Knowing Your Cost Principles…
MATERIAL TYPE COSTS
(Editor’s Note. Taking into account materials, subcontracts and inter-company transfers, material costs often represent a significant amount of incurred costs by government contractors. Contractors’ treatment of these costs vary widely and we will focus on the flexibility the regulations offer. The source of this article is based on various readings of the FAR, CAS, DCAA guidance and expert commentary over the years and we have closely followed the reasoning presented in the Accounting for Government Contracts,
Allowability Rules
FAR 31.205-26 and CAS 411 are the primary regulations addressing material costs. A reading of FAR 31. 205-26 strikes one with two reactions: (1) most material-related costs are allowed and (2) there is little prescription on how the costs must be treated. Material costs include raw materials, parts, sub- assemblies, components and supplies whether they are purchased or manufactured. In addition not only is inbound transportation and in-transit insurance included but also overruns, spoilage and defective work is usually allowable. Adjustments to material costs such as income and other credits such as trade discounts, refunds, rebates, allowances, cash discounts, credits for scrap, salvage and returned material are included. Also, material costs can include reasonable adjustments for differences arising from periodic physical inventories and booked inventories.
Flexibility in Treatment of Costs
Though the cost principle makes clear that most material related costs are allowable, it does not prescribe how they must be charged. Contractors have considerable discretion how to handle these costs and government insistence on just one way should be carefully considered before acquiescing. For example:
Cash Discounts. If a contractor takes advantage of a 3% cash discount offered by a vendor, the FAR allows a contractor to either reduce its direct material by 3% or credit its indirect cost pool by that amount.
Transportation costs. For transportation costs the buyer is responsible for, the contractor may either add the costs to its direct material or to its indirect cost pool, which can result in significant differences in unit prices.
For example, if 100 units cost $10 each and the transportation costs is a flat $20, the cost of each unit transferred to a job may be $10.20 ($1,020/100 units). If the transportation cost is charged to an indirect cost pool and the costs of that pool are allocated over the entire base of that pool, then the resulting allocation to the 100 units is considerably less. Say, the base costs are equivalent to the costs of 1,000 units, the unit costs would be $10.02 rather than the original $10.20.
If a contractor is covered by CAS, the requirements are a bit more restrictive. Contractors still have the option to charge direct or indirectly – the decision should be based on practicality. So unless it is not practical to do so, transportation costs must be directly allocated to the same cost objective (e.g. contract) to which the related materials were charged. Whatever the method selected, once it is adopted CAS requires it be consistently followed.
Special Tooling and Set-up Costs. Similar to transportation costs is special tooling and set-up costs. In many cases, companies may purchase items that require special tooling or other work by the vendor which is usually charged separately. Also, it is common for vendors to separately charge their customers set- up fees each time special tooling is required. If the material requiring special tooling and set-up is clearly allocable to a contract then the additional charges should be made to that contract. However, when the material is used for several contracts then tooling and set-up costs create a situation similar to transportation costs discussed above. The costs may be charged direct based on some computation method or indirect where an indirect cost can be justified on practicality grounds. Indirect charging has two advantages – it eliminates the need for manual calculations necessary to compute unit costs and it eliminates potential swings in units costs caused by variations in quantities purchased. An illustration of the second point is as follows: If there is a flat $500 set up fee, then a purchase of 100 units would require a $5 per unit fee while a purchase of 500 units would entail a $1 fee if charged direct. If charged indirect, the two $500 fees would be uniformly spread over 600 units resulting in a consistent $1.67 per unit ($1,000/600 units).
Made to Stock. It is quite common to produce items and subassembly items to stock and kept in inventory until they are needed in production. When such stock items are subsequently issued from inventory there are generally two options how to account for them. One way is to transfer the stock items at a single material cost per unit which includes all costs of labor, material and overhead originally incurred to produce the items. Alternatively, the labor, material and overhead costs can be segregated and considered separate costs to be allocated to various production jobs.
As for allocating G&A costs to these stock items, even CAS 410 provides latitude. The cost accounting standard gives contractors the choice of allocating G&A costs to items made to stock either in the accounting period in which they are produced or in the period they are issued from inventory to final production. If G&A is allocated during the accounting period in which the item is made for stock, the inventoried cost of the items for government contracting purposes may include the cost of G&A. Remember the method used for government accounting purposes may differ from that used for other purposes (e.g. financial reporting) as long as the method used is consistently applied.
Documentation costs. Material documentation requirements for government contracts (e.g. MIL-S-19500 requirements) can be significant. Such costs are sometimes an indirect cost, applied on the same base as other costs. It is also common for contractors to include these costs as part of the material price charged directly for a contract, especially when purchases for a contract can be clearly identified. Problems can arise under the direct method when surplus material charged to a contract is transferred to another contract that does not require the same extensive documentation. Since it would be inequitable to charge the new contract these documentation charges, there should be some traceability of the documentation charges so the base
material price may be charged to the new contract without the documentation charges following.
