The Good and the Bad — All in the Same Audit

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

1. Supporting Material Overhead rate
2. DCAA auditor independence
3. DCAA’s right to change their mind in subsequent audits
4. Tax vs. Book on depreciation issues
5. Bonuses
6. Accrued Costs crossing fiscal year
7. Unapproved subcontractors
8. An excellent example of DCAA properly developing findings.
9. Documenting consultants work product

The scratched out areas were discussed in previous articles. Today, I am going to talk about developing findings and documenting consultants’ work products. Again, I am not a lawyer and this is not legal advice.

 

Developing Findings

The fact that I consider this topic worthy of discussion illustrates the reality that the failure of auditors to properly develop findings is an ongoing issue in too many DCAA audits. Way too often, the first time a contractor hears about a proposed finding is when it is proposed.

During a recent DCAA auditor, the auditor thought she could benefit from the research she did on me and my views by announcing her agreement with what she thought was one of my strong assertions:

“Well, we all know that the Contract Audit Manual. is not regulatory and only guidance”.

My response had a visible impact on her: “The CAM is guidance for contractors, but it is your standing orders. I would expect a DCAA auditor to follow those orders.”

Let us see what those standing orders in the CAM say about developing findings:

4-303.1(b) The auditor should discuss preliminary audit findings (e.g., potential system deficiencies, potential FAR/CAS noncompliances, etc.) with the contractor to ensure conclusions are based on a complete understanding of all pertinent facts. These types of discussions do not impair auditor independence and are generally necessary to obtain sufficient evidence to support audit conclusions.

 

6-708(b). During the course of the audit, significant audit findings should be brought to the attention of, and discussed with, the contractor, and when appropriate with the cognizant principal ACO and CAC, as soon as possible to expedite the resolution process (See 6-902e). The discussions are to ensure that the auditor’s conclusions are based on a proper understanding of the facts and to ascertain whether the contractor/ACO/CAC has any additional information which would support or modify the audit findings. This will enable resolution of the findings to take place prior to the completion of the audit. If agreement on an issue cannot be reached, the contractor should be requested to prepare a rebuttal for inclusion in the audit report. The process outlined above will result in an efficient audit that will conserve both audit and contractor personnel resources.

6-709(b). During the course of the audit, significant audit findings should be brought to the attention of, and discussed with, the contractor, and, where appropriate, with the principal cognizant ACO and CAC, as soon as possible so as to expedite the resolution process (see 6-902e). The discussions are to ensure that the auditor’s conclusions are based on a proper understanding of the facts and to ascertain whether the contractor/ACO/CAC have any additional information which would support or modify the audit findings

I simply cannot stress how many times simple misunderstandings were cleared up because the DCAA field operator brought it to our attention before taking it to their supervisor, and after that writing it up as a proposed finding. Heading off trouble at the earliest stages is an essential aspect of successful DCAA relationships.

One famous example was a DCAA auditor putting together this extensive spreadsheet that “proved” the contractor was calculating social security taxes incorrectly and that highly compensated employees were not paying their fair share of social security tax. He was still pretty embarrassed, but at least he had not written it up and sent it to his supervisor.

No one likes egg on their face and contractors should avoid watching DCAA auditors make fools of themselves. Sometimes this results a stubborn refusal on the part of some DCAA auditors to admit an error, such as my aggregating “Backspace Key Crisis”

In the TSI case, it appears time and time again that both DCAA (at least the second auditor) and DCMA bent over backwards in the attempt to allow the contractor to dispute the findings. Despite this, it appears DCAA and DCMA stuck to their guns only to find the appeals board disagreeing with the auditors on over half of their findings.

Documenting Consultants Work Product.

It is a pure joy to hear the appeals board admonish DCAA with the exact arguments I made time and time again. I will let the judges speak for themselves:

The government labors under the false impression that the FAR requires a consultant to create “work product” merely for the purposes of proving its costs (see R4, tab 16 at 258, 260; gov’t br. at 54-55, 64-66). Though the FAR language in question is not as clear as we might like, it can be read- as we read it here – to impose no such requirement, Moreover, we have factually found the invoices submitted by TSI to be adequate to support a finding that TSI incurred the charged costs for SMI’s marketing activities.

