REJECTING A DCAA DISALLOWANCE OF “PUBLIC RELATIONS” EXPENSE
(Editor’s Note. Auditing advertising and public relations costs represent likely areas for audit scrutiny. This category of expense often represents significant dollar amounts and since they are often considered “expressly unallowable” often include penalty provisions. The regulations covering “public relations” costs is an example of one of the cost principles that can be subject to many interpretations. FAR 31.205-1 defines public relations costs as functions and activities dedicated to enhancing an organization’s image or products and maintaining or promoting favorable relations with the public and intends for such costs to be unallowable. But the same regulation makes certain public relations costs allowable so disputes will arise on whether a given transaction is an unallowable public relations expense or meets one of the many allowable activities. Below is a summary “case study” of a response our consulting group made to a DCAA draft audit report that questioned certain vendor charges as unallowable advertising and public relations expenses. The client is a large engineering firm and we will refer to it as “Contractor.”)
Background
The costs being questioned relate to various printed material Contractor produces and makes available to whoever asks for information. Contractor receives numerous requests from a large number of constituents to provide information about its technologies, capabilities, nature of its projects, experience of personnel, analyses of risks, contacts for follow-up technical questions, etc. Rather than respond individually to these requests, Contractor prepares material in advance to provide the requested information. The constituents who regularly request information include actual and potential clients (government and non-government), actual and potential vendors, various community groups, actual and potential teaming partners, security analysts, representatives of the media, etc.
The disputed material includes the following:
6.. Folders. These are two page two colored folders printed on glossy paper which are intended to hold the all the other material.
The material is usually located in one back area of each office so employees may collect and distribute relevant information to provide their constituents.
DCAA Position
During its audit of two years of incurred cost proposals, DCAA examined numerous transactions and isolated the invoices of one vendor that produced the material discussed above. The invoices included design and production of the material and DCAA questioned over $250,000 of the invoices in each year. It referenced FAR 31.205-1 as grounds for disallowing the costs stating the design and production costs associated with the material was “unallowable advertising and public relations costs.” Also, since FAR 31.205-1 “expressly disallowed the costs” DCAA recommended imposition of penalties on the questioned costs.
Our Response
Allowability
Though we agree that the referenced FAR 31.205.1 cost principle is the appropriate cost principle, we believe sections FAR 31.205-1(e)(2)(i), (ii), (iii) and (f)(3) are the relevant sections of the cost principle to consider. Specifically:
FAR 205-1(e)(2)(i). “Allowable public relations costs include costs of responding to inquiries on company policies and activities.” Rather than respond to large numbers of inquiries with individualized responses, Contractor believes it is prudent to anticipate inquiry areas and have ready responses that can be selected and sent out quickly. All the material in question is material used to respond to inquiries about Contractor’s policies and activities.
FAR 205-1(e)(2)(ii). “Allowable public relations costs include costs of communicating with the public, press, stockholders, creditors and customers.” The material in question is used frequently to communicate with each constituent identified in the above FAR section, especially customers and creditors (e.g. vendors).
FAR 205-1(e)(2)(iii). “Allowable public relations costs include costs of conducting general liaison with news media and Government public relations officers…” The material in question is also frequently distributed to representatives of various media (e.g. numerous industry publications, various media groups) and government representatives including government public relations officers, project managers, technical and contracting personnel. The material is provided either when requested or when Contractor decides the public needs to be informed about its experience or capabilities.
FAR 205-1(f)(3). “Costs (are unallowable) of sponsoring meetings, symposia, seminars, and other special events when the principal purpose of the event is other than dissemination of technical information.” The nature of the material in question can most accurately be characterized as “dissemination of technical information.”
Discussion of Material
IN OUR RESPONSE, WE DISCUSSED THE NATURE OF EACH TYPE OF PUBLICATION IN DETAIL DRAWING ON TECHNICAL REPRESENTATIONS, PREPARED DATA ON THE QUANTITY AND DOLLAR AMOUNT OF EACH TYPE AND PROVIDED MANY SAMPLES OF EACH. SINCE SOME ITEMS WERE CLEARLY RELATED TO DISSEMINATION OF TECHNICAL INFORMATION WHILE OTHERS NOT SO CLEAR, WE SOUGHT, AS A BACKUP POSITION, ALLOWABILITY OF AT LEAST A MAJORITY OF THE COSTS. WE HOPED TO THOUGH TOO DETAILED TO RECOUNT HERE, WE WILL SUMMARIZE THE MAIN ITEMS BELOW:
The item representing the majority of material, Statement of Qualification, clearly meets the allowable function of “dissemination of technical information.” It is a drab product – plastic spirals, single color printed on simple paper (only the cover sheet is multi-colored and glossy) and is single spaced where the text simply describes Contractor’s services, projects and personnel relevant to a specific technical areas (e.g. geoanalytics, storage tanks, solid waste, hazardous waste, etc). There is no way the contents of this item could ever be confused with “splashy” public relations brochures.