Inter-organizational Transfers
The general rule has always been that since an inter- organizational transfer does not affect the acquisition cost of materials, the cost for government contracts is the transferring entity’s cost rather than the price paid by the receiving entity. This principle was well established by Westinghouse Electric Corp. (ASBCA 11932) where the company sought to recover the price paid for an item manufactured by an affiliate and the appeals board ruled it was entitled only to the cost incurred by the affiliate to manufacture items.
However, there are numerous exceptions to this limitation of recovery and numerous acquisition reforms made in the 1990’s have expanded the opportunities to recover more than incurred costs. FAR 31.205-26(e) recognizes that, in some instances,inter-organizational transfers can be appropriately made at a price other than incurred costs. These circumstances include (1) when prices that are agreed upon are based on adequate competition (2) prices are set by law or regulation (3) when the product or service acquired is a commercial item (4) when a waiver has been granted or (5) when the transferred item is a modification of a commercial item. If any of these conditions are met, the price paid by the receiving company is allowable provided the CO does not find the price to be unreasonable. Recent expansions to definitions of commercial items and a 1995 rule eliminating the requirement for contractors to provide most favored customer status to the government provides greater recovery opportunities.
Government auditors are often told to carefully consider inter-organizational transfers at amounts other than costs. For example, in the DCAA Contract Audit Manual Chapter 6-314auditors are told to determine whether the price charged for the item has been “established by the operation of the competitive forces of the market place” cautioning auditors that proprietary, sole source or items produced solely or primarily for government use may not meet the conditions for acceptance ofinter-organization transfers at price.
Estimating Material Requirements
The FAR Table 15-2 describes how to submit cost or pricing data when certified data is required. It has a separate section for materials where a “consolidated priced summary” of individual quantities of material
by task, order or contract line item is called for. If exemptions to cost based pricing is put forth, data is required. If adequate price competition is asserted, for example, the contractor must show the degree of competition. For inter-organizational transfers at price, the offeror must explain the pricing method. For items not exempt and over the threshold set forth in FAR15.403-4, a narrative showing the source and reasonableness of the proposed price is required. Other requirements include (1) a summary of the offeror’s cost analysis and a copy of the cost or pricing data submitted by the perspective source if it represents the lower of $10 million or 10 percent of the prime contractor’s proposed price (the CO has the discretion to require these things on lower amounts) (2) assurance that the subcontractor’s cost and data is accurate, complete and current as of the date of price agreement or earlier date agreed to by the parties with the requirement to update the subcontractor data and (3) separate cost breakdowns of inter-organizational transfers and even commercial items if cost and pricing data is required.
CAS 401, requiring consistency in estimating, accumulating and reporting costs along with its similar requirements expressed in FAR, has long raised questions on how to treat the use of percentage factors to estimate costs of scrap, waste, spoilage, etc. For estimating purposes, it is quite desirable to propose additional costs over direct material costs to account for expected losses and estimate this by applying an appropriate percentage factor to estimated direct material costs. Since the regulations require consistency of costing with estimating, questions arise whether contractors can accumulate direct material costs in an undifferentiated account or do they need to accumulate actual costs of the lost material costs to compare with the proposed percentage estimates. The CAS Board has taken the position that accumulation of material costs in an undifferentiated account is not consistent with the practice of estimating a “significant” part of the costs by percentage factors. However, recognizing the difficulty in accumulating these loss factor costs separately and the impropriety of enforcing a one-size-fits-all prescription, the CAS Board has left the amount of accounting and statistical detail required up to the government and particularly auditors to decide on a case-by-case basis.
Accounting Requirements
For those contractors who must submit disclosure statements, Parts 2.1 through 2.4 pertain to material
costs. A description of principal classes of materials and service costs charged direct to contracts is required, the method and timing of direct charges and what material costs are direct and indirect. Additional disclosures are required of those contractors having standard material cost systems – how they identify standards used, how standards are revised, types of variance accumulated and the methods for accumulating and allocating the variances. Contractors not fully CAS covered may also want to “establish costing practices” in writing if they anticipate government challenges to certain cost accounting treatment of material costs.
Inventory Costing Methods. The FAR permits the use of any generally recognized method of pricing inventory materials provided the method is consistently applied and the results are “equitable.” CAS 407 and CAS 411 dictate the acceptable procedures for materials underCAS-covered contracts. CAS 407 covers standard costing which provides criteria under which standard costs may be used for estimating and costing purposes and how to dispose of the variances. CAS 411 covers cost accumulation and allocation for non- standard costs. CAS 411 allows only five inventory costing methods: (1) FIFO (2) moving-average cost
(3) weighted-average cost (4) standard cost and (5) LIFO while non-CAS covered contractors can use any method recongnized by generally accepted accounting standards.
MAXIMIZING RECOVERY
FROM DELAYS
(Editor’s Note. Delays on contract performance can wreak havoc on profitability of contracts. Knowledge of when a contractor can recover costs associated with delays and how to present a claim to get the most recovery is a critical antidote to a contract experiencing various delays. The following addresses these points and is based on an article written by Rand Allen and Phil Harrington of the law firm of Wiley Rein & Fielding LLP published in the Winter 2002 issue of the Government Contract Audit Report.)
