(Editor’s Note. DCAA has issued a third report to Congress that contains a variety of statistics on questioned costs and elapsed time to complete audits as well as proposals that indicate a “significantly greater intrusive focus” if they are adopted. The source of our information is based on an article in the September 2014 issue of Government Costs, Pricing and Accounting Report written by our colleague Bill Walter and Mark Burroughs of Dixon Hughes Goodman.)
Background
Though DCAA has been around a long time this report is only the third annual report issued. It is based on the requirement in the 2012 DOD Authorization Act for DCAA to issue an annual report describing its activities for the previous fiscal year that must include (1) significant problems encountered during its audits of contractors (2) statistical tables showing total number of audit reports completed and pending, priority given to each type of audit, length of time taken for each audit, total dollar value of questioned costs (including dollar value of unsupported costs) and pending audits (3) summary of recommendations of actions and resources needed and (4) any other matters of signifi cance.
Statistics
The report provides a variety of statistics for the last three years where the authors select reported statistics they believe show important trends that will most likely impact how contractors evaluate their pricing strategies and risk mitigation efforts.
Incurred Costs. In 2012 the first report addressed a large backlog of incurred cost audits that were not completed and that was growing. It told the GAO it would adopt a new risk assessment process to determine high and low risk submissions where all high risk ones and a small sample of low risk submittals would be audited where all other low risk submissions would be closed out administratively through the use of a memorandum and no audit would be conducted. In addition, its action plan to reduce the backlog included creating dedicated incurred cost audit teams, conducting multi-year audits, initiating low risk sampling and growing its workforce. Though it was not given additional staffing DCAA reported it had completed 8,616 audits in 2013 compared to 4,088 in 2012. It reported that in 2013 it had a backlog of 23,000 (15,000 “on hand” waiting to be audited and 8,000 “waiting” – received but returned to contractors for being inadequate) which was a reduction over 26,000 in 2012.
Net Savings, ROI and Questioned Costs. DCAA provided statistics showing that net savings to the government had increased from an average of $2.5 billion in the 2003-2009 period while it increased 50% in the last four years to $3.7 billion and another 75% over the earlier period in 2013 to $4.4 billion. Computing a return on investment, net savings sustained by contracting officers for each dollar spent, DCAA showed a $7.30 amount, the highest in a decade. DCAA also recommended $16 billion in recommended deductions from proposed or claimed costs which indicate a higher percentage of questioned costs as a percentage of dollars examined. The authors find this trend of increased questioned costs troubling in the current environment where contractors are working hard to find ways to decrease their costs to remain competitive while their costs related to compliance with government regulations are increasing.
Length of time to Complete Audits. Though it states it works closely with COs to establish due dates to meet government needs, DCAA, not COs, determines when an audit is to be completed. DCAA reports it has reduced the elapsed dates for a proposal or demand audit from four months to 3.25 while the time for incurred cost audits has increased from 2.6 years to three. Despite DCAA’s insistence it should not be limited to a standard time to complete its audits where it must comply with generally accepted government
Fourth Quarter 2014 GCA DIGEST
auditing standards (GAGAS) the authors point out that over three months to complete a proposal audit when most solicitations establish 30 days for a contractor to complete its proposal is too long to effectively support the CO in most circumstances.
DCAA Challenges
In its desire to provide the highest value to its stakeholders the report lists a number of deficiencies in the acquisition process and has recommended changes.
Forward Pricing. Though the report states there have been significant improvements since its proposal adequacy checklist was issued in March 2013 it still cited inadequate contractor proposals as a significant barrier to performing high quality and timely audits of proposals. It is recommending that a forward pricing rate proposal checklist be approved.
Sufficiency of Commercial Pricing Documentation. For the last decade there are demands for cost analysis to demonstrate a proposed price is fair and reasonable. DCAA’s report strongly reflects “heavily cost-justified approach to what is and is not adequate commercial – item pricing support” where now there are demands to include non-certified cost data called “data other than cost or pricing data.” The report, whether it addresses prime or subcontract offerings, states contractors do not provide sufficient documentation necessary to support commercial item documentation which the authors disagree with.