Similarly, the Atlas and Contractor’s folder is purely functional. The atlas provides information on the locations of environmental agencies while the company folder is merely a vessel to hold other information distributed to constituents.
Only the Comprehensive Resources Strategic Solutions and some of the single sheet inserts contains some of the elements that may be associated with brochures like multi-colors, photographs and glossy paper. These items, however, are rarely distributed by themselves but are usually sent with other material where the overall intent of the entire package is consistent with the allowable sections of the FAR 205-1 sections (e.g. communications, liaison, etc.) Most commonly, a package of information consists of most, if not all, the items identified in the exhibit below and are almost always sent for at least one of the following purposes – to provide “technical information” to a constituent, liaison with news media or government and most commonly to either respond to inquiries on company activities and policies or communicate with various constituents such as the “public, press, stockholders, creditors and customers.”
IN RESPONSE TO COMMON DISTINCTIONS DCAA AUDITORS HAVE MADE IN THE PAST, NORMALLY GLOSSY PAPER, MULTI-COLOR ITEMS ARE FLAGGED AS ADVERTIZING ITEMS WHILE MORE PLAIN ITEMS ARE MORE AMENABLE ALLOWABLE CATEGORIES
The existence of glossy paper and multi-colors on a few of the items the vendor provides should not be confused with advertising and public relations material. The days when there was a significant price difference between one to three colors printed on nondescript paper and multi-colored, glossy paper where the later was reserved only for “advertising” are gone. Now, there is little price difference between the two types of material so the existence of material printed on glossy paper using multiple colors does not mean the material is for advertising – we maintain that different types of printed material can and is used for allowable communications purposes.
Though beyond the scope of this article to discuss in detail, we also argued the FAR and DFARS “expressly unallowable” condition for imposing penalties on unallowable costs was not met because the regulation provides for some adverstising and public relations costs to be allowable and the current circumstances are ambiguous at best which fails to meet the courts’ criteria of “clear beyond cavil” condition for a cost to be “expressly unallowable.”
Financial risk assessment and financial capability audits have become a hot topic in the light of recent corporate scandals. Whereas financial capability audits were usually limited to new contractors to ensure they could perform and to large contractors, now financial risk assessments must usually be conducted annually. Audits can become quite detailed, especially in states where CPA credentialing authority allows these DCAA audits to meet the practice requirements of being certified.
The evaluation of a contractor’s financial capability to perform government contracts really involves a two distinct audit process.. The first step includes a financial condition risk assessment where …. The second process includes a financial capability audit where … In this article we will focus on the risk assessment steps since those are the requirement to conduct these steps will affect virtually all contractors and the most recent new audit guidance addresses this first step. We will discuss financial capability audits in a later article. Our source is the Defense contract Audit Agency Manual, Jnauary 2002 or later issues.
The Defense Contract Audit Manual (DCAM) Chapter 14-300 covers financial capability audits and that section has been extensively expanded. The stated purpose of the financial capability audits are to determine if the contractor is financially capable of performing on government contracts as required by FAR 9.104-1(a), where financial difficulties may disrupt production schedules or create inefficiencies that interfere with contract performance. These conditions can not only affect contract performance but can result in monetary losses to the government on guaranteed loans and progress payments.
Though many capability audits are performed in response to requests by contracting officers DCAA now stresses that auditors need to be alert to conditions indicating unfavorable financial conditions during the performance of their other audits. Now, field auditors must self-initiate an annual assessment of a contractor’s financial condition to determine whether there is a need to conduct a financial capability audit. The financial assessment, discussed below, will be conducted either as a separate review or in conjunction with other audits. The financial capability audit is intended to evaluate the contractor’s current financial condition and trends, near-term cash flows and near and long term capability to obtain funds outside normal operations. Whereas historical financial data can be useful to identify unfavorable financial conditions during the assessment phase, the audit focus is on the contractor’s capability to maintain future cash flows to sustain its contract performance.