For delays or disrupted performance, the government has created three clauses that permit it to order a contractor to stop or suspend contract performance. In return for this right, the three clauses create a corresponding obligation on the government to compensate the contractor for the interference. Entitlement to compensation is not automatic, putting the burden of proof on the contractor to demonstrate it suffered compensable harm as a result of the government-ordered delay. The proof requirements and elements of compensation vary depending on which clause the government issues to delay the work.
Relevant Regulations
Suspension of Work, FAR 52.242-14
Of the three clauses that permit the government to interfere with government work, the Suspension of Work clause is the least generous and places the most obligations on the contractor. This clause is most commonly invoked in construction and architect- engineering services contracts. The clause puts forth several hurdles before a contractor can recover the extra costs incurred by a government-directed delay:
1.The government caused the delay. This precondition can be a result of an act or a failure to act.
2.The government caused not just a delay but the delay was for “an unreasonable period of time.” There is no clear standard what is considered reasonable or unreasonable – under one circumstance even one to
10hours have been held to be unreasonable while under another, a delay of 12 days was considered reasonable.
3.The delay must not be attributable to the contractor’s fault or negligence. Court rulings have provided numerous examples of when a contractor was not entitled to compensation such as if the contractor could not perform the work required, the contractor did not furnish material the government required to permit work to proceed, or refused to cooperate with the government.
4.Must put government on notice within 20 days. The terms of the clause prohibit recovery for government- ordered delays “for any costs incurred more than 20 days before the contractor shall have notified the contracting officer in writing of the act or failure to act.” Contrary to what some believe, this does not require the contractor to file a claim within this 20- day window but rather to put the CO on notice of a triggering act or failure to act within the 20 days period.
5.The final steps for recovery of costs involves the filing of a claim. Though the clause requires a claim filed “as soon as practical after the termination of the suspension, delay or interference” it also states such a claim can be considered directly if it is submitted “not later than the date of final payment under the contract.” Thus under normal circumstances, timeliness of filing a claim should not be a bar to recovery.
Protest After Award, FAR 52.233-3
It is not unusual to receive a contract only to learn that a losing competitor has protested the award to the GAO. If a protest is filed the government agency is required to suspend contract performance and may issue an order to stop all work and take reasonable steps to minimize costs allocable to the contract. After the GAO issues a decision on the protest the agency either cancels the stop work order (or lets it expire) which permits the contractor to resume performance or terminates the work covered by the order. In either event, the clause allows the contractor to recover the costs it incurred during the stop work period. In contrast to the Suspension of Work clause, there is no requirement to show the government-caused delay extended for an unreasonable period of time. Also, the delayed contractor is entitled to receive profit on the costs it incurred.
The contractor is not required to stop all costs that may be allocable to the contract but rather to take prudent steps to minimize these costs. Thus in some circumstances it may be less costly to the government for a contract to continue to incur costs at some reduced level of activity than to stop completely and incur, for example, relocation and severance costs.
In some contracts the government is supposed to issue a Notice to Proceed (NTP) before the contractor can begin performance. Some agencies have attempted to escape their obligations under this clause by not issuing a NTP. Courts have ruled this is not a successful tactic stating that withholding a NTP subsequent to a protest should be treated as if it were a stop order under this clause.
Even if the clause is not included in a solicitation or ensuing contract, court ruling have held it is covered by the “Christian Doctrine” which makes the clause a part of the contract by operation of law. The “Christian Doctrine” provides that certain clauses are considered a part of the contract whether or not it is actually referenced or included in the contract when those clauses “express a significant or deeply ingrained strand of public procurement policy.”
The stop work order clause permits the government “to stop all, or any part, of the work called for by this contract for a period of 90 days after the order is delivered to the contractor, and for any further period to which the parties may agree.” The provisions of this clause are essentially the same as those under the Protest After Award (FAR 52.233-3) discussed above. Under this clause a contractor is:
Not required to show the period of delay was unreasonable
Entitled to recover profit on the costs incurred as a result of the delay
Not required to stop all allocable costs, only to minimize them
Entitled to an equitable adjustment on its contract.
In addition, at the end of the 90 day period the CO must either cancel the stop-work order or terminate the work covered by the order. If the stop work order is cancelled or the period expires the contractor is to resume work and the CO is required to make an equitable adjustment in the delivery schedule or contract price or both.
Recovering Costs and Profit
Procedures
As we have discussed the government has the right to suspend or stop contract performance and the agency must compensate the contractor for additional costs it incurred as a result of the delay as well as profit in the case of the last two clauses discussed above.
The burden falls on the contractor to demonstrate how much it is entitled to. The first step the contractor should take is to immediately begin to identify thedelay-related costs. It should establish a separate accounting charge number to identify and record the extra costs attributable to the government’s action and inform its employees of this separate charge number. We cannot count he number of times a fair equitable adjustment eluded a contractor because this initial step was not taken on a timely basis. This tracking of costs should proceed regardless of the duration of the government-caused delay.