We begin by examining that language of the FAR that the government holds out as requiring the generation and provision of “work product” to entitle recovery of costs for professional and consultant services. FAR 31.205-33, Professional and consultant service costs, provides in relevant part that:

(f) Fees for services rendered are allowable only when supported by evidence of the nature and scope of the service provided. work performed is proper and does not violate law or regulation shall include

(1) Details of all agreements (e.g., work requirements, rate of compensation, and nature and amount of other expenses, if any) with the individuals or organizations providing the services and details of actual services performed;

(2) Invoices or billings submitted by consultants, including sufficient detail as to the time expended and nature of the actual services provided; and

(3) Consultants’ work products and related documents, such as trip reports indicating persons visited and subjects discussed, minutes of meetings, and collateral memoranda and reports.

The government makes a superficially persuasive argument, that the FAR’s statement that the evidence necessary to determine that the work is proper “shall include … work products” and related documents, makes the provision of such documents mandatory (gov’t hr. at 54). The problem with this interpretation of the FAR is that it does not account for the case in which such documents were never created by the consultant. Moreover, it does not account for the case where, as here, the invoices include the data that the FAR defines as work product, such as persons visited and subjects discussed. We further note, that DCAA’s own audit manual, reflecting the government’s own interpretation of this FAR requirement, provides that, “[t]he auditor should not insist on a work product if other evidence provided is sufficient to determine the nature and scope of the actual work performed.” DCAA Manual, at 58-2 – 58-3. Moreover, amongst the “Frequently Asked Questions” in the relevant portions of the audit manual are responses indicating that other additional evidence may be considered to determine whether the services were, indeed, provided and allowable. Id. at 58-7.

Thus, we conclude that FAR 31.205-33(f) may require the provision of a consultant’s work product, if it exists, but is not so rigid as to require its creation when it would not otherwise be necessary for the consultant to perform its duties. To be sure, any lack of work product makes it more difficult for a contractor to prove that it incurred the costs for which it seeks compensation, and the lack of work product in an instance where the consulting work was of such a scale or scope that work product would be expected may properly subject the costs to question. As with most things, the proper amount of documentation and work product to be expected will largely depend on the scope of work performed, and we do not conclude that the FAR 25 intended to impose “make work” upon consultants that would only lead to higher costs to the contractor which would then be imposed upon the taxpayer.

Turning to the facts before us, we have found that the consulting agreements and the invoices provided, combined with the testimony given at the hearing, persuade us that the costs included in TSI’s FY 2007 ICP for SMI’s marketing services were, in fact, for that purpose and are allowable. This portion of the appeal is sustained.

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The Line Between Simplicity and Woops!

The  Armed Services Board of Contract Appeal is STILL down again for the second time in the last several months. I will not let this attack on democracy (although I am sure the government has an excellent reason for the prolonged denial of access to this information) stop our discussion of the TSI case.

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

1. Supporting Material Overhead rate
2. DCAA auditor independence
3. DCAA’s right to change their mind in subsequent audits
4. Tax vs. Book on depreciation issues
5. Bonuses
6. Accrued Costs crossing fiscal year
7. Unapproved subcontractors
8. An excellent example of DCAA properly developing findings.
9. Documenting consultants work product

The scratched out areas were discussed in previous articles. Today, I am going to talk about depreciation. Again, I am not a lawyer and this is not legal advice.

Depreciation

Depreciation and its evil sister Amortization often result in contractor upset stomachs and a desire to find a nice quiet spot somewhere where accountants can be beaten with long thin sticks. Tax and GAAP rules often differ significantly and can result in reconciling differences the contractor must track. To further add to this complexity, many accelerated tax depreciation methods are available for defined periods or under special conditions due to political decisions to impact the economy. Some depreciation methods are even restricted to certain neighborhoods (Okay, enterprise zones).

Too many contractors avoid this complexity and stick with a simple universal method for both tax and their financial (GAAP) books. This can cost the contractor real money but allows these individuals to sleep better.

TSI appears to have been one of those contractors who tried to keep tax and financial accounting together. Up until the year in question (2007), they depreciated their assets on a multiyear basis but in 2007 they ‘expensed’ out $26,198 in computer equipment of which $18,840 went onto the tax return as capital assets and expensed under Section 179. They claimed the full amount on the incurred cost submission.