Frequency of Definitions of familiar terms
For multi-division or multi-segment companies, the separate subsidiary or division of a contractor will not be considered as a separate entity unless obligations, including contract performance, is not legally binding on the parent organization. The guidance states that parent organizations are usually not legally responsible for the obligations of their subsidiaries so the focus should be at the segment level. Even if there is a guaranty agreement where the parent is responsible for the subsidiary, auditors are not relieved of the responsibility to evaluate the subsidiary – rather, the financial condition of the guarantor should also be evaluated along with the subsidiary.
Frequency of the Risk Assessment. The frequency of reviews has been increased. Each branch office is now required to conduct an annual financial condition risk assessment of the financial condition of both major and non-major contractors unless a risk assessment was performed and documented during other reviews during the year. For non-major contractors where there is no audit activity, a financial condition risk assessment will be performed at the first field visit during the next fiscal year.
A detailed financial condition risk assessment should be performed every three years with modified financial condition risk assessments performed during the years when a detailed risk assessment is not performed.
Financial Condition Risk Assessment Procedures
DCAA has developed a new audit program that identifies detailed steps for performing a financial capability audit. The audit program contains risk assessment steps the auditor needs to perform to determine the need for a financial capability audit. The detailed financial risk assessment consists of performing:
The modified financial condition risk assessments, which are performed in the years the detailed risk assessment is not performed includes:
If indicators of financial distress are encountered during the modified risk assessment then it should be expanded to perform a detailed risk assessment.
Much of the new expanded audit guidance involves detailed guidance of the above steps.
Analysis of Key Financial Ratios
The analysis of key individual financial ratios are considered the primary data source for evaluating the financial health of the contractor. The guidance states the ratios need to be “used with care” where general rules of thumb should be avoided. Rather, the contractor’s ratios should be compared with ratios found in the “applicable average industry ratios”. Ideally the ratio analysis of the contractor and industry should cover three to five years of comparable data. For companies not publicly traded, the source of data should be the contractor’s financial statements – Balance Sheet, Statement of Income and Statement of Cash Flows. The source of data for publicly traded companies as well as average industry ratios are maintained by DCAA at its Technical Support Branch. HOW TO ACCESS.
At a minimum, the following key ratios are to be calculated and monitored:
Current Ratio (Current Assets/Current Liabilities). This ratio is used to measure a company’s ability to pay its short term liabilities from its short term assets.
Acid Test or Quick Ratio (Liquid Assets/Current Liabilities). This measures a company’s ability to pay off its short term obligations from assets that are readily convertible to cash.
Return on Investment – ROI (Net Income/Total Assets). This measures economic performance and is used as an indicator of management effectiveness and to earn a satisfactory return.
Debt to Equity Ratio (Total Debt/Stockholders Equity). Measures the relative size of creditors’ claims compared to claims of owners.
Working Capital (Current Assets-Current Liability/Total Assets). The ratio of net liquid assets to total capitalization. Consistent losses will shrink current assets in relation to total assets.
Cash Flow to Debt (Cash Flow: Net Income +Depreciation +Depletion + Amortization/Total Debt). This is an indicator of available funds to satisfy debt obligations and is considered by many to be the best indicator of financial distress.
Cash Flow Return on Assets (Cash from Operations/Total Assets). Measures cash generated from operations as opposed to income.
Cash Flow to Sales (Cash from Operations/Sales). Shows the percentage of each sales dollar realized as cash.
Cash Flow Adequacy (Cash from Operations/Long term debt + Purchases of Assets + Dividends Paid). This measures ability to generate cash sufficient to cover cash requirements to pay debt, reinvest in operations and make distributions to owners.
Debt Coverage (Total Debt/Cash from Operations). Measures how many years it will take to retire all debt at current level of cash from operations.
The auditor is told to ask the contractor if there are other financial ratios that should be considered when evaluating their financial condition. The purposes of monitoring the ratios is based on the concept that as businesses deteriorate so do the key ratios. Similarly, comparison to industry averages provides another indicator of financial problems. When a contractor is experiencing a negative trend and it is worse than the industry average, red flags are raised requiring the auditor to perform a financial capability audit.
Failure Prediction Models
DCAA believes a bankruptcy prediction model is another key tool that provides insight into a contractor’s financial health. Auditors are instructed to use one of the three “Z-Score prediction models developed by Dr. Edward Altman.