Elements of Recovery
In considering what specific elements of costs are allowable, boards and courts have stated that the rules applicable to equitable adjustments under change
orders should apply. Under these rules, the basic pricing formula has been held as “the difference between what it would have reasonably cost to perform the work as originally required and what it reasonably cost to perform the work as charged”
(Modern Foods Inc., ASBCA No. 2090). The courts have generally held the purpose of the equitable adjustment is to make the contractor whole (Keco Indus., Inc. v. United States, 364 F.2d 838; Bruce Constr. Corp. v United States 324 F.2d 516). Put another way, once the contractor establishes the government interruptions caused a contractor to incur additional costs, the contractor is entitled to recoup those additional costs (Labat-Anderson, 42 Fed Cl at 857; AST Anlagen 92-2 BCA).
Generally a contractor should be expected to recover the following types of costs in equitable adjustments from the government caused delay (we have included samples of court/ board decisions or authoritative commentary that supports allowability of the cost):
Stand-by labor and related overhead. The costs of personnel who became idle as a result of the stopped/ suspended work should be separately identified and the labor costs and associated burdens should be recoverable (AST Anlagen).
Retention of personnel. The cost of retaining key personnel that may become unavailable if they do not remain with the contractor as a result of the stopped/ suspended work is allowable (Labat-Anderson).
Severance payments. Such payments that are incurred because of the delay are recoverable (Raytheon STX Corp. v. Dept. of Commerce, GSBCA No. 14,296-COM).
Recruiting costs to replace staff. If the work stoppage or delay occurs at the beginning of the contract, personnel recruited for the contract often take other employment requiring additional costs to recruit replacement labor (Cibinic & Nash Report, No. 671).
Idle and underutilized equipment and facilities. The cost of any equipment or facility that would have been used on this contract which became idle as a result of the stopped/suspended work can be recovered (Stroh Crop. V. GSA, GSBCA No. 11,029).
Demobilization and remobilization. These costs may be recovered if they are due to the delayed work (Marlin Associates, Inc. GSBCA No. 5663).
Material and labor escalation costs. The costs of performance should be escalated to account for anyinflation impacts resulting from slippage in performance period (Ginisco Technology Corp. ASBCA No. 49,664).
Loss of efficiency. If the contract contemplated lower prices due to efficiency or learning effects the impact of any loss of efficiency or learning resulting from the interruption should be recovered (Qualex International, ASBCA No. 41962).
Unabsorbed overhead. A disruption in contract performance results in an interruption in the absorption of overhead costs on the contract thereby causing other ongoing contracts to absorb more overhead costs. This unabsorbed overhead is a routine cost on equitable adjustments and the so- called “Eichleay formula” is the only method to compute this adjustment (Eichleay Corp. ASBCA No. 5183; DCAA Contract Audit Manual (DCAM), Chapt
12.803). We have discussed the Eichleay formula in the GCA DIGEST Vol. 3 No. 1)
Increased subcontractor costs. Any subcontractors impacted by the stopped/suspended work have the same rights to an equitable adjustment as the prime contractor. These subcontractor claims should be included as part of the equitable adjustment request (Tom Shaw, 90-1 BCA, NO. 22,578).
Profit on costs incurred. Profit is allowed on the equitable adjustment if the stop work was ordered under either FAR 52.233-3 or 52.242.15 (DCAM, Chapter 12.802- 7; Tom Shaw).
REA Preparation Costs. The costs of preparing, submitting and negotiating the request for equitable adjustment are allowable costs of the stopped/ suspended work claim (Western States Mgmt Svcs. Inc.
ASBCA No. 37,471; DCAM Chapter 12.606). Once the REA becomes a claim then the associated costs of pursuing the claim (usually legal and consulting costs) are not allowable under the equitable adjustment claim.
The authors note that many decisions have established that ascertaining all costs of an equitable adjustment “is not an exact science and where responsibility for damage is clear, it is not essential that the amount thereof be ascertainable with absolute exactness or mathematical precision” (S.W. Elect. & Mfg. Corp. v.
United States, 655 F.2d 1078). As long as it appropriately segregates its delay-related costs and provides a reasonable estimation of its damages the contractor should not hesitate to include such costs in its request for equitable adjustment. Of course,
you can likely expect an audit of your REA if it is significant.
(Editor’s Note. The authors correctly point out that if the government chooses to terminate some or all of the contract recovery of additional elements of costs are possible. We recommend our article “Getting the Most Out of Your Termination Settlement” in the GCA DIGEST Vol. 2 No. 1 for guidance on how to maximize recovery from a termination for convenience. Also, feel free to use our free “Ask the Experts” resource for answering questions related to your request.)
RECEIVING FASTER
PAYMENTS
(Editor’s Note. Receiving timely payments is obviously the purpose of doing business. Though doing business with the government has considerable advantages, the government payment process can cause considerable heartburn for contractors and subcontractors. The government has proposed numerous remedies to ease the burden but nothing concrete has yet passed. A basic understanding of the regulations covering payments is often the best antidote to counter lack of timely payments so we were glad to come across a recent article in the Summer 2002 issue of the Lyman Report written by Andrew Hollowell of the law firm of Piliero, Mazza & Pargament.)