TSI came up with an after-the-fact argument that reasonably argued some of the costs were not capital costs (short life), but admitted that not all of the costs fell into this category and could not identify the different equipment.

The Board took notice that TSI did not have any depreciation polices in 2007 or the previous years. In absence of contractor policies, the Board relied on consistency and noted that previous to 2007 the contractor utilized multiyear depreciation. As a result, TSI lost most of the 26k it expensed on the incurred cost proposal.

Depreciation policies and procedures are not specifically addressed in DCAA’s preaward audit program or in the government’s SF 1408. This is another excellent reason why contractors should adopt comprehensive policies and procedures and move past what DCAA looks at initially. The only real FAR restriction for small contractors, as noted by the Board, is not to charge the government more than is found on your financial books.

Depreciation Lessons

1. Depreciate Often and Wisely – Contractors should take advantage of tax benefits allowed and should set up systems that allow the differences between tax and GAAP to track easily by utilizing memorandum or reversing journal entries as a simple example. Many software programs offer to track this difference with little effort. This leads to the second point.
2. Policies and Procedures Protect and Explain – It is not just about compliance, excellent policies and procedures serve as a roadmap allowing a contractor to see where they have been (current policy and procedure) and figure out where they want to be (adapted policy and procedures). To phrase this in a way many of my engineering clients will appreciate: How can you begin to discuss modifications to a design without the current specification sitting in front of you? Policies and Procedures are your business specifications.

3. Excellent Policies and Procedures are Dynamic – Want to adapt accelerated depreciation? Look at your needs, GAAP, and other compliance issues and move forward. Just do not forget to include the changes on your Schedule M.

One final note, the Board, as is typical, ordered the government and TSI to recalculate the rates based on the Board’s decision. I wonder if there will be arguments on the allowable 2007 depreciation, given the lack of governing policies and procedures? I imagine they will eventually agree on the method used in previous years, but the DCAA may have question about those now that the light is focused on the issue. I am also curious if DCAA proposed disallowing ALL of the 2007 depreciation and the Board caught this.

One Little Email and We Might be Talking a Different Case

The Armed Services Board of Contract Appeal is down again for the second time in the last several months. I will not let this attack on democracy (although I am sure the government has an excellent reason for the prolonged denial of access to this information) stop our discussion of the TSI case.

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

1. Supporting Material Overhead rate
2. DCAA auditor independence
3. DCAA’s right to change their mind in subsequent audits
4. Tax vs. Book on depreciation issues
5. Bonuses
6. Accrued Costs crossing fiscal year
7. Unapproved subcontractors
8. An excellent example of DCAA properly developing findings.
9. Documenting consultants work product

The scratched out areas were discussed in previous articles. Today, I am going to talk about DCAA’s right to change their mind in subsequent audits. Again, I am not a lawyer and this is not legal advice.

 

DCAA’s Right to Change Their Mind

The disagreement between the ASBCA judges and too much of the 61-page opinion addresses the question of DCAA’s changing its mind from audit to audit and from auditor to auditor. To sum up, the two judges in the majority believe DCAA has a broad right to do so, while the minority judge does not.

I am not going to quote their respective arguments, which coincidently coincides with their website unavailability, because I believe this is a horrible case to address the issue.

If DCAA audits, or chooses not to audit, a subcontractor’s invoices in 2012 and sees nothing wrong; this does not prevent them from looking at the subcontractor’s new invoices in 2013 and deciding there is something wrong. All of the extensive legal arguments between the judges aside, the ability to look at costs fresh from year to year is simply common sense to me. This is not absolute but generally true.

One obvious area where DCAA must change its opinion is when there a change in law, regulation, or GAAP.

Does this infer that I believe DCAA is allowed to change their mind at any time and without any constraint? NO, IT DOES NOT. I just believe, despite the pages and pages dedicated to the issue, that this was not the case to explore DCAA’s mind changing abilities.

Let us look at some areas where I believe DCAA’s ability to change its mind is limited.

Reasonableness

Underlying this, as is often the case with DCAA, is the fundamental issues surrounding burden of proof. DCAA auditors can propose findings based on two conclusions: first; the finding is based on a violation of statute, regulation, or GAAP[1]; second; the finding is based on DCAA’s assertion that the cost is unreasonable or imprudent.