A contractor falls into one of the three models. Model l represents publicly traded manufacturing companies (primarily SIC codes 2000 through 3999), Model ll represents all privately held companies while Model lll represents all remaining companies. The bankruptcy models take several variables corresponding to key financial ratios – working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, stockholder equity/total liabilities and sales/total assets – and assigns point scores to each variable and computes a weighted average score that takes into account the contractors scores and how they compare against industry averages. (See Figure 14-3-2, The Altman Z-Score Formulas, in a recent DCAA Contract Audit Manual for additional information on the computation of Z-Scores.) DCAA maintains data for publicly traded companies and industry averages which are available at its OTST and also provides software programs for entering financial data and computing the prediction model scores.
Auditors are cautioned against putting excessive reliance on Z-scores but are told to use it as an initial indicator of financial problems. When using the Z-scores, auditors are encouraged to perform trend analysis of the current and previous two years as well as comparisons to industry averages. When the Z-Scores are below certain specified levels auditors are told a financial capability audit may be required. They are told to consider Z-Score trends, ratio analysis, financial statement evaluations and other indicators in deciding whether to go further.
Financial Statement Indicators of Distress
In addition to the financial ratios evaluated below, the new guidance points out that certain financial statistics of the contractor can provide additional insight into negative financial trends and distress. Common conditions may include recurring operating losses, working capital deficiencies and negative cash flow from operations. To identify indicators of financial problems auditors are told to obtain financial statements for at least five of the preceding years as well as the current and forecasted fiscal years. The financial data from these statements should be analyzed and trend data compiled in the following areas: profit/loss, net income/loss from operations, cash flow from operations, cash flow from investing activities, cash flow from financing activities, sales, working capital (current assets minus current liabilities), noncurrent liabilities and total assets.
The guidance states auditors are to be alert to any lack of operating success evidenced in overall losses or net losses from operations. When these losses exist particular emphasis should be placed on reviewing cash flow in the ordinary course of business. Also, significant deterioration in sales or increases in liabilities should be monitored since these affect the contractor’s ability to meet ongoing operations costs. If these statistics demonstrate the contractor is or will be in financial distress, DCAA should consider conducting a financial capability audit.
Internal Controls
Auditors are also instructed to consider the adequacy of contractors’ internal controls related to financial planning and monitoring. The internal controls to be evaluated should include: (1) written policies and procedures that require evaluation of current financial conditions in order to anticipate financial distress (2) preparation of cash flow forecasts along with documentation of assumptions (3) periodic assessments of accounts payable and accounts receivables that includes an analysis of aging and collectability of accounts (4) periodic assessments to ensure the company is compliant with loan covenants and debt payment schedules and (5) periodic assessment of contract cost performance.
Other Indicators of Distress
This section of the guidance is intended to identify any other indicators that raise questions about contractors’ financial distress. The guidance stresses that the auditors may become aware of significant indicators in their analysis of financial statements and accompanying notes, audit leads during prior audits, discussions with contractor personnel and other government representatives. Significant events and conditions to be alert to include:
defaults on loan/line of credit agreements
denial of usual trade credit from suppliers
restructuring of debt resulting in paying higher interest rates
noncompliance with loan/line of credit covenants
contracts in significant loss positions
legal proceedings/pending claims
loss of principal customers or suppliers
uninsured or underinsured catastrophes
labor strikes
(10) unpaid taxes
(11) contingent liabilities
(12) deteriorating bond ratings
(13) significant dollar amounts of accounts receivable
(14) material defective pricing findings from post award audits
(15) contract termination for default
(16) deferral of payments to suppliers
(17) failure to fund pension plans
(18) loans from employees or issuing of stock to employees in lieu of salary
(19) environmental clean-up impact
(20) significant unpaid contractor debts
(21) unusual progress payment or other billing concerns
(22) parent company undergoing financial distress
(23) physical condition of facilities
(24) unpaid insurance liabilities.
In addition, the auditor and supervisors should discuss with the contractor any plans to enter into significant lease, make significant capital expenditures, liquidate assets, borrow significant cash or restructure debt, reduce or delay expenditures and increase ownership equity. Also, any unusual compensation packages or outstanding loans to other company operations or offices that would drain financial resources from operating units having government contracts should be identified.
Once the applicable risk assessment procedures have been performed the conclusions should form the basis to decide to perform a financial capability audit. When the risk assessment is initiated by DCAA and no significant risk is identified then the results should be summarized in a memo for the record; when no significant risk is found for risk assessments requested by others then the conclusions should be communicated to the requestor and the conclusion that no further analysis is warranted should be confirmed in a memo. If the requestor still desires performance of a financial capability audit or DCAA has decided that sufficient risk exists then a financial capability audit should proceed.