The Prompt Payment Act
The road from “proper” invoice or voucher (which we will simply refer to as invoice) to a government check or soon, electronic transfer of funds begins with the submission of the invoice. Contents of a “proper” invoice and the government’s procedures for paying these obligations are set forth in the Treasury Department’s Prompt Payment Regulations that were issued in 1999. That regulation says a “proper” invoice or voucher identifies the contractor, contract, deliverables and documents the government’s acceptance of goods or services or the contractor’s success in meeting specified milestones for a progress payment. Examples of such documentation might include receiving reports or delivery tickets showing acceptance by the government or the contractor on behalf of the government. The contract will often specify which document must be provided with invoices – when it is missing or unclear, the contractor should make sure the CO provides a form enumerating the data required to be submitted.
Once an invoice is received, the Prompt Payment Act generally requires the government to accept or reject the invoice in seven days. If accepted, the government must transmit payment within 30 days if the invoice represents completed work (i.e. acceptance of deliverable, title passing to the government). The Prompt Payment Act also imposes interest on the government if it fails to pay promptly. Payment of penalties are supposed to be voluntary whether or not the contractor has asked for them. If the government fails to pay the principle or interest upon request, the contractor may file a claim under section 6 of the Contract Disputes Act. Additionally, if the contractor is a small business, the agency’s Office of Small and Disadvantaged Business Utilization can assist businesses in obtaining payments and interest. To encourage timely payment, agencies may not appropriate additional funds to replace the funds they use to pay interest.
A recent Department of Defense Inspector General report widely criticized several DOD organizations for failing to meet timely payments of outstanding invoices in spite of incentives to do so. DOD management apparently takes the report seriously and a recent memorandum cautioned all DOD components to ensure contract line items reflect the actual way contractors ship and bill items. For example, when contract line items show a contractor will deliver a finished item but the contractor’s invoice shows delivery of component parts of that item delays often result because manual reconciliation of inconsistencies is required resulting in mistakes.
Current Issues
In spite of a proper invoice submission, the government can withhold payment to the extent of any previous overpayments to a contractor. One of the more recent developments is the so-called“recovery audit” provision in the National Defense Authorization Act of 2002. It requires agencies with more than $500 million in annual contracts to conduct “recovery audits” and “recovery activities” to identify and recapture “amounts erroneously paid” to contractors. At present, little is known what form these will take, leaving development of rules and
procedures to the Office of Management and Budget (OMB). What is known is that “recovery auditing” will require auditing contractors’ records as opposed to studying government payment records. Also there is a “bounty hunting” provision of the act (Section 831) which allows agencies to hire private sector contractors to conduct the audits and pay them on a contingency basis.
In late 2001, several FAR clauses were amended to require contractors to contact contracting officers for instructions regarding disposition of extra money received. These clauses effectively impose an obligation on contractors to identify overpayments and duplicate payments before the government becomes aware of them. Though penalties for noncompliance are not yet specified, they are subject to a claim under the False Claims Act. Also, as we note in the article below, DCAA has issued changes to its audit manual calling for special audits of billing system internal controls to ensure overpayments are quickly identified and amounts due are promptly offset or refunded.
Subcontractor Problems
In addition to being subject to all payment requirements discussed above (which flow down from prime contractors and upper tier subcontractors) subcontractors face additional uncertainty of being paid by private companies. Most prime contractors and upper tier subcontractors impose payment restrictions on their subcontractors that do not require payment until a designated period of time after they are paid. Thus late payments by the government reverberates to subcontractors. Moreover, upper tier contractors experiencing financial difficulties may divert funds earmarked for subcontractors to other pressing obligations.
The core of the subcontractor’s dilemma is its lack of privity with the government. Lacking a contractual link with the government customer, it is unable to secure payment directly from it. The FAR does provide some options. For example, FAR 32.112-1 grants the CO authority to investigate and make determinations regarding subcontractor allegations of non-payment. If the agency finds the allegations have merit, it may intervene by either encouraging the prime contractor to make timely payments by reducing or suspending payments to the prime. Unfortunately for subcontractors, the language of the FAR is not mandatory, leaving the level of pressure brought on the prime to the agency. Generally, agencies are reluctant to become involved in disputes between a prime contractor and its subcontractors, which the government views as purely private in nature. However, if the subcontractor can convince the agency services were rendered and there was no performance related issues, the government may intervene to ensure that funds earmarked for the subcontractors have not been wrongly diverted. (Editor’s Note. We have found the mere threat of escalating a dispute to the government is a most effective method to expedite payment, making the “squeaky wheel” principle particularly relevant. Of course, though the threat can be inferred often, the act should be used sparingly if you want to continue as a subcontractor.)
