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”

Both Books graphic

Available on Amazon and www.dcaacompliance.com

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