If a subsequent DCAA auditor objects to a cost that a previous DCAA auditor allowed because the previous auditor missed an applicable regulation, then the new DCAA auditor is not only within rights to question, but is ethically obligated to proceed with the finding development. However; if the proposed finding is based on reasonableness (or unreasonableness), I believe the contractor enjoys a strong argument that the actions of the previous auditor establish the cost was reasonable and that the personal differences in auditors cannot form the basis for a finding.

Implicit in this is the assumption that both auditors actually sampled and audited the cost. If the first auditor did not actually sample and audit the cost, there is no assumption made.

Sometimes I believe the only person some DCAA auditors lacks respect for more than a contractor is another DCAA auditor. It does not surprise me that this second guessing occurs frequently, but I have now provided a basis for evaluation and objection.

For a closer look at burden of proof issues, look at these previous articles.

Documentation

Another common area where we witness disputes between prior and present DCAA auditors is regarding documentation. The first auditor accepts the documentation while the subsequent auditor does not. Again, there is the assumption the first auditor actually sampled and reviewed the documentation. Again, if there is a SRG issue, especially a change in one of them, I believe the subsequent auditor has the right to raise the issue.

In most cases, the difference arises out of a different interpretation of the SRG. A good example is how some auditors read the requirement for consultant documentation. We will discuss this thoroughly in a future article on this case, but I will just point out that the judges noted that the subsequent DCAA’s auditor’s interpretation of the regulation on consultant documentation was wrong.

Where the documentation is basically identical, the issue gets a bit trickier. As the recent Lockheed Martin case asserted (I would link it if the website was up), inadequate documentation is not a reasonable and prudent argument. Because of this the burden of proof that the documentation is inadequate rests with the government auditor. Now the auditor has to demonstrate the documentation is inadequate despite the previous auditor’s acceptance. I think that is a challenge, but not an impossible one.

Policy and Procedure

Where DCAA should respect prior audit opinions is in the area of a contractor’s policies and procedures, and accounting structure.

DCAA recommended approval of an accounting system is a positive assertion on their part that the contractor’s accounting system is adequate for government contracting purposes. This is done by the auditor signing the SF 1408.

Some consultants sign the SF1408 and argue that this is the contractor’s privilege. I absolutely believe this is contrary to the regulation and it also takes away the DCAA signature accepting your accounting system and the positive assurance I am talking about.

I would argue that if it is covered by the SF 1408, the contractor and the government is provided assurance by DCAA that the system, to include policies and procedures is adequate.

For example, section 2(c) of the SF 1408 addresses allocation method.:

“A logical and consistent method for the allocation of indirect costs to intermediate and final cost objectives. (A contract is final cost objective.).”

There is a critical grammar mistake on the government’s part (is it “A contract is a final cost objective” or “A contract is the final cost objective”?).

Grammar question aside, an approved SF 1408 is an approval of the contractor’s allocation method (Total Cost Input, Value Added, or otherwise). DCAA should not subsequently object to the contractor’s allocation method unless there is a change (SRG or internal).

The SF 1408 is not comprehensive even if your policies and procedures are. Unfortunately, this does not mean that, as part of the process, when you send DCAA your hundred-page accounting policies and procedures you can assume they are all approved. I would only assume the ones covered by the SF 1408 are.

The best example of this are bonuses, which are not addressed in the SF 1408.

TSI believed they addressed the issue with DCAA. Their bonus plan was new to the year that was the subject of the audit findings and the appeals case. Before the submission they started a discussion on the bonus plan with DCAA :

“Mr. Fletcher testified that he met with DCAA auditor Marie Pepin for approximately two hours on 28 February 2008 to discuss the ICP for FY 2007 that would be submitted later in 2008, and raised the executive bonus plan with her during this discussion (tr. 2/121-22). According to Mr. Fletcher, Ms. Pepin said words to the effect of “this looks good to me,” and then they moved on to other subjects (tr. 2/123). We find, as a matter of fact, that this discussion was relatively short and superficial in nature and did not constitute any representation that the government gave final approval to the bonus plan as proposed or executed.”

I wonder if the court would have thought differently if TSI had employed my recommended procedures and followed up the meeting with an email documenting the agreement and attaching the plan?

If TSI had sent that email, we might have had a good case for deciding when and how DCAA can change its mind, even if DCAA ignored the email.