If subcontractor wages remain unpaid as a result of a prime contractor’s failure to pay additional options are available. The government may withhold payments to a contractor if its finds that federal wages and hours laws applying to contractor personnel are violated. For example, determination by the Department of Labor that the Service Contract Act or Davis-Bacon Act have been violated can cause COs to withhold sums owed to contractors until violations have ceased (FAR 52.222-41(k).
Subcontractors can also arrange, with enough advanced planning, to assign moneys to an escrow agent (typically a bank) to disburse funds to a subcontractor. FAR 32.8 provides guidelines for such arrangements and they are not uncommon in high dollar service contracts where continued cash flow is critical for the subcontractor to meet ongoing payroll.
In construction contracts, subcontractors are even more protected. The Prompt Payment Act requires prime contractors under construction contracts to pay their subcontractors within seven days of receiving payment from the government or pay interest on the amount due. This provision is flowed down. In addition, contractors may be held for civil and criminal penalties under the False Claims Act (Section 3729) if they submit invoices that inaccurately reflect previous payments to subcontractors and suppliers.
FAR Clause 52.232-5 also requires prime contractors and upper tier subcontractors to certify on all fixed price contracts for each invoice submitted that payment to subcontractors and suppliers have been made from payments previously received and timely payments will be made to subcontractors from the proceeds of the invoice in accordance with the terms and conditions of the contract. At present, the FAR is being amended to strengthen this certification to state “all payments due to subcontractors and suppliers…have been made.”
RECENT DCAM CHANGES
(Editor’s Note. The Defense Contract Audit Agency Manual
(DCAM) is a two volume, 15 Chapter Plus compendium of guidance for DCAA auditors. It is updated twice a year and is used as a reference for not only DCAA but is considered authoritative guidance by other agency auditors and prime contractor audits of subcontractors. We frequently report on significant guidance issued during the year in the GCA
REPORT and the DCAM incorporates these changes as well as other changes it makes. In this article, we will report on changes to both the January 2002 edition (we received our copy late) and the more current July 2002 edition.)
The January 2002 edition includes:
Chapter 14, Implementing paid cost rule. Under the category of “Incurred costs” for payment requests, the new guidance now recognizes the paid cost rule that eliminated the requirement of large contractors to pay a subcontractor before including the amount in its vouchers or progress payment requests. It adds conditions for billing the government for costs not actually paid by limiting such billings to whether (1) they will be paid in accordance with the terms and conditions of either the subcontract or invoice and
(2) they will ordinarily be paid before the contractor’s next payment request.
Chapter 14, Risk assessments of financial capability. The new guidance alludes to DFARS 232.072 that stresses the need of contracting officers to determine the financial capability of contractors and as their financial advisor, stresses it is DCAA’s responsibility to evaluate their financial condition. The new guidance addresses how DCAA is to conduct the first stage of a financial capability audit – the risk assessment – whether requested by the CO or self-initiated by DCAA.
DCAA offices are now required to conduct an annual financial conditions “risk assessment” at both major and now nonmajor contractors, unless such a risk assessment was performed and documented as part of another audit. For nonmajor contractors, if an annual risk assessment is not performed due to audit inactivity, an assessment will be performed at the first field visit. A detailed risk assessment should be performed cyclically every three years with a “modified” financial risk assessment made in the other two years.
Chapter 14-304, “Financial Condition Risk Assessment Procedures” has been extensively expanded to provide detailed steps in conducting a risk assessment for theonce-every-three-year assessment. These steps include:
1.An analysis of the contractor’s key financial ratios and trends as well as comparisons with averages for applicable industry ratios.
2.An analysis of the financial data using theso-called “Z-Score” bankruptcy prediction models developed by Dr. Edward Altman. (Though too detailed to discuss here they are included in Figure 14-3-2 in the DCAM).
3.Evaluation of adequacy of the contractor’s internal control structure for financial planning and monitoring and
4.A follow-up on any indicators that raise questions about a contractor’s financial capability.
The procedures for the modified risk assessment conducted in all other years include:
1.Calculation and analysis of the trend of key financial ratios without comparison with industry averages.
2.Analysis of any significant events the auditors become aware of that can impact the contractor’s financial condition.
If indications of financial distress are encountered during the modified assessment, auditors are told to expand to a detailed assessment.
At a minimum, the following financial ratios are to be determined and evaluated:
1.Current ratio (Current Assets/Current Liabilities).
2.Acid Test or Quick Ratio(Current Assets – Inventory/Current Liabilities)
3.Return on Equity (Net Income/Total Assets)
4.Debt to Equity Ratio (Total Debt/ Stockholders’ Equity)
5.Working Capital (Current Assets – Current Liabilities/Total Assets)
6.Cash Flow to Debt (Cash Flow
7.Cash Flow Return on Assets (Cash Flow/Total Assets)
8.Cash Flow to Sales (Cash Flow/Sales)
9.Cash Flow Adequacy (Cash Flow/Long Term Debt + Purchases of Assets + Dividends Paid)
10.Debt Coverage (Total Debt/Cash Flow).
