(Editor’s Note. There are several acceptable ways to account for contract labor for costing and pricing purposes and each should be considered in the light of your pricing objectives. Purchase labor has been a “hot topic” of late and our article, though based on no particular source, is a result of numerous articles and our own working knowledge.)
The use of contract labor has definitely increased over the last few years. Several factors have contributed to its proliferation. First, significant downsizing and early retirements in recent years have contributed to a significant staff shortage requiring use of former employees as consultants. Second, a tendency to use more specialized subcontractors and teaming arrangements have expanded the integration of subcontractors into the prime contractor’s workplace. Thirdly, the price competitiveness of many firms chasing fewer dollars have resulted in the use of temporary staff to cut down on overhead and fringe benefits. Whatever the reason, the use of such purchased labor has proliferated at both the prime and upper tier subcontractors’ own facilities and field offices.
There are numerous way of accounting for contract labor that work at the contractors workplace:
Direct Costing
The most common way of accounting for this labor when the dollars are insignificant is to allocate the costs to “other direct costs” when the work is for a contract or as “indirect cost” when the work is for an indirect function. However, when these costs are significant, the direct costing allocation may be inappropriate. For example, if half the workforce at a contractor’s facility is contract labor while the other half is employees and all individuals work at the same place, then the normal practice of allocating overhead only on employees may greatly alter cost allocations to specific contracts when the ratio of purchased labor to employees is not uniform. The failure to allocate the workplace costs to both contractor employees and non-employees may be considered inequitable by the government.
Other Costing Methods
One solution for such inequitable cost allocations would be to include the cost of contract labor in the direct labor cost allocation base for overhead. For pricing purposes, when average direct labor rates are used, the cost of contract labor would have to be included with contractor employee costs to determine an average rate. This has the result of increasing direct rates and lowering overhead (because of the high denominator number).
Commonly, contract labor rates per hour are greater than employee rates especially when a company is providing the purchase labor because they may be paying limited fringe benefits and are including a markup. If the entire amount was a direct charge it might be inequitable because fringe benefits for employees would be allocated to direct labor which includes employees and contract labor, where the later already may include fringe benefits and markup. Consequently, contract labor charges may be excessive if they include two fringe benefits allocations (e.g. one from the subcontracting company and one from the contractor) and the markup would be charged only to that contract(s) where the contract labor is used and not to others.
When the rate difference is substantial, other cost accounting techniques may be necessary. One method would be to segregate the invoice from the company (or from the individual consultant or contract employee) into a direct labor cost portion and an overhead portion. The justification for this treatment is that the invoice is comparable to the direct charge plus some overhead of contractor employees. The segregation of costs can be accomplished in three ways:
Segregate the direct labor cost portion based on the direct labor rate of a comparable employee and allocate the remainder of the cost to overhead pools.
Segregate the direct labor cost portion based on invoice information from the provider.
Prorate the invoice to direct labor and overhead based on the ratio of direct labor to overhead experienced by the contractor.
Though Option 1 is the most common method, the concept underlying all three has been validated by an Armed Service Board of Contract Appeal decision (Software Research Associates, ASBCA 88-3 BCA). In the case, the contractor entered into a time and materials contract where all-inclusive fixed rates for various labor categories were established. During contract performance, the contractor used contract employees and billed at the rate established for direct labor categories. The government argued this labor could not be billed as direct labor because the labor was performed by non-employees resulting in an unfair windfall for the contractor. Rather the contract labor should be invoiced as an “other direct cost” or as “material” of the T&M contract.
The Board disagreed because the work performed by the contract employees was indistinguishable from that provided by contractor employees. The government’s windfall argument was insufficient to overcome this fact and the Board concluded one of the three methods (or a similar alternative) identified above would be acceptable provided the method used was consistent with the way it booked charges for government reporting purposes.
DCAA Guidance
The Defense Contract Audit Agency has a section in its Contract Audit Manual on Purchased Labor in Chapter 7-2102. Unless purchased labor is used to meet temporary or emergency requirements, auditors are told to “carefully study” the contractor’s practice to determine whether additional costs are reasonable, necessary and properly allocated to government contracts.
Initially auditors are told to (1) review any written policies on treatment of purchased labor (2) analyze the practices of treating purchased labor in the current and most recently completed fiscal year (3) determine the number of purchased labor (4) ascertain the duration of engagement (5) compare number of employees in each relevant classification to purchased labor (6) compare the cost per staff-year with contractor’s comparable personnel (7) evaluate the reasons for using purchased labor especially for periods exceeding one year and obtained technical input if needed and (8) determine the extent of purchased versus employee labor on government versus commercial work and on cost type versus fixed price government work.
