(Editor’s Note. We addressed this issue about nine years ago in the GCA DIGEST where we thought it would be timely to revisitit now. The government is requiring auditors to review contractors’ accounting systems more often, sometimes once a year in many cases. New requirements to focus on “business systems” of contractors and a new push by source selection officials to ensure awardeeshave adequate accounting practices have resulted in accounting system assessments being one of the biggest areas of audit scrutiny
these days.
One of our most frequent consulting engagements involvesconducting a “mock audit” of clients’ accounting practices wherewe put on our “audit hat” and conduct a review of theiraccounting practices to identify weakness that can result inadverse findings during an actual audit. Our audit usually entailsmost of the steps identified below where the result ends in ourpresenting a report on strengths and weakness of the systemalong with recommendations for improvements, provision ofworkpapers that detail the basis of our findings, arecommendation addressing possible changes of accounting forand charging indirect costs and normally either improving orpreparing written policies and procedures government auditorsdeem essential. We thought it would be a good idea to presentsome of the essential steps of conducting such a review socompanies can conduct their own “mock audit.” The advantages of contractors conducting their own audits or askingother independents are substantial: (1) identifies weaknessesbeforehand so there is ample time to take corrective action and
(2) supports the perception that you maintain strong internalcontrols since a key element of such controls includes independentmonitoring of the system. (In the past, if the system was deemedacceptable we would allow the auditor to examine our reportand workpapers which often resulted in reduced transactiontesting since we are CPAs and former DCAA auditors/supervisors. This approach also worked somewhat whencompanies would do their own internal assessments but withincreased emphasis on strict adherence to government auditstandards these days, auditors have significantly lessened thatopportunity but it is still considered an essential internal control.)
Adequate Accounting system
When auditors discuss an adequate accounting systemthey usually do not mean the accounting software youchoose but rather your ability to identify, segregateand report on costs of distinct final cost objectives.“Final cost objective” (FCO) may mean a contractor subcontract but it may also mean contract line itemsor individual task or delivery orders within contracts depending on what are the specific requirements ofthe contract. Basically, you need to demonstrate youraccounting system (no matter what type it is –packaged software, customized software, spreadsheetsor manual) is an adequate project accounting systemcapable of identifying and reporting full costs on aproject basis, particularly for government contracts.
Auditors used to issue one of three opinions –“adequate”, “inadequate in part” or “inadequate” butlately the “inadequate in part” opinion has beeneliminated. This development is unfortunate becausethe majority of opinions used to be “inadequate inpart” where relatively minor fixes could beimplemented and a return visit by auditors normallyresulted in a happy ending. Now, only two opinionsare possible – adequate and inadequate – where thereis little guidance for auditors on how to distinguishbetween the two so not only have “inadequate”opinions proliferated but one auditor’s opinion maydiffer widely from another’s. The critical objective isstill to avoid an “inadequate” opinion since a varietyof undesirable consequences can occur such as failureto be awarded a contract based on cost and pricingdata, suspension of payments on existing contracts,generation of additional audits (e.g. invoice),withdrawal of direct billing privileges, the need todemonstrate adequacy at a later date, etc.
Elements of Adequate AccountingPractices
At a minimum, contractors need to demonstrate theycould pass a pre-award accounting survey that iscommonly conducted by the Defense Contract AuditAgency. The criteria identified in this survey appliesnot only to new contractors who are likely to undergosuch a survey before being awarded a contract butthe same criteria is used to evaluate veteran contractors during subsequent accounting systemreviews. More detailed reviews are required for manylarger contractors but this survey is required of allwhen the government wants to be assured a contractorcan account for specific project costs. The criteria which is identified in Standard Form 1408 includes:
Direct costs are properly segregated from indirect costs.
Direct costs are identified and accumulated by finalcost objective (e.g. grant, contract, subcontract,contract line item and task or delivery order).
Logical and consistent method of allocatingindirect costs to contracts. Allocation of costs need not necessarily be part of the financial accountingsystem but, for example, is accomplished onspreadsheets for those contracts needing adequatecosts (e.g. cost type contracts, fixed price contractswhere there are progress billings or will be used toprice follow-on work, etc.).
Identification of contract costs in general ledger.That is, the costs that are separately identified in a costledger are reconcilable (i.e. visible) in accountsincluded in the general ledger.
Timekeeping system is capable of identifyingemployees’ labor by FCO.
Interim (monthly) determination of contract coststhrough posting to books of account.
Exclusion of unallowable costs.
Must demonstrate cost-type contracts can meetlimitation of cost and payment clauses e.g. visibilityof year-to-date and inception-to-date costs so the 85%notification can be provided. Also, whether fixed price contracts can meet progress billing requirements.Even if fixed price government work is the norm,contractors expecting to use cost data for pricingfollow-on work or if requests for equitableadjustments or terminations occur, you will also needto demonstrate adequate accounting practices forpricing those items.