[1] I am going to refer to proposed findings based on statute, regulation or GAAP as “SRG” for the rest of this article.

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Very, Vary, Variance

Let us take a break from the Technology Services, Inc (TSI) case and talk about a continuing flaw in most small government contractor’s accounting system: tracking variances, specifically those associated with cost type contracts and the associated indirect costs.

Simply put, the variance is the amount the government owes you because your rates ran higher than your billing rates or the amount you owe the government because your rates ran lower than the billing rates.

DCAA’s Information for Contractors discusses the subject in Enclosure 5.

3. Provisional Billing Rates.
4. FAR 42.704 provides the CO (or cognizant Federal agency official) or auditor responsible for establishing the final indirect cost rates also shall be responsible for determining the billing rates. The Government allows interim payments, if authorized by the contract, during contract performance by progress payments for fixed-price contracts, or by public voucher for cost-type contracts. Reimbursement of indirect costs for these payments is generally made through billing rates that are established to approximately equal the expected final indirect cost rates for the contractor’s fiscal period, as adjusted for any unallowable costs. These billing rates are used for interim reimbursement purposes until settlement is reached on final rates after the end of the contractor’s fiscal year. Billing rates may be prospectively or retroactively revised by mutual agreement, at either the Government’s or contractor’s request, to prevent substantial overpayment or underpayment. Once the final rates are established, an adjustment is made for any variance between the billing and final rates.
5. Upon receipt of the certified final indirect cost rate proposal, FAR 42.704(e) provides that the Government and the contractor may mutually agree to revise billing rates to reflect the certified proposed indirect cost rates. The proposed indirect rates will be adjusted to reflect historically disallowed amounts from prior audits until the proposal has been audited and settled. The historical decrement will be determined by either the CO or the auditor responsible for determining final indirect cost rates. If billed costs exceed claimed costs, the contractor must appropriately adjust the next voucher or remit or otherwise credit the Government for the difference.

This government publication points to one of the critical knowledge areas for small business government contractors. If you keep your books and accordingly run your business like the IRS wants their information, your will probably go out of business. If you do the same with regards to DCAA, you will almost certainly go out of business.

The IRS wants to collect information in a manner that makes it easier to assess your tax liability and collect the taxes. They simply have no interest in how your business is doing, your success or failure is not within their job description. DCAA enjoys a theoretical interest in a contractor’s success as it assumes that the contractor’s work is necessary to the government, but their institutional focus has been on the contractor’s expenses in terms of allocability and allowability. Profitability, to DCAA, is, at best, out of their scope of work. At worst, contractor profits can be a focus of suspicion for DCAA.

And variances have a direct impact on profitability and the ability of the contractor to succeed and prosper. Here are a couple examples from my work over the years:

A couple of decades ago, a contractor I worked with secured a $10,000,000 contract with the government and managed to talk them into a $5,000,000 advance payment on the contract. Almost unheard of, even back in those days.

Unfortunately, the owner died tragically just after receiving the advance payment. The company made the IRS happy and paid the taxes on the $5,000,000 and recorded the “revenue” on the books. Properly, the company should have booked the advance payment as Deferred Revenue, a liability, and the money should only have hit revenue as it was earned. This is an excellent example of how you fill out your tax return often should have no influence on how you manage your business.

I am sure you can guess, the contractor spent a lot of the money before they even began serious work on the contract and struggled for a couple of years to do the work without any new money for the work.

In another example going the other way, a client of mine brought me in to work some audit issues on a $27,000,000 contract. As I looked everything over, I asked about any variances and they assured me there were no variances. I looked at the billing for the five years and could not see any variance billing, and asked to take a look at one year to check. After some resistance, they agreed and I found they underbilled the government about $75,000 in the sample year. That justified taking a look at all five years and the amount grew to approximately $900,000 never billed to the government.

The latter one annoyed me a bit as this contractor paid me to help create their policies and procedures. These policies and procedures called on the contractor to track the variance on a monthly basis. Obviously this did not happen.

Other contractors I worked with over the years discovered during the preparation of their Incurred Cost Proposal that they owed the government tens of thousands of dollars they did not anticipate. Another former client never had a variance, his books somehow tied exactly to the billing rate year after year. It is a bit more innocent than it sounds. He actually thought he was contractually obligated to spend to that amount exactly.