The guidance notes that contractors may treat purchased labor as either other direct costs (e.g. subcontractors) or as direct labor with the excess over employee labor charged to overhead. In determining whether the allocation of costs are “equitable” the guidance states auditors should follow the fundamental requirements of CAS 418 that states pooled costs should be allocated to cost objectives in a reasonable proportion to the causal or beneficial relationship of the pooled costs to cost objectives. Purchased labor should share in an allocation of indirect expenses when there is such a causal beneficial relationship and the practice should be consistent with the contractor’s disclosed or normal practices. The guidance states sometimes a separate allocation base may be necessary to allocate significant overhead costs to purchased labor such as supervision and occupancy costs or it may be necessary to eliminate certain costs that do not benefit purchased labor such as fringe benefits.
For example, consider the difference between inhouse and offsite purchased labor. When purchased labor is used in-house, the guidance states normal overhead costs excluding fringe benefits may need to be allocated to purchased labor. When purchased labor is performed offsite where supervision and control is by an entity other than the contractor, none of the contractor’s labor overhead costs may be allocable to purchased labor. When contractors use other practices they will need to show that either the impact is not significantly different or that it is justified.
(Editor’s Note. In addition to exploring “hot issues” in reasonable depth, the GCA DIGEST also tries to provide practical help in costing and pricing actions. In the following guest article, we attempt to give some insight into how the government will respond to a contractor’s cost proposal and what information you may want to consider providing in order for the government to justify awarding you the contract at an attractive price. The article was written by Katherine Szymkowicz who is a principal and consultant with The Acquisition Network (TAN) and before that was a Contracting Officer for the Federal Government (GSA, Navy, Army) for over eighteen years. Kathy can be contacted at 415861-0556 and says “She’d love to talk with you”.)
As a contracting officer overseeing up to thirty COs and Specialists, I saw every type of submittal and heard every argument for a price that you can imagine. I have seen (through horrified eyes) negotiations stalled for months over the number of brooms to be used to clean a ten-story building. I’ve seen negotiations for a $10,000 job take over a year to complete! I have seen contractors walk away from the negotiation table because they simply couldn’t afford the time it was taking to submit their proposal in another format. How easy it could have been if only the contractors understood what the CO wanted.
It all comes down to the cost proposal. All business development effort and expense you put in is aimed at getting that cost proposal to the contracting officer. The better you understand what the CO wants and how the cost proposal is reviewed, the better are your chances of presenting a proposal that will result in the award of a price you want.
The CO receives the Government Estimate (GE) from the technical person supporting the job. The GE will be itemized into a format with a cost for each line, totaled for the bottom line GE. When you bid a job or are a part of competitive negotiations (i.e., “the Best Value”), bottom line is what counts. But during one-on-one negotiations the CO will be looking for agreement among those lines of numbers provided by the technical expert.
Most often the contracting officer reviewing a cost proposal is not a technical expert in the field for which the procurement is being made. This means the CO will depend very heavily on the Government Estimate that is prepared by the technical specialist. The CO will take the GE and assume it is correct. Your cost proposal will be compared, line by line, to the GE. Anything that does not match, whether higher or lower than the GE, will cause concern.
This approach emphasizes the need for your cost proposal to be in the same format as the GE. The more information you have up front about the Government’s estimating format the better. Most of the time the GE will itemize each work classification (i.e., Principal, Project Manager, Electrician, etc.) as well as materials, supplies, overhead and profit indicating percentage for each. If negligible, these and other items may be grouped as a single item but do not be afraid to over itemize.
If you have identified different work categories, the CO might question or disallow prices that are in fact close or identical to the Government Estimate because the cost is not recognizable to him in the format you provided. For example, your proposal might present Project Management as a single category for costs, showing a line item cost of $45,000 which includes costs for a site office. The Government Estimate shows Project Manager at $23,000 and Principal at $12,000. The CO looks at this, compares $45,000 to $35,000 and lets you know you are too high and it becomes clear after several rounds of (costly) negotiations that he will not accept more than $35,000. Now he has not told you what his GE looks like, so without asking the proper questions and giving him the proper information, you will not know that in fact your price includes elements that are not included in his.
In this case the CO has not considered the fact your Project Management includes the direct costs for the site office. The CO has allowed for this in the development of his overhead estimate. What he has not done is move it from the overhead allocation to the Project Management line to match your proposal. Your best approach at this point is to explain to the CO exactly what is included in your Project Management costs. Basically what you are attempting to do is show him that he has included the cost somewhere else, but you are not given the luxury of viewing his total proposal to know exactly where the costs are hidden. You must give him enough information to make the determination himself.
There are other circumstances where your costs are simply higher than the GE. When this occurs, it is your job to tell the CO why your costs are higher in such a way that he can justify the increase. Again, this can be a game of twenty questions since you don’t know exactly what the Government has based their estimate on. But with the right information, you can lead the CO to the place where he sees that your price is higher because you have included something that he did not include AND THAT HE NEEDS!