Auditors are told that comparing a contractor’s ratios with industry average ratios and with trends of the company are strong indicators of financial health. When these indicators are negative, auditors are told to perform a financial capability audit.
The July 2002 edition of the DCAM addresses the following:
Chapter 5-700, MMAS. This section has been changed to implement a December 13, 2000 rule revision to DFARS 242.72 and the related material management and accounting system (MMAS) contract clause of252.742-7004 that eliminated the often onerous requirements for certain contractors to demonstrate compliance with MMAS policies, procedures and operation instructions. The guidance stresses that in spite of the elimination of the demonstration, the MMAS clause still (1) provides the same rights of access to contractors’ records (2) requires compliance with the ten MMAS standards outlined in the DFARS clause (3) requires contractors to assess their capability and to take timely corrective action and (4) provides for reduction and/or cessation of vouchered costs and progress payments if MMAS deficiencies have not be corrected.
Chapter 5-1107, Update to provisional billing rates to reflect actual costs. The revisions remind auditors that contractors’ billing of direct and indirect costs should be as close as possible to actual costs. Auditors are told to make sure contractors monitor their costs throughout the year and adjust billings either during or end of year if significant deviations between billed and actual costs exist. Auditors are also told to evaluate contractors’ procedures and controls to ensure prompt adjustments are made and that a contractor’s billing system can adequately provide cumulative cost data by contract over multiple years to assure billing costs do not exceed ceiling amounts.
Chapter 5-1107.11, Catching Overpayments. A new section has been added to ensure contractors’ billing system controls are adequate to identify contract overpayments, refunds to government are made on a timely basis and that any offsets of overpayments and underpayments are based on ACO or paying office instructions.
Internal controls need to include (1) identifying all outstanding over/underpayments (2) timely notification to CO and paying offices and (3) documentation for reasons of over/underpayment. Auditors will make sure the contractor has documentation for its (a) notifications to COs and paying offices (b) significant activities during resolution and (c) compliance with CO/paying office instructions.
For offsets, the guidance recognizes that contractors may offset overpayments and refunds against underpayments but the auditor is to verify the contractors’ controls include: (1) significant offsets are made only after notifications and instructions from CO/paying offices (2) offsets are made on a timely basis (usually within 30 days) of identification of overpayments and (3) maintenance of a list of all significant offsets.
The contractor also needs to show it has policies and procedures in place to ensure their subcontractors’ accounting and billing system includes adequate identification and timely resolution of overpayments, refunds and offsets.
Chapter 6-711.3, Preparing cumulative allowable cost worksheets. Additional audit guidance was issued to provide clarification on the purpose, use and requirements of the Cumulative Allowance Cost Worksheets (CACWS) as well as how they should be
prepared. The guidance states auditors should verify receipt of cumulative cost and closing data in the contractor’s incurred cost submission (generally Schedules I and O). If not submitted, the proposal should be rejected as inadequate. The data should be examined and verified where the scope of examination will depend on the strengths and weaknesses of the contractor’s billing system. The lack of acceptable cumulative cost data should be viewed as a “billing system deficiency” where auditors will follow procedures for such deficiencies. If prior submittals lacked adequate data but the contractor is willing to provide the information prospectively, auditors will work with the contractors to establish a mutually agreeable process for closing old contracts where cumulative data is absent.
Auditors are also told to be flexible on the format of the information where contractors need not adhere strictly to the DCAA recommended format of the CACWS. The basic data required for the CACWS to be used by the CO to close out a contract includes (a) contract number and delivery/task order number (b) whether or not the contract is subject to the FAR penalty (c) whether or not the contract is ready to be closed (d) prior years’ settled costs (e) current year(s) costs (f) contract limitations on contracts ready to be closed (g) any unresolved assist audit amounts (h) if level of effort contract, actual hours incurred and (i) fee for contracts ready to close.
Once the information is compiled by DCAA, the CACWS should be attached to the rate agreement letter. The auditor should make it clear to contractors that their concurrence to rates also means they are concurring with the CACWS data and that that data will be the basis for closing out contracts. A signed rate agreement with the CACWS must be included in the incurred cost audit report. Most of the time the CACWS should be acceptable to the CO to close out contracts without requiring a contract close out audit.
Chapter 8-303, Audits of Disclosure Statements/Disclosed Practices. It has often been confusing for contractors when they were supposed to be going through reviews of disclosure statements or disclosed practices’ compliance with the cost accounting standards and FAR and the audit shifted to detailed audits of cost transactions. New guidance clarifies that compliance audits of initial disclosure statements should be limited to determinations of whether the disclosed practices comply with CAS and FAR. Testing of transactions, where practices are evaluated, should be conducted separately as part of the routine audit cycle.
Chapter 9-206, Auditing Other Than Cost or Pricing Data. In spite of the existence of numerous exemptions to having to provide certified cost or pricing data to a proposal, contracting officers are still responsible for determining whether the government is receiving a fair and reasonable price. When they cannot obtain sufficient information from either the government or outside sources to assure price reasonableness yet still cannot or do not want to seek out cost or pricing data they must rely on information “other than cost or pricing data.” Such data encompasses a broad range of data which is defined as “any type of information that is not required to be certified” where examples include price information, rate information or cost information that is not certified. The type of information other than cost or pricing data requested by the CO will differ depending on whether a price or cost analysis is being conducting and DCAA’s role of evaluating this information will largely be at the discretion of the CO.