(Editor’s Note. Subcontracting with the federal government can be quite profitable but the roles, rules and requirements of subcontractors can be uncertain. “Subcontractors” include any suppliers, distributors, vendors or firms that furnish supplies or services to prime contractors or other subcontractors. Sometime the federal procurement rules apply to subcontracts but other times they do not – relatively few subcontractors know the difference. These uncertainties are exaggerated by the fact many subcontracts are awarded in a “hurry up” context, where negotiations between the prime and subcontractor might be conducted by telephone, fax or email under rushed circumstances. Subcontractors are often saddled with uncertain contract terms because they feel they have to “take it or leave it.” Given these pressures and the lucrative opportunities that exist both prime contractors and subcontractors need to understand the fundamentals of subcontracting. In this article we will provide a brief overview of the key procurement rules affecting subcontracts, the requirements for and type of flow-down clauses, the relations between prime contractor source selection and subcontracts and several contract administration issues. The following article is based upon an excellent article we found in the February 2003 edition of Briefing Papers written by Steven W. Feldman of the U.S. Army Engineering and Support Center. The author provides references, either regulations or case decisions, for virtually every assertion but we will avoid such extensive footnoting.)
Basic Procurement Rules
Federal statutes, regulations and “common law” (i.e. case law principles) govern the relationship between U.S. procuring agencies and contractors. The Armed Services Procurement Act governs purchases by DOD and NASA while the Federal Property and Administrative Services Act govern the civilian agencies and the General Services Administration. Then special statues further affect federal acquisitions such as the U.S. General Accounting Office that consider protests and the Contract Disputes Act (CDA) that cover postaward claims and disputes. In addition, the Office of Federal Procurement Policy Act issued the Federal Acquisition Regulation and then most federal agencies have issued their own acquisition regulations supplements. Most federal statutes and regulations do not apply to subcontractors because the federal government and subcontractors generally lack “privity” – a direct contractual relationship. However, in numerous instances that we will discuss the statutes and regulations can apply to federal subcontractors.
Publicizing and Planning Procurements. The FAR provides that the federal government announce most acquisitions exceeding $25,000 at the government-wide point of entry located at www.fedbizopps.gov. Businesses interested in becoming subcontractors for a particular acquisition should contact the agency for a copy of the solicitation and perhaps more importantly, attend the agency’s in person proposal conference in order to gain additional insight about the procurement and interact with other firms especially prospective prime contractors and upper-tier subcontractors. Other FAR provisions in the procurement planning process affecting subcontractor under larger acquisition include (1) agencies must address their plans for achieving subcontract competition (2) establish solicitation mailing lists for interested firms and (3) will have small business specialists to aid small businesses.
Subcontract Competition. Though most federal procurements are subject to the “full and open competition” requirements where all responsible sources must be permitted to compete, these requirements do not apply to subcontracting giving prime contractors great leeway on subcontractor competition. The only exception is for cost reimbursement contracts that include the “Competition in Subcontracting” clause at FAR 52.244-5 that requires prime contractors to select subcontractors “on a competitive basis to the maximum practical extent.” The contractor is required to determine the availability of subcontractor sources unless the government includes a warranty of the source’s availability or direct all prospective prime contractors use a particular subcontractor.
Contractor Team Arrangements. Ordinarily the government will recognize the integrity and validity of contractor team arrangements as long as the arrangements are identified and the company relationships are fully disclosed. The chief exception to this rule is where the combination violates a federal antitrust law.
Subcontract Consent. Sometimes the government must consent to the placement of subcontracts. If a prime contractor has a government approved purchasing system prior government consent will be limited only to subcontract limitations set by the CO in the “Subcontract” clause of the prime contract. If there is no such approval consent to subcontract is required for cost reimbursement, time and material, labor hour or letter contracts and for un-priced actions under fixed price contracts exceeding the simplified acquisition threshold (currently $100,000). Under cost type contracts, the contractor must notify the agency before award of any cost-plus-fixed-fee subcontract and any fixed-price contract that exceeds the dollar limits specified by regulation. In granting consent the CO must consider several issues. For example, COs may not accept cost type subcontracts exceeding certain minimum allowable fees or an agreement that requires the CO to deal directly with a subcontractor.