For example, your estimate shows 98 hours for Painters; the GE is much lower (though of course the CO won’t tell you how much lower, only that it is A LOT). Tell the CO exactly what the Painters will be doing and how you determined the hours. When you say “I allowed for 8700 square feet, two coats, you may find a difference in square footage or the CO may realize that the GE is based on one coat (the specs were vague). Or when you explain that OSHA requires two workers for the height involved, you may learn that the Government forgot that little detail in their estimate! But the more information you give the CO, the more he has to justify your price. Just remember that the CO will never write: “GE says 45 hours but the contractor insists she needs 98!” He will write: “The GE allowed for a crew of one person, but OSHA regs for the height involved require a two person crew. The increased crew does not provide for accelerated accomplishment of the painting since the structure makes it impossible for more than one painter to work at a time for 80% of the effort.” But he will write this only after you have helped him understand the justification!
Justifying costs can be done by itemizing the work included and by using industry rules of thumb. “The CADD Specialist is producing this many drawings in this many hours, the Project Manager is 10% of the total labor hours. “ This type of reasoning gives the CO what he needs to justify your price.
The bottom line is realizing that the CO must justify any deviation from the Government Estimate. This line is higher, this line is lower and this is why. This is the purpose of the final Memorandum of Negotiations which results in your award. The GE and your proposal will be lined up, item by item and where there are deviations after negotiations, the CO will state the justification for the change to the GE. Where you do not provide adequate justification, the GE will remain unchanged and your price adjusted.
Understanding what the CO wants and why is the first step in successful negotiations. By providing the CO with a proposal in the proper format, then giving the justification needed for any areas of concern will likely result in a price you can love and will make the CO’s job easier. You can bet he will remember that next time he’s looking for a contractor in your field.
(Editor’s Note. Under such names as “outsourcing” and “privatization” the government is definitely moving toward having private firms provide many of the services and goods formerly provided by government employees. In 1998 Congress passed the Federal Activities Inventory Reform (FAIR) Act that sets the ground rules for outsourcing. Once government agencies identify their list of activities that can be outsourced the FAIR Act requires them to compare the proposed costs of private sector procurements with performance costs of the activity by the government. Since many costs incurred by one sector is not incurred by the other comparison of private versus public costs of an activity must be comparable to determine who is offering the lowest price. The office of Management and Budget has issued guidance for computing and comparing such costs in Circular A-76 “Performance of Commercial Activities” and its Revised Supplemental Handbook. The following article presents some of the guidance government agencies follow when they estimate their costs and conduct a cost comparison following the OMB guidelines which should be useful to contractors who want to have an idea on the prices they need to beat. It is based on an article in the January 2000 issue of Contract Management written by Steven Berkowitz, a CFO in the National Institute of Health who has conducted more than a dozen cost comparisons.)
An agency develops a cost comparison based on the government’s most efficient organization for accomplishing the work as described in the performance work statement (PWS). The PWS does not necessarily reflect current staffing or costs to perform the work but rather the most efficient effort. The PWS is what both private contractors and other government agencies bid on.
The cost comparison includes only those costs that would change if an agency either contracted out or brought in-house a commercial activity. The cost comparison should not include costs that would be the same regardless of who conducts the work such as government furnished supplies, materials, space, etc. There are two types of cost comparisons: an extensive cost comparison for those commercial activities requiring 65 or more full time equivalents (FTE) of effort and a streamlined approach for cost comparisons conducted for commercial activities with less than 65 FTEs. The streamlined cost estimates rely on the same techniques but focuses mostly on personnel and material costs. The following will focus on the extensive cost comparison.
Personnel and Fringe Benefits
Personnel and fringe benefits are usually the largest cost factor in a cost comparison. To compute these costs, the guidance calls for first identifying the number of productive hours required by the PWS separated by the type of labor required and the general schedule and federal wage schedule grade level of the staff. The next step is to calculate the FTE’s by grade level by dividing the total productive hours identified in the PWS by 1,776 hours. For intermittent positions, divide by 2,007 to derive the FTE’s. Third, use the civil service pay tables for the geographic location of the activity under consideration, using a step 5 (out of 10) for GS level staff and step 4 for FWS level staff and multiply this salary by the FTE’s identified in Step 2. Do this for each pay grade required by the PWS and add any differential or premium pay required for staff under the PWS.
For fringe benefits use the following percentages:
1. Insurance and health benefits -5.7 percent of payroll plus an additional 1.45 percent of payroll for medicare.
2. Workman’s Compensation and Unemployment benefits
1.7 percent of payroll.
3. Retirement costs -Under the Civil Service Retirement System (CSRS) and Federal Employees Retirement System (FERS) use 24 percent of payroll plus 7.65 percent of payroll for FICA. For law enforcement and fire protection employees the rate is 38.2 percent and for air traffic controllers it is 33 percent.
4. Severance Pay -4 percent of payroll.
To project inflation, use the inflation factors reflected in the most current president’s budget request. Also, adjust future performance period productive hours and FTE’s according to the PWS.