Authority to Review and Subpoena “Data Other Than Cost or Pricing Data.” In what the authors state is the greatest risk to industry, DCAA wants to substantially broaden its subpoena authority, which is currently limited to “certified cost or pricing data,” to have subpoena authority to “data other than cost or pricing data.” The report puts the contracting community on notice that a proposal for this subpoena power has been submitted.
Other Access Expectations
The report also indicates that DCAA is expanding its reach to areas contractors do not allow DCAA auditors to reach: (1) Access to Internal Audit Reports – despite court ruling that internal audit reports are judgments of the audit team and not cost or pricing data DCAA is continuing to press unlimited access to these reports where now such access is limited to internal control objectives (2) Access to Employees -DCAA is seeking legislation to provide its auditors with direct access to conduct interviews and observe contract employees which it asserts is a requirement of GAGAS where contractors want to ensure that DCAA talks only to those employees who have knowledge of the topic or issue being audited and (3) Read-Only Access to Online Data – DCAA continues to push for legislation to provide read-only access to contractors’ online data where some contractors currently do so while many others do not.
TREATMENT OF DEDUCTIVE CHANGES
(Editor’s Note. Reductions of work effort under current contracts are proliferating in the current budget constraint environment. You usually have choices in the way you characterize these reductions which will affect how much you may recover. Several changes have occurred since we last addressed this issue. Many parts of the following article are based on a recent article in the September 2014 issue of Contract Management by Mark Garrette who is a contracting officer at Wright Patterson AFB while those sections how to quantify changes and terminations are based on our consulting experience helping clients prepare, negotiate and resolve proposals related to deductive changes.)
Over the next several years the government contracting industries are expecting an explosion of contract reductions and partial or complete terminations to meet the across the board spending cuts being projected (e.g. $1.2 trillion from sequestration). When the government scales back requirements on existing contracts they must consider how they will treat the reductions where there are basically three types of treatments: (1) a “change” (covered by FAR 52.243-1 through 4)(b) or (2) “termination for the convenience (T of C) of the government” (FAR 52.242-2).
In all circumstances, the government will be looking to make a downward equitable adjustment in the contract price for these actions where the contractor is entitled to specifi c types of cost recovery since their business may be impacted from the reduction in contract price. The way a scope reduction is characterized directly affects the amount of the price adjustment. Though the decision ultimately lies with the contracting offi cer, contractors, in practice, usually have considerable input in how to characterize the reduction.
Why a Termination or a Change?
There are several reasons why a termination or a
change would be preferable over the other:
Recovery under a Termination Versus a Change
The termination for convenience clauses provide that the contractor may request an equitable adjustment in the price of the work that remains on the contract to compensate it for any additional costs incurred by performing the remaining work. Under a termination for convenience (T of C), a price adjustment may be requested on the continued portion of the contract. When calculating costs under a T of C circumstance, the costs are usually those already incurred, that is retrospective. The adjustment will not (1) include anticipated profits from the terminated work (2) increase the contractor’s profit margin or (3) reverse a loss position. (Editor’s Note. For more information on maximizing recovery under a T of C, see prior articles using our word search at our website. We intend to address new developments related to T of Cs in future articles of the DIGEST,)
The changes clauses provide a slightly more convoluted approach to cost recovery. A deductive change subtracts the amount that the deleted work “would have cost” including the profi t reasonably attributed to the cost of that work. Stated differently, the price adjustment the government is entitled to is the difference between the estimated reasonable cost of contract performance without the deletion and the estimated reasonable cost of performance with the deduction. Unless the deleted work is clearly severable from the contract (discussed below) the contractor’s actual bid price is irrelevant. For example, consider the scenario where there is a contract to provide new carpeting installed in a five story building for $50,000. If the government decides not to carpet three floors it must lower the contract value by the actual amount this work would cost to perform. If the three stories of carpet costs $8,000 for each story, the contractor would be paid $26,000 ($50,000 minus $24,000).