And of course I have to mention the major accounting firm that called an emergency conference call because they did not understand why the rates on the incurred cost proposals differed from the billing rates.

Tracking variances is cost accounting 101. No one should be surprised by a variance. Contractors should track the variance on each contract each month. You calculate the variance (actual vs. billed) for the month and post the difference to the balance sheet. If you the variance is up one month and down the next, this method will show the contract-to-date total each month. Putting the variance on the books of record and reporting it on the balance sheet formalizes the process, making it a routine item to discuss at those monthly finance meetings.

After writing the first draft of this article this morning I reviewed standard report from one the popular government contracting system and discovered, to my great annoyance, that the variance was reported as an increase of profits!!!!  How do you explain this to your boss when you have to pay the money back? Maybe it is a setup issue, sigh….

There is some disagreement about where on the balance sheet to post the variance. I prefer to post the balances to an accounts receivable account (“CPFF Variance”) and the offset is to “CPFF Variance Revenue”. Some contractors use an inventory method, posting the variance to an inventory Work in Progress account on the balance sheet and posting the other side to a Cost of Goods Sold account.

Either way, you know where you are each month and there are no surprises.

What do you do if you are caught by surprise? Depending on your circumstances, there are some legitimate methods for addressing variances starting with a thorough analysis of allocability, allowability, and costs.

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Material Overhead Rate — Off and On

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

1. Supporting Material Overhead rate
2. DCAA Auditor independence
3. DCAA’s right to change their mind in subsequent audits
4. Tax vs. Book on depreciation issues
5. Bonuses
6. Accrued Costs crossing fiscal year
7. Unapproved subcontractors
8. An excellent example of DCAA properly developing findings.
9. Documenting consultants work product

I talked about unapproved contractors in the last article and today I am going to look at item one: Supporting Material Overhead rate. Again, I am not a lawyer and this is not legal advice.

The material overhead rate did not actually end up as part of this case only because the second DCAA auditor did not pursue it. TSI proposed a material overhead rate of 1.05% that the first DCAA auditor recommended be 100% disallowed while the second auditor accepted the rate. TSI alleged that the first auditor “had it in” for them and we will discuss the minimal discussion on DCAA auditor independence later.

Almost all of this article is speculative on my part and should not be taken to represent what actually occurred, but when I got the page where the initial DCAA auditor rejected all of the material overhead rate I thought “Crap, that has been a long time coming”. When I saw that DCAA backed off in the second stab at the audit, I breathed a sigh of relief and thought, “Not this time”.

Two Sides of the Circle or Contractors with Multiple Government Bosses

It is important to remember that government contractors circle around two extremes of government compliance. On one side, there is the programs staff and their associated contracting officers. These are the guys who issue the RFP, decide you are the guy they want, and issue the contract in coordination with DCMA.

On the other side of the circle is DCAA which looks at the contractor’s costs and business systems then recommends actions to DCMA based on their audit work.

A government contractor needs to make both sides as happy as possible, and I would argue that Material Overhead Rates is one of the bizarre evolutions within government contracting that arose to make this hope of making both sides (programs and compliance) happy a reality. The concept exists in established cost accounting practice but is not as universal as many RFPs would imply.

Just Where Do We Put that Pesky G&A?

The FAR, CAS, and DCAA are strong on contractors allocating general and administrative (G&A) costs utilizing a method labeled Total Cost Input (TCI). TCI allocates G&A costs over all other costs (direct (to include materials and subcontractors), overhead, fringe and so on). CAS actually states “A total cost input base is generally acceptable as an appropriate measure of total activity of a business unit”.

Thus TCI is automatically accepted as a valid way of allocating G&A by everyone. Everyone except the government people on the other side of the circle (programs and their branch contracting officers). It often seems a majority of them think burdening travel, materials, subcontractors, and materials with a G&A rate is an outrageous and immoral act. Addressing this indignation over the years, it is clear to me that many of the associated program people (including buyers) look at this allocation as a mark-up not an allocation of actual allowable indirect costs.

I will give you two recent examples. One was a final four major accounting firm auditing a client’s incurred cost proposal on a DOE contract. The supervisor auditor entered my office at the client site (I was there supporting the audit) and spent a lot of time arguing that allocating G&A on a subcontract was unethical (his words) since the subcontract contained its own G&A and this meant the government was being charged twice.