Materials and Supplies
Base the estimated costs for materials and supplies for each of the performance periods under study using past performance or benchmarks obtained from similar or complementary activities. If the agency purchases items from other federal government agencies the guidance stresses the price should reflect full costs. Future performance periods should reflect items consistent with the PWS and the costs should be inflated by the inflation factor discussed above.
Rent, Utilities, Maintenance, Facilities and Depreciation
If the government does not provide space, buildings, land and machinery under the PWS, these costs need
to be identified in the cost comparison. If the rental cost cannot be discretely identified then a rental cost per square foot should be calculated. Likewise, costs for heating, air conditioning and other utility consumption needs to be calculated by using either direct metering or an allocation base such as cost per square feet.
The government does not normally identify depreciation or cost of capital (e.g. interest) on its financial statements. The guidance instructs agencies to estimate a depreciation charge by prorating a share of the asset’s original cost as an expense over the asset’s life and apply this expense to existing and new assets acquired to conduct the PWS. The base of allocation is either a straight-line pro-ration of the asset’s cost over its useful life or some other basis such as hours usage or pieces of output.
For cost of capital, the guidance references OMB Circular A-94 that currently uses a 4.7 percentage for a three-year performance period (4.8 percent for a five year period) to be applied to the total depreciable cost of assets called for in the PWS.
Property and Personnel Insurance
To reflect the cost of property insurance in cost comparisons, the government will use a factor of .005 times the sum of the net book value of equipment and facilities plus the average value of materials and supplies used by the activity. The government’s personnel liability cost is equal to .007 times the total personnel related cost computed above.
Subcontract Cost
The guidance requires the government to estimate both the subcontract costs and the cost of overseeing the subcontract. The subcontract cost is to be adjusted downward for the amount of federal income tax the subcontractor will pay on its taxable income. OMB Circular A-76 provides tax rates for most commercial activities and these rates are to be multiplied by the subcontract cost to derive the estimated taxes which are, in turn, subtracted from the subcontract cost.
OMB Circular A-76 includes factors to use for quantifying the cost of administering contracts and subcontracts. These contract administration costs are expressed in terms of FTE’s and range from 0.5 FTEs for a staff of 10 or less to 2.5 FTE’s for a staff exceeding 451.
Overhead
Overhead costs is considered to be cost for general management and administration that does not directly benefit the activity being studied. To capture these indirect costs, the cost comparison is to multiply the personnel related costs plus fringe benefits by 12 percent for each year. (Yes, only 12 percent!)
Adjustments to Contractor or Other Agency Prices
The sum of all the costs discussed above plus any other identified cost is considered the total government cost to perform the PWS. This cost is to be compared to either the contractor’s price or other agencies’ price. The contract price for firm-fixed price contracts is the amount bid. For cost reimbursement contracts, the contract price is the negotiated estimated cost to perform the PWS. For a contract with an incentive or award fee, the contract price is the contract cost plus 65 percent of the potential maximum incentive award. Since some of the price will be returned to the government in the form of income taxes, the estimated income tax is to be reduced from the price. OMB Circular A-76 includes rates by type of industry.
Contract Administration
Because the government will incur costs to administer the contract, these costs are added to the contractor’s price. These costs are based on the number of staff included in the contractor’s estimate and OMB Circular A-76 includes these factors.
One-Time Conversion Costs
Converting from in-house performance to contract performance often results in one-time conversion costs and these are to be added to the first year cost of contract performance. Such costs may include (1) the cost to inventory supplies, material, and equipment the agency may provide to the contractor (2) severance pay and other related expenses and (3) clearances and other costs to convert to contract performance. If the government sells assets that are usable under the PWS rather than provide them to the contractor the gain on the sale of assets (net sales price less book value of the asset) will be used to reduce the contractor’s price.
Cost Comparison
To ensure the government does not make conversions to realize only minimal savings, OMB Circular A-76
has established a cost savings threshold of $10 million or 10 percent of the government’s personnel costs, whichever is less. If the cost comparison is being used to consider conversion of an activity from either a contractor or other agency to an in-house function, the cost differential is to be added to the government’s cost estimate. More often, if the cost comparison is being used to convert the activity from in-house to either a contractor or other agency, the cost differential is to be added to the contractor’s cost estimate. The award decision is to be based on a comparison of the total costs and cost differential.
Though we focus on contract cost and pricing requirements rather than financial and taxes, we are often asked about financial accounting issues unique to government contractors. Since many of our subscribers are in accounting and financial positions we decided to address some of the financial accounting issues government contractors commonly face. Last issue we discussed the completed contract and percentage-of-completion methods while in this issue we will discuss some financial reporting requirements under generally accepted accounting principles that are particularly relevant to contractors. In the next issue, we will touch on some tax issues. For these three articles, we are particularly indebted to the Mathew Bender text, “Accounting for Government Contracts” edited by Lane Anderson. In response to many inquiries on where to obtain this book, call
(800) 833-9844).