Subcontractor Costs and Pricing. The CO determines price reasonableness for all awards including subcontract costs. Prime contractors (and higher-tier subcontractors) must contribute to this process by (1) conducting appropriate cost or price analysis to determine reasonableness of proposed subcontract prices (2) including the results of these analyses in their price proposal and (3) submitting cost or pricing data, when required, as part of its own cost or pricing data. The meaning of “cost or pricing data” has a long history of dispute but it basically means all verifiable factual information as of the date of price agreement which a prudent buyer and seller would expect to affect price negotiations significantly. The author reminds us the FAR has a rather complex set of rules on when cost or pricing data is required or exempted from prime contracts (e.g. commercial items, adequate price competition). Regarding subcontracts, the prime contractor must obtain and analyze cost or pricing data when the higher-level contractor is required to submit the data and (1) the subcontract is $10 million or more or (2) the agreement is more than $550,000 and is more than 10% of the higher-level contractor’s proposed price, unless the CO considers such data unnecessary. On the other hand, the CO may require submission of cost or pricing data below the above threshold where deemed necessary for reasonable pricing.
Patent and Data Rights. The FAR has extensive rules governing rights in patents and data in contractor deliverables. These FAR prescriptions are implemented through more than 20 possible contract clauses plus additional ones in individual agency supplements. The authors recommend contacting a legal specialist in these areas but offer a few general observations. FAR Part 27.3 addresses contractor patent rights and the general rule is the policies and procedures covered here apply to all contracts at any tier. FAR Part 27.4 covers data rights and the government’s policy is to strike a fair balance between the agency’s mission needs and the contractor’s legitimate proprietary interests. Since rights in data – such as computer software documentation – frequently concerns subcontractor products the authors urge subcontractors to achieve a full understanding beforehand with their prime contractors about the rights in deliverables provided to the government. As for data right rules in DOD contracts, the applicability of data rights to subcontractors is still “unsettled”. DFARS Part 227.71 states data rights are to apply equally to prime contractor and subcontractors which implies that DOD clauses are included in subcontracts as a matter of law; however case law indicates that subcontractor’s rights in technical data are controlled by its contract with the prime, not the prime contract with the government.
Taxes. The FAR provides that prime contractors and subcontractors are generally not considered agents of the government for purpose of claiming the government’s immunity from sate and local taxation. Only an exemption under state or local law – if one exists at all – will provide tax relief for a transaction where the subcontractor provides supplies or services to a higher tier contractor. FAR 29.305 prescribes the rules whereby subcontractors may obtain state and local tax exemptions.
Commercial Item Subcontracting. The FAR expresses a strong preference for prime contractors and higher-tier subcontractors to incorporate “commercial items” or “non-developmental items” as components of items delivered to the government. The prime or upper-tier contractor has the discretion to make this determination and is not required to include any particular FAR clause in its lower level agreement except those required by regulation which is addressed in the “Subcontracts for Commercial Items and Commercial Components” clause at FAR 52.244-6.
Flow-Down Clauses
To maintain control over government agencies and ensure consistency in federal procurements FAR Part 52 contains numerous mandatory clauses to be included in prime Government contracts under stated criteria. (Editor’s Note. We refer the interested reader to our Fourth Quarter 2002 issue of the GCA DIGEST (Vol. 5, No.4) where we provide a complete list of mandatory and recommended FAR clause flow-downs that are identified by the Committee on Federal Subcontracting Section of the Public Law group of the American Bar Association. You can call them at 1-800-285-2221 to obtain a copy of their publication for $45.) Where the FAR authorizes COs to include the clause in the prime contract by reference i.e. FAR citation, title and date as opposed to the entire text, prime contractors must flow down the substance of FAR clauses and not just incorporate them by reference.
The author stresses the need to carefully review the clauses flowed down by the prime or higher-tier subcontract since there is the tendency for subcontracts to indiscriminately include excess FAR clauses including those intended only for a prime contractor. Typically, a prime contractor may use a commercially available standard subcontract that includes fill-ins and preprinted terms (e.g. contract payments, changes, terminations) and then will incorporate wholesale all the FAR prime contract clauses in the subcontract with little consideration for whether it should be flowed down. The results frequently are (1) the FAR clauses duplicate or often conflict with the preprinted commercial terms (2) the clauses have no substantive application to the subcontract because they are prime-contractor unique and (3) inclusion of the referenced FAR clauses likely fails to reflect the intentions between the parties. Another common example is under a cost plus fixed fee prime contract where firm fixed subcontracts are issued, the prime contractor often flows down its cost type clauses resulting in considerable confusion. Problems are not fixed when the prime contractor simply introduces the clauses by stating the word “prime contractor” will substitute for “government” or similar expressions. Subcontractors are encouraged to ensure their agreements do not include all prime contract FAR clauses and also when FAR-prescribed flow-down clauses are incorporated other conflicting terms should be eliminated.