An important consideration in deciding which method to use is whether the contract is in a profitable or loss position. As a general rule, if the contract is profi table, deletion of work through a deductive change is better for the contractor while on a loss contract, a partial termination is better. In the case of profi table work, the contractor may be entitled to retain a substantial part of its anticipated profit under a deductive change scenario since it must quantify the reduction by only its projected costs. Under a partial termination for the deducted work, the contractor would be entitled only to a “reasonable” profit on the work actually performed. However, when the work on a contract is unprofitable the effects are amplified. A contractor bears only a proportionate a share of its anticipated losses on the unterminated work under a partial termination while a deductive change would cause the contractor to lose the same aggregate amount of money as before work deletion. This can be clarified by an example. In the hypothetical example described above, consider the same facts in the $50,000 contract except the contractor bid too low and it will cost the contractor $12,000 to carpet each fl oor ($60,000 total). If the government decides to carpet three floors, that will reduce the contract value $36,000 leaving the contract with $14,000 to complete the two floors costing $24,000. So here, just as the contractor would have lost $10,000 had there been no deduction, it loses the same $10,000 after the deduction.
Other Considerations
The Court of Federal Claims was more ambiguous saying if major portions of the work is deleted and no additional work is substituted then the partial termination is supposed to be used (Niger Ele. Co v. US., 442). A CO’s determination that deleted work is a deductive change will not be overturned if the government and contractor has consistently treated the deletion as such while the change was being executed. In the case, the board considered the government action to be a termination but ruled it could be treated as a change because “it did not want to disturb the parties’ treatment of the work as a deductive change” (Goetz Demolition Coo., ASBCA No. 39129).
Several cases have addressed what evidence should be accepted over other when pricing the deductive change. These include: (1) actual costs of identical work was considered more relevant than government use of estimating manuals (ASC Constr. Co.) (2) invoice between a contractor and vendor for an identical item was better than a contractor’s proposal (Atlantic Elec. Co.) and (3) postaward quotes from vendors were superior than a contractor’s prebid estimate (Glover Const. Co.). In another case addressing a common error made by the government, the Board rejected the government’s attempt to price partially completed work by applying a straight proration of the line item amount to the percent completed noting such an approach ignores that certain fixed costs and other costs are expended early in performance making the performance rate of expenditure non-linear with the pace of performance (Tom Shaw, Inc.).
When the government is unable to validate estimates based on the contractor’s cost records, the Courts have shown a willingness to consider other means for pricing deductions such as (1) when deleted work is a commodity, market prices have been used (2) estimating manuals can be used to develop a price in absence of cost data though such evidence must give way to actual contractor costs (3) absence of consideration of learning curve estimates when they should apply has resulted in downward adjustments and (4) contractors’ certified cost and pricing data has been used (this makes artificially high cost estimates not only subject to defective pricing allegations but costly if they are used for estimating deductive changes). Lastly, specific provisions in a contract for pricing deductive changes have been ruled to prevail over general rules.
The exception has been extended by the courts to punish contractors who use unbalanced bidding or when a significant windfall would occur. For example, the government deleted certain encapsulation work from an environmental remediation contract where the contract price was $52,000 but the contractor proposed $1,200 based on a subcontractor’s bid price for the work. In spite of the fact the encapsulation work was not severable in the contract the court ordered the price adjustment to be $52,000 because to provide $1,200 would result in an unfair windfall.
Case Study…
CHALLENGE TO QUESTIONED COSTS CLAIMED TO BE NON-ALLOCABLE “COMMERCIAL” COSTS
(Editor’s Note. Though the government is required to pay a “fair” price for its products and services, there is considerable effort put into lowering prices paid. One of the most fruitful methods of lowering the price paid is to assert that a given cost allocation method adopted by a contractor should be altered to achieve a more “equitable” (translated – lower) price. We frequently encounter such positions in our consulting practice and when we think the government’s position is wrong, we challenge them. In our ongoing interest to provide our readers with “real life” case studies, we thought we would present the results of a consulting engagement we had to challenge a Defense Contract Audit Agency draft report questioning significant costs on the grounds the expenses were “commercial” and hence not allocable to government contracts. The following presents a highly compressed list of challenges we presented where though every point put forth would likely not apply to your unique circumstances, some most definitely will.)