Revenue
Revenue recognition is a key accounting concern and under the percentage-of-completion method, revenue must be estimated. Such estimates are particularly complicated for government contractors because of change orders, options and additions, claims, terminations and use of government-furnished materials.
Change Orders
Changes to a contract are common and when such changes result in a contract cost adjustment revenues and costs should reflect only adjustments agreed to by both parties (unapproved or changes in dispute should be treated as claims discussed below). The accounting principles are as follows:
a. Costs under change orders should usually be included in contract costs during the period incurred.
b . Costs that will be recovered through an adjustment price can be accounted for in two ways: either defer the costs to the period when the price adjustment is made or charge the costs when incurred but recognize revenue only to the extent of costs incurred.
c. If the contract price adjustment exceeds the costs incurred under a change order, the contractor should recognize the additional revenues and the costs in the period in which the revenue becomes reasonably determinable.
Before revenue from a price adjustment can be recognized the contractor must assess the timing and probability of recovery. Determining whether recovery is probable three conditions should be ascertained: (1) whether the government has confirmed the basis for the price adjustment (2) the adequacy of supporting documentation and cost records and (3) the historical experience in negotiating similar adjustments.
Options and Additions
An exercised option or addition to an existing contract can be combined with the original contract, treated as a separate one or treated as a change order to the original contract. Combining into the initial contract can occur if they relate to one project, have substantially common costs and are performed concurrently or sequentially at the same or close facilities. They are treated as separate contracts if (1) the product or service differs significantly from the product or service of the original or (2) the price of the new product or service is negotiated without regard to the original contract and involves different economic assumptions or (3) the product or service is similar but the contract price and “anticipated contract relationship” are significantly different. If options or additions do not meet either the conditions for combining with the original contract or treating it as a separate contract then they are to be treated as change orders to the original contract as discussed above.
Claims
Revenue should be recorded only to the extent the costs are incurred and only if there is a high probability the claim will result in additional revenue. Because of uncertainties in resolving claims the most practical approach is to recognize additional revenue only when received or awarded. Otherwise, revenue from claims may be recognized to the extent costs have been incurred and (1) entitlement is established, often obtained through obtaining a legal opinion (2) additional costs were incurred as a result of unforeseen circumstances and not as a result of contract deficiencies and (3) the claimed costs are identifiable or otherwise determinable and are reasonable for the work performed and (4) support for the claim is objective and reliable and not based merely on management intuition.
Termination for Convenience
Under a T of C, income effects are realized when the termination value (e.g. costs recoverable under FAR 31.205-42) can be reasonably identified and estimated. Revenue including negotiated profit from the termination should reflect the probable recovery amount and associated costs should be expensed.
Government-Furnished Materials
Often when the government provides materials, the value of them is not considered a cost, is not included in the contract price and is not booked by the contractor. If a contractor is at risk for the material, however, the value of the materials should be included in the contract price, reflected as both a revenue and cost. The contractor is “at risk” when (1) it is responsible for the nature, type, characteristics or specifications of the material (2) if it purchases as an agent of the government and (3) is responsible for the ultimate acceptability of the performance of the materials.
Costs
Whereas cost is of paramount concern for government contract accounting, recognition of income is key for financial reporting purposes. Consequently, GAAP rules covering costs of government contractors are primarily oriented to accuracy in reporting earned revenue and income, particularly for percentage-or-completion contracts.
At any time during the life of a contract, total estimated contract costs consist of costs incurred to date plus estimated costs to complete. Contract costs must be identified, estimated and accumulated with a reasonable degree of accuracy to assure proper income measurement.
Contract costs are accumulated in the same manner as inventory costs. Like inventory costs, contract costs are recognized in the income statement only as the related contract revenues are recognized. Contract costs include all direct and indirect costs identified with a contract. Costs not clearly related to a contract or are unallowable are treated as period costs and expensed as incurred.
Though recognition of income depends upon the accounting method used (percentage-of-completion or completed-contract) contract costs are accounted for in the same manner under both methods. They are allocated and accumulated in the same way but like revenue, they are recognized at different times for financial reporting purposes.
Since revenue and income on percentage-ofcompletion contracts are generated based on estimates of costs, the AICPA seeks to prevent manipulating income by providing the following guidelines for estimating costs:
“Systematic and consistent procedures” need to be used for periodically comparing actual and estimated costs.
All significant elements of costs should be identified Estimates to complete should include the same elements of costs that are included in actual accumulated costs and expected price increases should be reflected.
The effects of future wage and price escalations should be taken into account. Escalation rates should not be a blanket overall amount but the escalation rate(s) should cover labor, material and indirect costs based on consideration of history and other pertinent data.
Estimates to complete should be reviewed “periodically” and revised as appropriate to reflect new information.