Obviously he did not enjoy a great deal of experience with value added taxes, and I responded by asserting that was the subcontractor’s G&A and not the prime’s (my client). The two could simply not be compared. A G&A rate is not arbitrary and represents an allocation of legitimate indirect expenses, expenses of both the subcontractor and the prime contractor. It is not a ‘profit’.

He then argued that the allocated G&A simply stood out of proportion to the base cost. It takes a great deal more G&A to administer direct labor than cut a check to a subcontractor. I actually thought this a much stronger argument, but he was still out of his league. I reminded him that the prime is responsible for the subcontractor and it is never as simple as cutting a check.

He still argued on and on about the injustice of the allocation. I finally made two additional points that finally closed the argument. First, all allocation methods are ultimately subjective and arbitrary. Second, please leave my office and come back with a statutory or regulatory basis that supported his argument.

The second example involved an Army contracting officer complaining that because their contract with the contractor was about half materials and the Air Force’s contract was all services, the Army was receiving an inequitable allocation of G&A. I responded by stating that the inequity could only be applied on a government wide level and not a branch level.

The thought behind these arguments and the countless other times I encounter them, is that a dollar spent on direct materials, subcontractors, and even travel, should not receive the same amount of G&A as direct labor. To approach from a different angle, given a G&A rate of 10% it is unfair to burden $500,000 of material costs with $50,000 of G&A.

One way I attempt to explain this to the program’s side is by trying to tie them into the whole picture:

“Okay, if a contractor has $75,000 in direct labor, $25,000 in subcontractor costs with $10,000 in allowable G&A, we have to allocate the $10,000.  The government is legally obligated to pay for the $10,000. Total Cost Input gives $7,500 to the labor costs and $2,500 to the subcontractor costs. How would you do it?”

Too often I get a response such as “I do not know, but that is too much on the subcontractor”.

The Program People Come Up with an Idea

This, I believe led to the development of “Material Overhead Rate”, “Subcontractor Handling Rate” and other similar line items on various RFPs approximately fifteen years ago. These line items are intended to relieve materials and subcontractors of G&A costs while acknowledge there are indirect costs associated with these direct cost elements.

Problem solved?

The number one question I get from contractors working on these RFPs is “What rate do we use?” or “How do we calculate this rate?” In other words, how do contractors separate out from G&A the part of G&A associated with subcontractors or materials. The base is defined, but how do you populate the pool? How do we justify a 3% Material Overhead Rate with a separate 10% G&A rate?

If you want a glimpse at the potential can or worms these rates may open look at questions 12 -21 on the “Contractor Forward Pricing Rate Proposal Adequacy Checklist” under DFARS 215.403-5.

Again, this is supposition on my part, but I wonder if the first DCAA auditor asked TSI for just such documentation, the justification for creation and operation of the Materials Overhead rate. I am guessing she decided it was inadequate. I am also guessing the second DCAA auditor understood the complexity of this issue and decided to focus valuable time elsewhere.

Material Overhead and Subcontracting Handling are legitimate cost accounting objectives The challenges in developing and maintaining the rate are reduced for larger contractors where the size and frequency of activity makes it easier to allocate and define such allocations.

Small business contractors face greater challenges developing, implementing, and defending these rates. If you can identify time spent on handling materials on a specific contract, is this Material Overhead or Direct Labor? The same is true of the time spent reviewing a subcontractor invoice. Even if you feel comfortable with the methodology you develop there is no guarantee DCAA will not question it this year or next year (which is another issue raised in this case that we will address later).

This is one of those rare occasions where I will not share some of my approaches for addressing this issue among small business contractors. I prefer to share these on a case by case basis with DCAA if required. They are ethical and defensible, but vary from contractor to contractor.

Some RFPs appear to acknowledge some of these complexities and replace Material Overhead Rate with Material Overhead Fee. Take them at their word and treat it as a fee, a request not to burden materials or subcontractors with G&A while compensating contractors for the acknowledged costs involved in administrating those costs (materials and subcontractors). Do not include it in your rate proposal.

That is until some bright DCAA auditor wonders if the fee should be included in the base….