Background
The company (the contractor is real but we will not divulge the name) creates and sells software and provides IT services to a variety of government and commercial clients as both a prime contractor and subcontractor. The market for its software products and IT services varies. Products originally intended
for the government market sometime become potential and actual sources of commercial business while, conversely, products developed for commercial use often become attractive to its government sector clients. For example, many of its products and IT services originally targeted for the commercial market are included in GSA schedules marketed to the government sector.
In 2005, the company purchased a company that sold software to a variety of commercial companies in the energy field. The company was attractive because its technology could enhance Contractor’s existing line of products and it saw a large potential business in both the commercial and government markets. Though some of the technologies were adapted to Contractor’s existing product line, the product line of the new company was discontinued in 2007 due to significant software problems that could not be fixed. Included in the labor overhead pool are costs associated with the new business line where Contractor chose to capture these costs in three separate accounts to ascertain what its investment was.
DCAA conducted an accounting system audit in early 2006 where it concluded Contractor’s accounting system was “adequate” and provided “a logical and consistent method for allocation of indirect costs to intermediate and final cost objectives.” During earlier incurred cost proposal audits in 2004 and 2005, the company actually proposed creating separate commercial and government rates where DCAA rejected that suggestion, recommending instead that the overhead pool be established on a companywide basis. Contractor agreed not to attempt to segregate overhead between government agencies and commercial customers and subsequently submitted its 2005 Fiscal Year Overhead Submission on a basis which did not distinguish overhead rates based on the class of customer. This was accepted by DCAA.
DCAA’s Position
In its audit of Contractor’s 2006 incurred cost submittal, DCAA eliminated $650,000 of indirect costs from its overhead pool representing the three cost accounts discussed above, asserting these costs were related to “commercial activity.” DCAA also eliminated $75,000 from the overhead labor base asserting these were direct costs associated with the “commercial” contracts of the acquired company. The result of these questioned costs were to reduce Contractor’s overhead rate by over 30 percentage points.
The basis of DCAA’s position was that allocation of about 50% of the firms overhead costs were associated with “commercial activities” of the new product line while the labor base associated with this activity represented only 10% of the total overhead base of direct labor. They asserted the commercial contracts provided little “proportionate benefit” to the government and resulted in an “inequitable” allocation of costs to government contracts. DCAA asserted these costs “represent(s) indirect expenses identified to Contractor’s commercial product lines that are not allocable to government contracts and should be allocated to the commercial contracts through a commercial direct labor base.” Rather, consistent with FAR 31.201-4(b) and 31.203(b) Contractor should create separate indirect rates for its commercial work.
Basis for Disagreeing with DCAA’s Position
(Editor’s Note. In the past, we have successfully put forth the equitable estoppel argument. The principle, supported by many court and board decisions, will not permit a retroactive disallowance of costs when the contractor can show that it reasonably relied on the government’s prior conduct especially when it can show a history of acquiescence or approval of a particular cost accounting practice by the government which is the case here. However, recent cases have established that the hurdle for asserting the equitable estopple argument is significantly higher where now the Contractor must show the existence of bad faith on the part of the government in addition to the other conditions.)
Whereas FAR 31.203(b) provides general guidelines in grouping indirect costs (i.e. logical groupings such as manufacturing overhead and G&A, selecting an appropriate distribution base) there is no suggestion that overhead pools should be grouped by customer type. It is simply too great a stretch to reference this FAR section as providing support for distinguishing commercial versus government costs and then advocating that separate rates be established.