Earned Income
Under the completed-contract method, earned income is simply the difference between contract revenue and contract cost when the contract is completed (or significantly completed). Under the percentage-ofcompletion method, computation of estimated earned revenue involves estimating the revenues earned to date and the costs related to that revenue. The AICPA recognizes two acceptable approaches for estimating earned revenues and matching costs.
Approach 1. Earned revenue to date is computed by multiplying total estimated contract revenue by the percentage of completion. Any excess of the total amount over amounts recognized in prior periods is the revenue for the current period. The cost of the earned revenue is computed the same way – multiplying total estimated costs by the percentage of completion and recording as costs of the period the excess of this amount over costs recognized in prior periods. Any difference between actual costs incurred and costs of earned revenue are reported on the balance sheet as a current asset or liability.
Approach 2. Earned revenue is the amount of gross profit earned on a contract during the period plus the costs incurred during the period. Costs of earned revenue for the period equals the costs incurred during the period (the costs incurred may exclude the costs of materials purchased but not yet used and the cost for subcontract work yet to be performed). Gross profit is computed by multiplying the total estimated gross profit on the contract by the percentage of completion. The excess over the amount recognized in prior periods is the gross profit earned in the current period.
Anticipated Losses
Whether the completed or percentage-of-completion method is used, losses should be recognized in the period they are discovered. Normally the loss is reported in the income statement as an addition to contract costs rather than as a reduction in contract revenue.
Contractors often attempt to defer recognition of contract losses. One approach is to spread the losses over the period remaining in the life of the contract. Another approach is to defer the loss in the hopes of recovering it through obtaining future or follow-on contracts or the customer anticipating exercise of options. Neither approach is acceptable under GAAP.
Guidelines for Financial Statement Presentation
Balance Sheet Presentation
Common asset and liabilities relatively unique to government contractors include:
Assets
Accounts receivable on contracts (including retentions)
Unbilled contract receivables
Cost in excess of billings and estimated earnings
Other deferred contract costs
Equipment and tooling specifically purchased for an individual or group of contracts
Liabilities
Accounts payable on contracts (including retentions)
Accrued contract costs
Billings in excess of cost and estimated earnings
Advanced payments on contracts
Some words about a few of these.
Receivables. If receivables from government contracts are significant or if billed or unbilled government receivables are material, GAAP requires they be disclosed separately either in the balance sheet or a footnote. Unbilled amounts occur when revenues, though appropriately recorded, cannot be billed yet (e.g. contract terms not determined, unit prices not established) but will be billed later. Some contractors prefer to label unbilled receivables as “accrued” which is permissible under GAAP. Few companies disclose unbilled receivables on the face of the balance sheet and choose rather to (1) treat them as billed or (2) disclose them in a footnote.
Retention. Retention amounts (holdbacks of a percentage of billing) should be disclosed on a balance sheet or in a note. Though most companies do not disclose them in a way for the reader to identify them, they are usually included as a part of unbilled receivables. For example, a note might say “receivables include approximately $ X billed to customers but not paid pursuant to retainage provisions in the contract.”
Inventories. The accumulated costs of contracts in process are reported according to the type of contract and accounting method used. Costs incurred under cost-type contracts are usually reimbursable so they are billed as incurred. For fixed-price contracts contractors receive payment as work progresses or units are delivered. The usual balance sheet description for accumulated costs under completed-contract method is “Contracts in progress” while under percentage-of-completion method, the balance sheet description is typically “costs incurred under U.S. government contracts less amounts applied to units delivered and unapplied progress payments.”
Progress Payments. Progress payments on fixed price contracts are usually applied first to unbilled receivables and then to accumulated costs of contracts
in progress. Amounts representing progress payments billed but not yet collected are not usually shown on the balance sheet because it would be incorrect to show uncollected progress payments as an offset to inventories.
Advance payments. Advanced payments (they differ from progress payments in that they are not related to progress on a contract) are reported similarly. Advance payments received in excess of unbilled receivables and accumulated costs are classified as a liability and if material described by such titles as “advance payments on U.S. Government contracts” or “amounts received in excess of costs incurred under U.S. Government contracts.”
Income Statement Presentation
The income statement of a government contractor is basically the same as that for any other business. Revenues and expenses are usually not segregated between government and other commercial business. There are some unique circumstances to government contractors that may affect either comparability or future operations and therefore may need detailed disclosure. These might include (1) abnormal contract price adjustments (2) provisions for a substantial loss
(3) recognition of significant incentive income (4) material changes in contract estimates (5) claims activity that can significantly affect revenue or losses and (6) big problems in performance that can materially affect future operations.
Statement of Cash Flow Presentations
The form, content and descriptive captions for statement of cash flows are the same for government contractors and commercial businesses. The primary issue for government contractors is how to report progress payments and advance payments. These payments should be reported gross and if the indirect method is used (most common among government contractors) the payments should be shown as a separate adjustment to reconciling net income to cash flow. Alternatively, progress payments and advanced payments can be shown as borrowings rather than related to operating activities and if so should be reported as cash received from financing activities.