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Some of Those Pesky Questions Surrounding Timekeeping

With DCAA’s announced return to audit functions other than incurred cost proposals (Annual Report of Congress 2015), contractors need to dust off those policies and procedures and ask themselves a couple of questions. Let us start with labor, timekeeping, and payroll:

How do you control where staff are allowed to charge their time?

DCAA holds to the belief that contractors should authorize employees to on a project and restrict their ability to charge without authorization. Implicit in this is the concern that if Jane, assigned to work on Project A, does not have anything to do on project A, the government does not believe she should wander over to Project B and lend a hand without someone planning for this.

How do you address idle time?

There can be a couple of subtle levels to this question. The first level is literal; how do you address idle time. The correct answer is by charging overhead or G&A.

The second level is: when is idle time too much? When does it become unreasonable and thus DCAA might see the idle time as unallowable?

The old joke about auditors comes to mind – “Definition of an auditor: someone who shows up after the battle and bayonets the wounded”.

I once had a 622% overhead rate approved by the government based on idle time, but not without a fairly extensive fight with the DCAA auditor. The rate arose out of five engineers charging overhead 100% of their time for a few months. The story that won the approval actually involved the Princess of Wales and robots. How could you not win with such a cast? We attributed the idle time to a conflict between a DOD agency and an Army field commander. First, DOD sent these engineers into a foreign area as a perfect place to test their emerging technology. When they got there, the Army field commander informed them that the location was not a laboratory but a combat zone and wanted to know what the heck the paratroopers were going to do with the civilian engineers. DCAA then raised the allegation that the contractors turned the time into a vacation while DOD hashed it out as The engineers sat around charging overhead until the field commander finally sent them home.

I told the DCAA auditor, with a straight face, that I believed the engineers should have charged the project direct and not overhead; but since it was a single contract division it did not really matter.

The point is that idle time is often a reality of government contracting and is not always the contractor’s fault. Addressing idle capacity often calls for hard decisions and the contractor needs to prepare to defend those decisions when tax dollars are involved.

GAO Ruling Supports GSA Decision that Favors DCAA Accounting System Audits Over Private Firm Audits

A recent GSA RFP awarded 9.15%  (7,600 out of 83,100 points) of possible RFP scoring points for approved accounting and purchasing systems, systems approved by DCAA or another government agency. The approval of the critical systems by private accounting firms did not receive any points.

“Evolver and AFSC challenge the agency’s basis for assigning certain points.  Specifically, both Evolver and AFSC challenge the RFP provision that, in order to be awarded 5,500 points for an “audited/adequate cost accounting system,” an offeror’s proposal must include proof of a federally audited and approved accounting system.  The firms maintain that this requirement is overly restrictive of competition, as there are independent public accounting firms that can verify the adequacy of an offeror’s accounting system for federal contracts.  The firms further argue that proof of an acceptable system should not be required with proposal submission; rather, proof should be provided only at the time the government actually requires the service for which the certification is necessary.”

Here is GAO ruling:

“Under these circumstances, where the agency can reasonably anticipate that DOD will be the prime user of the Alliant 2 GWAC, and where DOD does not accept third party certification of a contractor’s cost accounting system, we find nothing improper about the solicitation’s provision that gives an evaluation preference to firms that have a federally audited and approved accounting system.”

Now here is the troubling part of the ruling:

 “In this regard, the agency explains that allowing firms to accrue points in this manner helps to provide a GWAC where successful offerors have experience in government contracting.  In addition, successful offerors will be able to perform cost-reimbursement task orders for DOD from the first day the GWAC is awarded, and procuring agencies issuing task orders under the GWAC will not have to waste time and resources while vendors subsequently obtain an audited and approved system.  Id.  Given this explanation by the agency, we find nothing improper about the solicitation’s approach of awarding points to offerors that have proof of an audited system at the time of contract award.” (emphasis added).

Gee, wouldn’t it be wonderful if a contractor could just call DCAA and schedule an accounting system audit?

http://www.gao.gov/products/B-413559.2,B-413559.8#mt=e-report

 

Really? Meals and Entertainment Expenses

While working on another project this morning, I recalled that twice in the last year; two separate DCAA auditors working thousands of miles apart, asked why the contractor had separate accounts for Meals and Entertainment in their Chart of Accounts.

Enough said?

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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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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