Though Contractor is not CAS covered, the cost accounting standards are instructive. It should be noted that there would be a violation of CAS 401 (consistency of how costs are proposed , accumulated and reported) because DCAA’s proposed retroactive establishment of separate rates would confl ict with the manner in which it proposed prices on its prior contracts including its prices used on the GSA schedule. Further, CAS 418 provides that indirect costs shall be accumulated in indirect cost pools, which are “homogeneous.” The Standard provides in part: “An indirect cost is homogeneous if each significant activity whose costs are included therein has the same or a similar beneficial or causal relationship to the cost objectives as the other activities whose costs are included in the cost pool.” (underscored for emphasis). Contractor’s overhead pool is homogeneous. The elements included in its overhead pool, for the most part, have the same or similar beneficial or causal relationships. As stated above, Contractor is a laborintensive business and the support costs are similar for both government agencies and commercial customers. Contractor’s employees are not assigned by class of customers and they work on both government and commercial contracts.
We are waiting to hear DCAA’s response.
Knowing Your Cost Principles and Cost Accounting Standards
GIFTS AND HOSPITALITY RULES AFFECTING GOVERNMENT CONTRACTORS
(Editor’s Note. In this era of increasing GAO and IG investigations of government contractor actions all individuals and companies interacting with government officials must become aware of the strict ethics rules of doing business with government agencies. New rules and cases in this area has made it timely to address this issue. The following article is based on the June 2014 Briefing Papers by Jessica Tillipman, Assistant Dean at the George Washington University Law School.)
FAR 31.101-1 articulates the overall policy of all government entities, whether federal, state and local or foreign – “Government business shall be conducted in a manner beyond reproach and except as authorized by statute or regulation, with complete impartiality, and with preferential treatment for none. Transactions relating to the expenditure of public funds require the highest degree of public trust and an impeccable standard of conduct.” To ensure individuals involved in government procurement adhere to this standard, government entities in nearly all jurisdictions have established codes of conduct, ethical restrictions and anti-corruption laws where nearly all have established prohibitions on gifts and hospitality that may be accepted by government officials. While gifts and hospitality play an important role in conducting business in the private sector in the public sector these common practices and courtesies may be interpreted as attempts to infl uence public offi cials. Ethics and anti-corruption laws vary widely by jurisdictions resulting in considerable confusion over what rules apply. The following article attempts to provide an overview of these rules.
Government Ethics Restrictions on Gifts and Hospitality
Most of the laws target the relationship between the government and contractor to ensure the transactions are free of corruption or even the appearance of impropriety. Contractors that work in a variety of jurisdictions – federal, state-and local and foreign – are faced with a bewildering assortment of rules.
US Federal Restrictions
The Office of Government Ethics (OGE) maintains a website that summarizes relevant laws as well as provides guidelines and training materials. In recent times, the complex rules have been complicated by the expanding use of government outsourced personnel where contractor-employees work side-byside with government officials where common office traditions of birthdays, retirement and holiday parties create ethical issues. Though the policies are straight forward, the rules are fairly complicated where they are riddled with exceptions and nuances. As a general rule government employees are prohibited from directly or indirectly soliciting or accepting “gifts” from a “prohibited source.” Companies that contract with or seek to contract with the federal government fall under the definition of “prohibitive source” while a gift is deemed to be given because of a federal government employee’s official position if a gift would not have been offered or given if the employee was not working for the government. The definition of “gift” includes hospitality as well as any other item of monetary value. Excluded from this definition are items of little intrinsic value such as modest refreshments (that are not a meal), plaques, discounts available to the public and honorary degrees. However, included in the broad definition of “gifts” are many items that are business courtesies in the private sector such as meals, entertainment and transportation. If an item is not explicitly excluded as a ‘gift” it is probably prohibited unless a limited exception applies. Unless a gift falls under one of the following exceptions, it is “the safest course” to assume the gift is prohibited.