(Editors’s Note. Since there are numerous recent efforts to expand awards to small businesses we thought it would be a good time to review some of the rules affecting small business opportunities. An understanding of rules for contracting with small business is important not only for small businesses pursuing government opportunities but also large businesses because they must establish subcontracting goals and often compete against or team with small businesses. In this first of two articles, we will focus on (1) the basic rules of eligibility (2) set-aside programs and (3) requirements of prime contractors to establish subcontracting goals. In the second article we will discuss Certificates of Competency, protection against bundling and specific programs available to different types of businesses. We have relied on a recent two part series in the October and November 1999 issues of Briefing Papers written by Stephen Ruscus of McKenna & Cuneo, L.L.P.)
Eligibility
“Small business concern.” A “concern” is defined in the FAR as a business entity organized for profit (even if owned by a non-profit). It must have a place of business in the U.S. and make a contribution to the U.S. economy through payment of taxes and use of American labor. Permissible legal structures include proprietorships, partnerships, corporations, joint ventures, cooperatives or associations.
Size Standard. An offeror must not be dominate in its field and has to qualify as a small business under the criteria and size standards established by the SBA. The size standards are set on an industry-by-industry basis using the Standard Industrial Classification (SIC) System and are stated by either average annual receipts (ranging from $500,000 to $25 million) or number of employees (ranging from 500 to 1,500 employees). Size standards by SIC code can be obtained from the SBA or are cited in FAR Part 19. The contracting officer determines the appropriate product or service classification and related SIC codes for a solicitation which may be multiple codes for different products or services in a procurement. If a solicitation calls for two or more items with different size standards the offeror must meet the size standards for each item for which it submits a bid; if a solicitation calls for more than one item and the offeror must submit a bid on all items the offeror can qualify as a small business if it meets the size standard of the item accounting for the greatest percentage of the total contract value.
Affiliation. A small business can have affiliates but must be independently owned and operated. Affiliation is synonymous with direct or indirect ability to control – it is immaterial whether such power is actually exercised but only matters if it exists. The SBA has identified many factors that do or do not connect or affiliate different firms such as combination of assets, stock ownership, common management, previous relationships or ties and contractual relationships and uses a “totality of the circumstances” to determine affiliation. Though joint ventures are normally classified as affiliates for size calculations two or more small businesses forming a joint venture may be excluded from affiliation and hence submit an offer as a small business if each is small under the SIC code and (a) for a procurement having a revenue-based size standard the procurement exceeds one-half the size standard assigned to the contract or (b) for an employee-based SIC code the procurement exceeds $10 million.
Subcontracting with Large Contractors. Small businesses awarded a set-aside contract (procurements reserved exclusively for small businesses) may subcontract to large businesses unless it is prohibited by the solicitation or some regulation. Such a subcontracting relationship will not in itself be considered an affiliation for size determinations provided (a) the large subcontractor will not manufacture or produce the end item but the small company will make a “significant contribution” in the case of manufacture or production or (b) for a service contract (excluding construction), at least 50% of the cost of the contract and for a supply contract work for at least 50% of the cost of manufacturing the supplies (not including the cost of materials). The exception is the subcontract relationship will be considered an affiliation under the “ostensible subcontractor” rule where the relationship is a sham and the large contractor actually controls or has the power to control the relationship.
Self-Certification. The initial determination of size is made by the offeror itself through a self-certification as part of a bid or proposal in connection with a specific solicitation. In the absence of a written protest by another offeror or other credible information the CO may have to question the concern’s size, the CO will accept the self-certification at face value.
Challenges. An offeror’s self-certification may be challenged in a protest to the SBA by the CO, other offerors or the SBA. The interested party needs to make the challenge to the SBA through the CO within five business days after bid opening or in a negotiated procurement, within five days of receipt of notice identifying the successful offeror. The protest should include specific factual reasons why the concern is not small at which time the burden falls on the challenged contractor to prove its size and supply all requested
information to the SBA. There is no right of appeal though the SBA’s Office of Hearing and Appeals (OHA) has the discretion to review a size determination.
Small Business Set-Asides
To ensure a fair proportion of government contracts are placed with small contractors, Congress has authorized the restriction of entire procurements or portions of procurements for award to small businesses.
Procedures. The decision to set aside a procurement is within the discretion of the agency but certain statutory and regulatory requirements must be followed. The CO must review acquisitions to determine if they can be set aside for small business. The CO must give consideration to the recommendations of the personnel representing the agency’s small business and it must document why it decided not to use a set-aside. A set-aside decision can also result from a recommendation from the SBA Procurement Center Representative with the CO’s concurrence. If the CO rejects the SBA’s recommendation to make a set-aside, it must furnish a written notice within five days of receipt of the recommendation. The SBA then has two days to protest the CO’s rejection to the head of the contracting activity who must, in turn, render a written decision within seven business days. If the head of the contracting activity agrees with the CO then the SBA may, within one business day, request the CO suspend the procurement until it appeals to the agency head. The SBA then has 15 days to appeal to the head of the agency and to notify the CO. The agency head then has 30 days to reply to the SBA during which time contracting activity is suspended unless the CO decides in writing performance is in the national interest.