Auditors are told they no longer can render an audit opinion on whether a proposal provides the basis for negotiating a fair and reasonable price when the proposed price is based only on sales or pricing information. Since prior acquisition reforms eliminated the old SF 1412 form that established objective criteria on sales or pricing information (e.g. specific percentages of sales made to the public) an audit opinion can no longer be given since new attestation standards require review of only objective data. Though no opinion can be made, auditors may still assist COs to determine price reasonableness by applying “agreed-to procedures” (i.e. more limited steps than a full-scale audit). Such procedures will be based on discussions and agreements with the CO with the understanding the audit report will disclaim an opinion.
If information other than cost or pricing data does include cost data (even if not certified) then auditors may perform “examinations” of a proposal, either as a whole or just certain parts. DCAA will determine whether the submitted cost data is sufficient to render an opinion and new guidance in Chapter 9-212 points to various types of opinions and qualifications of opinions that may be provided. Audits may also be conducted on only specific cost elements (e.g. labor rates) of a proposal or even part of specific cost elements (e.g. indirect labor rates) where information other than cost or pricing data is submitted. Auditors are also instructed to evaluate the adequacy of the information given and to express an opinion on whether the government’s interests are protected.
GOVERNMENT
REQUIREMENTS FOR SCANNING DOCUMENTS
(Editor’s Note. Many of our readers have indicated they are either currently in the process or may soon convert their paper documentation into electronic imaging. Though formal guidance on this relatively new phenomenon has not been issued by any government agencies we know of there are numerous indications such changes are being accepted by the government if they are properly done. When confronted with this issue, most COs are delegating the task of evaluating contractor efforts to DCAA and our informal discussions with DCAA auditors indicate some reviews are being conducted. Though none of our staff have been personally involved as either consultants or former auditors, we thought it would be a good idea to identify the relevant regulations and guidance DCAA is using to evaluate such conversions. Though contractor personnel in charge of this process are rarely knowledgeable about government rules the following considerations should be incorporated into the conversion process. Feel free to distribute this article to the relevant personnel involved in your conversion.)
Regulations
FAR Subpart 4.7 covers contractor records retention. FAR 4.703(d) was amended in 1995 to allow contractors to retain records in any medium (including computers) or any combination of media if the following requirements are met:
1.All requirements of FAR Subpart 4.7 are satisfied.
2.The process used to create and store records must reproduce the original document, including signatures and other written or graphic images, completely, accurately and clearly.
3.The procedures for data transfer, storage and retrieval protect the original data from alteration.
DCAA Guidance
Though we were not able to find any official guidance or audit programs, auditors we spoke to indicated they must follow guidelines in Chapter 1-505 of the DCAA Contract Manual (DCAM). Those guidelines provide 14 requirements for transferring records from a hard copy to a computer medium a contractor must meet to demonstrate it is in compliance with FAR 4.703(d). They are:
(1) A reliable computer medium (which includes vendor supported benchmark data).
(2)Documented procedures for data retention and transfer which provides reasonable assurance the integrity, reliability and security of the original hard copy data will be maintained.
(3)An audit trail describing the data transfer.
(4)A computer medium which cannot be destroyed, discarded or written over. The guidance suggests the contractor needs to consider appropriate transition to non-erasable storage.
(5)A transfer process that includes all relevant notes, worksheets and other papers necessary for reconstructing or understanding the records, including appropriate back-up procedures.
(6)Adequate internal controls including segregation of duties, particularly between those responsible for maintaining the general ledger and related subledgers and those responsible for the transfer process.
(7)A procedure prohibiting record destruction during the implementation phase until it can be shown that the system actually provides acceptable copies of the records transferred.
(8)An acceptable system of continuing surveillance over the computer medium transfer process. This includes comparisons of original records and the computer generated copies as well as periodic internal control audits. The policies and procedures should provide for maintenance of adequate evidence of this continuing surveillance.
(9)A requirement to maintain all original records for a minimum of one year after the date of transfer.
(10)Adequate procedures for periodic internal and external audit.
(11)Adequate procedures for labeling and storing the computer medium in a secured environment. The
storage procedures should meet the minimum standards prescribed by the National Archives and Records Administration for maintenance and storage of electronic records.
(12)Adequate procedures for the random sampling and testing of all records retained in accordance with the National Archives and Records Administration. Procedures should include provisions for notifying the CO of significant losses on a timely basis.
(13)Procedure for retrieving records at the time of audit. Procedures should include provisions for printing a hardcopy of any record. In addition, policies should include provisions for access by government representatives at the time of examination to the necessary computer resources that are necessary for the production of the retained records.
(14)Procedures for preventing the destruction of any hard copy records that are required to be maintained by existing laws or regulations.
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