State and Local Ethics Restriction
Though federal rules can be difficult they can nonetheless be identified on user friendly websites while tracking down the vast work of state and local ethics rules can be a huge task. Though no single article can summarize the gift and hospitality rules of all 50 states and thousands of local agencies, the article does provide a few useful examples that appear to be common in most locales. Some states maintain “zero tolerance” (“no cup of coffee” states) such as New Jersey where “no state officer or employee…shall accept any gift, favor, service or other thing of value” except something of trivial value or offered to the general public under the same terms and conditions. At the other end of the spectrum are states that place no monetary restriction of giving gifts or hospitality to government officials where in South Dakota the only restriction is to prohibit giving to improperly influence an official action, making gift giving virtually limitless. Some states have had similar permissive gift giving where they are now tightening rules such as Virginia where there is a recent executive order to cap gifts at $100 though there is still no cap on cumulative value. Assuming a contractor can locate relevant state gift restrictions it must also consider more stringent rules applicable to specific agencies or localities.
Foreign Ethics Restrictions
Contractors doing business with governments outside the US may have the most difficult task locating gift and hospitality prohibitions where they often must hire local help to wade through the requirements. Many restrictions in other countries are notably less stringent than those in the US where because the foreign laws are comparatively newer, they are not well developed or well enforced. A few examples follow.
US Foreign Corrupt Practices Act
Generally, the FCPA prohibits the bribery of foreign government officials and requires covered persons and entities to maintain accurate books and records and an adequate system of internal accounting controls. The anti-bribery and accounting provisions are intended to work in tandem where companies are to be prevented from hiding bribes or other improper transactions in off-book accounts or slush funds but also the government may prosecute companies for violating accounting provisions even in the absence of a separate anti-bribery violation. Key provisions include:
to convince other countries to enact anti-bribery prohibitions similar to the FCPA, contractors conducting business outside the US are likely to find themselves within jurisdictional reach of criminal anti-bribery laws of other countries.
Compliance
The problems of complicated and difficult to find laws and rules both domestically and internationally is exacerbated for contractors by a multitude of different rules in a particular jurisdiction. They are faced with the question of how do they ensure compliance with the law when the same activity of giving gifts and hospitality is subject to dozens (maybe even hundreds) of different laws and standards with varying interpretations. A vigorous compliance program is needed. Though too detailed to summarize here, a few words might be helpful.
Written Guidance
Many jurisdictions have developed guidance. For example, the DOJ and SEC has “A Resource Guide to the US Foreign Corrupt Practices Act” that outlines the “Hallmarks of an Effective Compliance Program.” Many other jurisdictions also have written guidelines.
Policies and Procedures
Written policies and procedures are highly advised. The common format of Gift and Hospitality Policies and Procedures might include: (1) Defining the Purpose, Scope and Relevant Terminology (e.g. who is covered, limited to government officials versus all private parties) (2) General Policies and Procedures (e.g. a brief statement saying the company competes solely on the merits of its products and services) (3) Prohibited Gifts and Hospitality (e.g. cash, cash equivalents, per diem payments, loans, etc.) (4) monetary caps (e.g. determine if any dollar cap should be imposed, consistent with the 20/50 rule) (5) Government Offi cials vs Private Parties (e.g. separate policies may be desirable for each group (6) Spouses, Relatives and Friends (e.g. generally prohibited) (7) Personal Funds (e.g. can’t use personal funds of covered individuals (8) Travel and Hospitality Expenditures of Government Officials (e.g. detailed provisions) (9) Acceptance of Gifts (e.g. compliance with Anti-kickback Act, monetary thresholds)
Internal Controls
The level of controls will likely vary with the vulnerability of the company, size and desire of how dedicated corporate funds should be used to address the compliance functions. Examples of controls might include (1) Gift & Hospitality Request Form (e.g. as part of a detailed approval process) (2) Approval Authority (e.g. designating individuals or positions that must approve) (3) Procedures to Address Red Flags (4) Itemized Receipts Required and Information Needed) (5) Proper Recording in Books and Records (6) Gift and Hospitality Database (7) Routine Audits and (8) Training (e.g. annual anti-corruption and compliance training to covered individuals).