incurred cost proposal with fractional modifications, I noticed problems when I first glanced at the contractor’s general ledger.  I wondered, along with DCAA, about an 18 to 1 ratio of G&A labor to direct labor. I did not even need to ask the contractor, I simply ran a job ledger and saw hundreds of thousands of dollars marked with active jobs but booked to G&A labor. DCAA apparently saw the same data.

You might argue about the matching (proposed finding six), but given the extent and support surrounding the other findings, it would be drowned in all of the valid DCAA arguments.

I can only report what I found and my subsequent experience with the contractor. I continued to work with the contractor years after the events described. They were dedicated, even to the point where they considered compliance their patriotic duty. They understood, committed to, and adopted my recommendations, even though new issues with DCAA arose over the next several years. The last recommendation of mine they finally adopted was to leave government contracting. They were losing money with cost sharing contracts (no fee) and if the government wanted their technology the government could buy it like everyone else.

Next – “Potty Training”

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Accounting System, Cost And Accounting, DCAA Relations, Running Your Business

The Life of a Contractor: Part Two – Early Childhood or “How DCAA, Contractor, and Consultant Can Ruin an Audit”

Despite the apparent belief by the Air Force that DCAA would not show up, DCAA did. The contractor, with no professional accounting staff and an outside tax CPA who disavowed all knowledge of government contracting, hired an outside consultant (not me). It did not go well.

I am going to talk about what happened. I am going to talk about what the contractor did wrong and I am going to talk about what I believe the consultant did wrong. I am even going to talk a bit about what I believe DCAA did wrong.

I am uncomfortable criticizing another consultant for obvious reasons, but I believe the story of this contractor is an excellent example of the extremes that many small business government contractors face. The first consultant is part of this story.

Before I do this, I want to talk about why I believe hiring the right consultant is almost always the best step for a small government contractor to take. Since I happen to be the consultant I know best, some of what follows is self-serving and thus a little arrogant. I feel like I need to talk about what I see as the ‘good’ consultants and how to select one. I am sure many of you will take exception, please feel free to discuss.

The Risk and Consequences of Not Getting Help

The decision about bringing an outside consultant in to deal with DCAA is a difficult choice small business contractors make every day. Of course, before they even consider going alone, they should purchase and read my second book: Surviving a DCAA Audit: The Accounting System.

First incident of self-promotion aside, it is all a question of risk and consequences. The risks and consequences of an inadequate accounting system hits contractors in two major areas.

First, the lack of an excellent accounting system translates into poor knowledge about how efficient and profitable the company’s individual activities (jobs or projects) are. Small business owners utilize excellent common sense in this area; but improved data provides, if nothing else, a competitive advantage to either you or your competitors (those guys you are bidding against who know their costs).

Second, if DCAA determines the accounting system inadequate there can be major consequences. Just ask Lockheed Martin, who could not collect most of the profit on a major government contract for years after the government decided their cost accounting system inadequate. Also, look back at the small business contractor discussed in the first article of this series and their inability to recover money they believed the government owed them.

Cost seems to be a driving factor in deciding to select a consultant.  One of the biggest factors impacting consultant cost is contractor knowledge, contractor commitment, and the consultant’s ability to transfer that knowledge to the contractor.  I belief it is a natural conclusion that If you turn everything over to a consultant your costs, short term and long term, are higher. You also never gain the critical ability to assess their work.

Anyone reading my books or poking around my website quickly realize that I believe contractor knowledge is critical and reduces the cost to the government and the taxpayer. I like clients to graduate from my services or training programs. They know I am always there when they are not sure about an issue or there are major changes they want a fresh look at.

The quality of the consultant is an area that challenges contractors as they begin to look at the idea of bringing a consultant aboard. Here is another area where I believe providing potential clients with a serious look at the world of government contracting via my books and website helps with this decision. Although I know excellent consultants without a website and few of us author books.

I will address one common myth: Some contractors seem to believe that hiring a former DCAA auditor as a consultant is an obvious approach. Unfortunately, I believe this myth is simply not valid.

I know at least two excellent consultants who are former DCAA auditors and do simply outstanding work, but I know at least a dozen former DCAA auditors who do not. Before the former DCAA auditors scream at me, I believe the same about other consultants who never worked for DCAA. I know a handful of outstanding ones and dozens who are not.

My point is this:  experience as a DCAA auditor does not necessarily translate into success as a consultant working with DCAA. There is no special advantage or knowledge that a former DCAA auditor offers. There is no secret handshake or inside knowledge. I look forward to reading the arguments and support of anyone who claims otherwise.

Good auditors have a healthy amount of distrust. On numerous occasions we faced encounters where one DCAA auditor signed off on an item one year only to have another DCAA auditor object the next year to the very same item. If DCAA auditors have a healthy distrust of fellow DCAA auditors, why would they have more trust in a former DCAA auditor?

I noticed over the years on LinkedIn and other places that some former DCAA auditors continue to take DCAA’s positons on compliance issues; positions that myself and other experienced consultants do not necessarily agree with. According to DCAA’s own reports to Congress, only about half of DCAA positions are sustained. It is always easier to agree with DCAA but it is not always profitable or fair.