Prime Contractor Source Selections and Subcontracts
Most acquisitions over $100,000 are government negotiated contracts governed by FAR Part 15 where price and non-price factors are considered, discussions are allowed and revisions to proposals are common once proposal deficiencies are pointed out. Under negotiated proposals, subcontractor information and eligibility are key items.
Subcontractor Participation. Some regulations or contract terms may limit the offeror’s ability to use subcontractors In small business set aside prime contracts the “Limitations on Subcontracting” clause (FAR 52.219-14) restricts the amount of subcontracting in service contracts where the prime must use at least 50% of the cost of contract performance incurred for personnel for its own employees. Construction contracts will commonly prescribe certain percentages of the work done. Several clauses strongly encourage prime government contractors to subcontract with small business concerns and disadvantaged small businesses and FAR 52.219-10 requires that each successful offeror on a contract exceeding $500,000 ($1 million for construction) submit an acceptable subcontracting plan where monetary incentives for outstanding performance (FAR 52.219-10) and penalties for lack of good faith performance (FAR 52-219-6) is included. Subcontracting is important in research and development contracting where in FAR 35 the government emphasizes agencies need to know whether proposed subcontractors are qualified and hence need to have advanced knowledge of subcontracts for technical or scientific work.
Organization Conflict of Interest. Sometimes organizational conflict of interest (COI), which exists when because of other activities or relationships an organization is unable or potentially unable to render impartial assistance to the government, can create grounds for protests. The GAO has held an awardee will have an unfair competitive advantage when the proposed subcontractor possessed competition-available information through its prior government work which is not available to other offerors.
Subcontractor Experience. When the solicitation has no restrictions on subcontracting there is significant room to use subcontractor to enhance proposals because the government may accept a proposal with substantial subcontracting and no offeror may be penalized merely for proposing subcontractors. Agencies may reasonably consider a proposed subcontractor’s experience when rating prime contractor qualification if the solicitation allows subcontractors to perform the particular work and if the RFP does not prohibit such evaluations. Also, no prohibition exists against more than one offeror proposing the same contractor.
Subcontractor Past Performance. When evaluating an offeror’s past performance the agency may grade the offeror based on the performance of its proposed subcontractors on previous projects because the prime contractor is responsible for its subcontractors’ performance. Government evaluators may reasonably decide not to credit the offeror with its subcontractor’s performance when the subcontractor would do minimal work under the contract.
Mistakes in Subcontract Offers. The general principle is that awards can be adjusted for mistakes when they are clear-cut clerical or mathematical errors or misreading of specifications as opposed to judgmental errors. When the prime contractor’s error is based on the subcontractor’s error the prime contract is still adjustable as long as the prime contractor was unaware of the underlying error.
Subcontractor Responsibility. COs are prohibited from awarding contracts to “nonresponsible” contractors (e.g. deficient in financial resources, ability to meet contract requirements, satisfactory performance record, integrity and ethics) so contractors need to affirmatively demonstrate its responsibility including that of its subcontractors. Agencies may assume the prime properly ascertained its subcontractor’s responsibility unless evidence shows the prime made an insufficient investigation. The government is entitled to make its own independent determination of a subcontractor’s responsibility.
Debarment and Suspension. Agencies may debar or suspend subcontractors form participating in government contracts when they are debarred or suspended. The government uses the List of Parties Excluded From Federal Procurement and Non-procurement Programs available at http://epls.arnet.gov.
Subcontractors’ Right of Protest. In general, since subcontractor arrangements are essentially private matters between prime contractors and subcontractors, aggrieved subcontractors have few rights in a federal forum to challenge alleged violations of procurement rules before award of the contract. The General Accounting Office is the usual forum for “protests” – a written objection by an interested party to a solicitation or award where the objection alleges improprieties in the award of a contract. Since an “interested party” is defined as an “actual or prospective bidder or offeror whose direct economic interest would be affected by the award” a subcontractor would not meet this definition. This interested party exclusion also applies to protest efforts at either the U.S. Court of Federal Claims and at the agency level since the definition of interest party is the same.
The GAO does recognize an exception for subcontractor protests where the subcontract selection is “by” the government. This process occurs when all or most meaningful aspects of the procurement are controlled by the federal agency officials and the prime contractor is a mere conduit of the agency whose primary concern is administrative. Also, subcontractors may be entitled to monetary relief when their prime contractors prevail in a joint effort protest to the GAO where successful protesters may recover costs for bid and proposal preparation costs and protest costs.