Conducting the Mock Audit
1. Request all written policies and procedures related to thegovernment accounting system. This does not include normal, often voluminous material on the accountingsoftware nor detailed employee instructions but higherlevel policies addressing the criteria above.Demonstration that contractors have adequate internal controls are critical to demonstrating the accountingsystem is acceptable and written policies andprocedures are often the most critical element ofinternal controls in the eyes of government auditors.The absence of most critical written policies andprocedures will rarely result in an “adequate” opinionthese days. The critical policies and procedures youshould be able to provide include basic accounting
(e.g. distinguishing direct versus indirect costs,charging final cost objectives, accumulating andallocating indirect costs and monitoring those coststhroughout the year), screening unallowable costs,timekeeping, expense reporting and billing (thataddress requirements for adjusting billing rates andensuring subcontractors’ practices are adequate). In addition to these five essential policies, be aware thatsome auditors may have their own personal favoritesthat they consider essential where the most commonones include estimating, purchasing and treatingstandard costs.
2. Conduct interviews. The “mock auditor” should sit down with the key government accounting person(s)and conduct a detailed interview on how the systemworks from the time a source document is received
(e.g. vendor invoice, employee timesheet) through theaccounting system to job cost reports and billings tothe government. Examples of relevant reports (e.g.labor distribution, other direct costs by project, etc.)should be requested and examined. The results of this should be written up, either as a narrative or as aflowchart. In addition other topics where properwritten policies do not exist should be covered in theinterview and notes written up covering such topicsas (a) how direct versus indirect costs are distinguished
(b)
how indirect costs are computed and allocated tocost objectives (c) how actual indirect costs aremonitored during the year and the process forchanging provisional rates (d) timekeeping practices
(e)
expense reporting (d) practices and training onscreening unallowable costs and (f) how limitation offunding requirements (e.g. notification when 85% ofauthorized contract value is expended) are met.Additional topics should be determined beforehandcorresponding to the type of industry the contractoris in and requirements of key contracts either awardedor being bid on.
3. Trace a sample of recent invoices through the system. Select, at least, one or two invoices on high dollar cost typework or job cost records from other high dollargovernment work and trace reported costs backthrough the system.
a.
Trace the invoice to a job cost report identifying costs. If invoice and job cost records don’t match,provide reconciliation.
b.
Trace job cost report to intermediate reports likelabor distribution and AP reports. DCAA is particularly interested in reconciling job cost laborexpenses to labor distribution reports that, in turn,tie to labor hours identified in timesheets.
c.
Reconcile direct job costs to general ledger accounts. If G/L accounts separately identifydirect and indirect costs that’s great; otherwise thedirect costs identified in job costs should beincluded in specific accounts in the general ledger.
d.
Trace a sample of direct costs to source documents. For labor, trace hours to timesheets and hourly rates to payroll records. For a sampleof high dollar ODCs, trace to source documentssuch as vendor invoices and expense reports.Select at least a couple of expense reports andtwo vendor invoices. Reconcile any discrepancies.
e.
Examine selected timesheets and expense reportsto ensure they are consistent with written policies.If there are no written policies, ensure they areadequate according to required prescriptions setforth in the DCAA Contract Audit Manual. Though this mock audit is not intended to evaluatelabor charging practices, gross inadequaciesshould be identified and brought to the attentionof the contractor.
Many companies undergo an accounting system auditwhen they receive or are about to receive their firstcost type or even a time-and-material contract eventhough they may have a long history of fixed price orcommercial item government contracts. Be aware that auditors will not express a favorable opinion onpotential adequacy – they want to see actual contractcost data when they come. When they do come, theywill ask to see the types of records discussed aboveon an actual contract so be prepared to show at leastthree months of actual data. We usually recommend“pretending” one of you government contracts is acost reimbursable contract and generate at least aquarter’s worth of direct cost data for that contractensuring the reports discussed above are available.If not easily accomplished with your normalaccounting system, generating off-line spreadsheetsis normally accepted as long as the data is reconcilablewith your accounting system data.
Prepare workpapers. Compile workpapers where, atleast, an evaluation of each major element of anaccounting survey is identified. Ensure each significant observation is identified and eachconclusion is logically tied to adequate documentation.If the contractor’s system is likely to be consideredadequate, either as it is now or after certain specificitems are fixed, then be sure the workpapers are inlogical and proper order so that an auditor mayreview them.
Write a report. Prepare a report that includes anexecutive summary and details of each major section.We prefer to use an observation-evaluationrecommendation format but other formats are fine. Both positive and negative evaluations should beclearly spelled out and corrective action needed toreceive an “adequate” opinion highlighted.
Both the workpapers and report can be provided toa government auditor if the accounting practices areadequate or will be adequate by the time accountingpractices are audited. If not adequate, you need notalert the auditor to the report. The process ofpreparing a “mock audit” plan, drafting a request fordata, conducting the review, preparation ofworkpapers and a report usually takes about 10 days(probably more your first time). We find that contractors unanimously consider the benefits of the“mock audit” to be worth the effort.
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