Again, according to DCAA’s own reports to Congress, the average number of audits completed by a DCAA auditor each year is under 1.5. That is not a lot of audit experience. I close a great deal many more than that each year.

I apologize that this seems to be an advertisement for myself and the few unidentified consultants I deem, in my arrogance, to label competent. As noted above, what follows is not only the story of a small business contractor who entered and later decided to leave government contracting; it is also the story of two consultants working with one of the more interesting (difficult) DCAA offices I work with.

To be continued…

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Accounting System, Cost And Accounting, DCAA Relations, Running Your Business

A Note on the Birth of the Contractor, the Previous Article.

One quick note about the contractor is described in the previous article, how I described their critical technology, and the way this often impacts the compliance process and audits.

Too many contractors believe that the importance of their work should provide them with a free pass on accountability.  I join with DCAA auditors and taxpayers in rejecting this positon.

DCAA auditors are required to walk a fine line between protecting taxpayers’ assets (money) and assuring that the service members DCAA are supporting get the resources they require. Often, the auditors have no knowledge of the contractor’s work and its importance.

In my book, Accounting Policies and Procedures: For Small Government Contractors Working with the DCAA and Other Government Agencies I encourage contractors to begin their accounting manual with a description of the company and the work they do:

“The manual should start with a little background information on your company as an introduction for the DCAA auditors. You would be surprised how hungry auditors are for this information, and how critical it is in their assessment of your operations. Rightly so, the DCAA auditors are an essential aspect of our nation’s defense and it is only natural they wish to make some attachments to your efforts in our nation’s defense. “

It does not appear that any such knowledge made any impact on this case, but I believe the concept is valid.

4th-ed-cover

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Accounting System, DCAA Relations, Running Your Business

The Birth, Life, and Death of a Small Business Contractor

 

 

Part One – The Illegitimate Birth

 

One of my clients is a small government contractor in the South with only a few employees. They are developing a technology that anyone could easily identify as critical in both military and civilian applications. The development is at a ‘job phase’ where units are built individually in the attempt to improve the process and the technology. Each one of these individual units are functional and critical.

Almost all of the national labs, many foreign countries, and others in industry have purchased these units and employed them immediately, even as the technology continues to be developed. I should say that the technology saves lives and is not a weapon.

Of course the military wanted the technology; but instead of going out and buying a unit, the military issued a contract, a cost type contract.  In 2010 the United States Air Force issued the contractor a cost type contract.

The Federal Acquisition Regulations (FAR) restricts the government from issuing cost type contracts to contractors unless “The contractor’s accounting system is adequate for determining costs applicable to the contract or order…” (FAR 16.301-3(a)(3)). During this time, standing orders required the Air Force to wait on an opinion from DCAA about the contractor’s accounting system and for DCMA to issue an approval of the accounting system.  This was during a period where local contracting officers could not always know when and if DCAA would show up and the Air Force really wanted the technology and issued the contract without an approved or audited accounting system.

Why the Air Force did not simply follow the example of the National Labs and issue a fixed price contract or a purchase order, we will never know. Instead, the Air Force issued a cost type contract to a contractor without an approved or even audited accounting system.

The contractor did not realize that the Air Force actions transferred almost all of the risk concerning the contract to the contractor, the opposite of what a cost type contract is ‘designed’ to do.

The fact that the FAR prohibited the Air Force from issuing the contract is not a defense the contractor may raise as one contractor found out when they complained to the Armed Services Board of Contract Appeals. In this case, the contractor claimed the government owed them hundreds of thousands of dollars. The government successfully argued that the contractor’s inadequate accounting system made any such claim impossible to support. An adequate accounting system protects the contractor and the government.

Of course, the Air Force or DCMA did order an audit and the contractor hired and consultant (not us) to help them with DCAA. This did not turn out well.

But a government contractor was born, arguably illegitimately, but born none the less.

Next, “How DCAA, Contractor, and Consultant Can Ruin an Audit”.

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Wait a Moment

As pointed out by Ken Bricker, DCAA has announced that they are all caught up on incurred cost submission and will begin working on audits outside the Department of Defense. And the world turns……

http://www.dcaa.mil/mmr/16-PPD-008.pdf

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A World Without DCAA– Today

NASA awards contracts to 6 audit services companies

NASA has awarded contracts to six companies to provide agency wide contract auditing support services, previously performed by the Defense Contract Audit Agency, the company said.

The selected companies are: Castro & Company, Kearny and Company PC, CohnReznick LLP, KPMG LLP, Moss Adams LLP and Regis and Associates PC.
The contracts are fixed-price, indefinite delivery/indefinite quantity contracts that include a one-year base period and four one-year options, with a combined maximum potential value of USD100 million.

The NASA Shared Services Center (NSSC) at Stennis Space Center in Bay St. Louis, Mississippi, administers the contract. The NSSC performs select business activities for all NASA centers.

NASA awards contracts to 6 audit services companies

If you are looking for someone to support you while being audited by an auditor trying to audit like DCAA, drop us a line at mail@dcaacompliance.com.

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