Fair market price. A set-aside may not be awarded if the cost to the agency exceeds the “fair market price.” The fair market price is based on reasonable costs under normal competitive conditions (which can include a premium price due to a firm’s small business status) and not on lowest price. While the price need not be as low as it could be through full and open competition it must not be excessive or unreasonable. In making the reasonableness determination, a CO may select whatever price analysis technique it wants including comparison of proposed prices received or a comparison of proposed prices with (a) current proposed prices (b) with prior proposed or contract prices or (c) with independent government estimates. Since the CO has broad discretion in determining fair market price, protests have rarely been successful unless fraud or bad faith is demonstrated.
Total Set-Asides. The entire amount of an acquisition or class of acquisitions between $2,500 and $100,000 is automatically reserved exclusively for small business unless the agency determines there is not a reasonable expectation of obtaining two or more bids from responsible small businesses. Such set-asides are subject to simplified acquisition procedures and expedited payments specified in FAR Part 14. The CO will also set aside any acquisition over $100,000 where there is the same reasonable expectation of offers from two responsible small business and the award will be made at a reasonable price. To determine whether there is a “reasonable expectation”, the CO must make a reasonable effort to explore the market but not necessarily an exhaustive one. (Editor’s Note. Acquainting COs with your small business capabilities is advisable.) In response to protests, the GAO has ruled the CO has broad discretion in making set-aside decisions and unless there is a clear “abuse of discretion” will not rule against an agency’s decision.
Partial Set-Asides. Sometimes a small business can furnish only a portion of the entire government’s needs and the CO will set aside a portion of an acquisition for small business participation (with the exception of construction). Conditions for such set asides are (a) a total set-aside is inappropriate (b) the requirement is severable into two or more units each of which is an economic production run or supply lot and (c) small business could furnish one of those portions at a reasonable price. Under partial set-asides, the CO awards the non-set-aside portion using normal contracting procedures and when all awards have been made, the CO negotiates with the eligible concerns and makes an award.
SBIR Set-Asides. To increase government’s use of innovations coming from small businesses federal agencies must set aide at least 2.5% of their research and development budget to small businesses. SBIR awards are increasing in frequency and are becoming a great source of opportunity for small businesses (see GCA DIGEST Vol. 2, No. 1 for a detailed discussion of SBIR opportunities).
Competitiveness Demonstration Program. To test competitive capabilities of small business, the government has eliminated set-asides in four industries
– construction (except drudging), architectural and engineering services, refuse systems and related services and non-nuclear ship repair. The moratorium of set-asides will continue as long as the award goal of 40% in the four industries in each participating agency is met and if the 40% percent goal is not met then set-asides must be re-instituted.
In order to not eliminate set-asides completely in the four industry groups, the SBA has created a new class of small business eligible for preferential treatment – the “emerging small business” defined as a small business whose size is no greater than 50% of the size standard applying to the applicable SIC code. As part of the 40% goal, 15% of awards must be given to emerging small businesses and to achieve this goal, all contracts of $25,000 or less in the four groups will be set aside (higher levels will be set if the 15% goals are not being met). The 10 agencies participating in the Program (DOD, DOE, HHS, NASA, EPA, Transportation, Agriculture, VA, Interior and GSA) will be expected to expand the program to an additional 10 targeted industries (yet to be identified).
Very Small Business Pilot Program. Contract requirements between $2,500 and $50,000 will be awarded to very small companies in certain areas served by SBA district offices when the CO determines there is a reasonable expectation to obtain offers from two or more VSBs. A VSB is defined as having no more than 15 employees and average annual receipts of $1 million or less. The areas include Albuquerque, Los Angeles, Boston, Louisville, Detroit, Philadelphia, El Paso and Santa Ana and for goods and supply items the buying activity must be located in one of these areas and for other contracts, the work must be performed within these districts.
Subcontracting Plans
Any contractor receiving a procurement for more than $100,000 must agree in its contract that small business concerns, small business concerns owned by service-disabled veterans, HUBZone small businesses, SDBs and women-owned small businesses will have the “maximum practicable opportunity” to participate in contract performance. In both negotiated and sealed-bid acquisitions, the apparent successful contractor must submit an acceptable subcontracting plan in procurements expected to exceed $1 million for construction and $500,000 for all others. Failure to submit such a plan renders the prime contractor ineligible for award and failure to comply in good faith with the plan will be a material breach of contract and can include liquidated damage penalties. FAR Part 19.7 provides some specific subcontracting plan requirements such as establishing percentage goals, planned dollar amount of work, method used to develop goals and identify sources and various efforts to ensure small businesses have an equitable opportunity to compete for subcontracts.
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