Contract Administration Issues
Miller Act Payment Bonds. Contracts covered by the Miller Act require payment bonds from the prime contractor on projects exceeding $100,000. The Act is intended as a substitute for a subcontractor’s right to obtain a mechanics lien under state law because federal property is immune and the Miller Act is quite effective in ensuring payments to subcontractors. The payment bond protects subcontractors by ensuring payments to all persons supplying labor or material for the contract. Payment bond coverage is limited to the first and second tier subcontractors so no coverage exists for subcontractors of suppliers or third or lower tier subcontractors.
Subcontractor Payment. Subcontractors’ ability to obtain assistance from the government in collecting payments from the prime contractor is pretty limited. Congress amended the Prompt payment Act in 1988 to help ensure timely subcontractor payments on construction contracts by adding the “Prompt Payment for Construction Contracts” clause at FAR 52.232-27 that requires subcontractor payments for satisfactory performance within seven days out of payments received from the government with an interest penalty for late payments. This clause has flow-down coverage for each lower-tier subcontractor. Since the statute and clause are unclear how COs should deal with subcontractor complaints of untimely payments Congress enacted another statute (National Defense Authorization Act for 1992 and 1993) requiring COs to take certain actions upon receiving complaints of subcontractor nonpayment for all type of contracts. Implementing the statute in FAR 32.112, if the CO finds the prime contractor is not in with compliance with subcontractor payment terms the CO may (1) encourage the contractor to make timely payments or (2) reduce or suspend progress payments to the prime as authorized by the applicable payments clause. Subcontractors should not expect extensive CO mediation or resolution of the controversy since lacking privity with the subcontractor, the government usually does not wish to expend the time and resources to investigate all the facts and instead, expects the prime and subcontractor to resolve their own disputes. Most COs, however, will be concerned about whether the prime contractor’s certification of payment of a subcontractor or supplier accompanying its payment request accurate. As a final aid to subcontractors, FAR 32.112 provides that upon request of a subcontractor or supplier, the CO must promptly advise the inquirer as to certain information such as whether the prime contractor has submitted requests for progress payments to the government or whether it has received final payment.
Government Contract Quality Assurance. The various QA functions such as inspection provided in the contract will generally will not performed for subcontracts except in limited circumstances. For example, the government must perform the QA function at the subcontract level when the item is to be shipped from the subcontractor’s facility to the using activity and the inspection at the source is required. It should be noted that such government review does not relieve the prime contractor of its contract responsibilities.
Use of Government Supply Sources. Addressed in FAR 51 the government may permit the subcontractor to use government supply sources (e.g. GSA Federal Supply Schedules) under cost type contracts or other subcontracts where the majority of the supplier’s subcontracts are cost type.
Effect of Subcontractor Default. Under the standard “default” clauses the prime contractor is accountable for excess costs of re-procurement based on a default stemming from delays in providing goods or services even when such default is caused by the subcontractor. An exception is allowed when the failure to perform based on the subcontractor’s default is beyond the control of the prime or subcontractor and neither is at fault or negligent. Cases have held that illness or death of subcontractor personnel is not excusable because contractors must provide acceptable workforces but prime contractors can be excused for subcontractor delays due to production difficulties beyond the existing state of the art and that were outside the contemplation of the principle parties at award.
Pricing of Contract Adjustments. When the government and prime contractor negotiate a pricing adjustment action from, say an upward equitable adjustment for a change, the prime ordinarily will make the adjustment to its price when the change affects its subcontractor where the adjustment made below the prime contract level is governed by the subcontractor clause addressing changes. Conversely, the prime contractor and subcontractor can be affected when the government and prime contractor negotiate a downward price adjustment from say, deleted government work, but difficulties arise when the subcontract does not include the subcontract clause. Board cases have held the that where the prime contract change reduces subcontract costs the prime contractor can be liable to the government even though it is unable to obtain a price reduction from its subcontractor so the prime must protect itself by inserting appropriate coverage in the subcontract.
Impact of Terminations. When the government terminates a prime contact the prime makes a corresponding subcontract termination and the provisions of FAR 49 spell out the procedures for settling both the prime contracts and subcontracts. The overriding principle is the subcontractor has no contractual rights against the government upon termination of the prime contract and the prime contractors and subcontractors are responsible for the prompt settlement of their termination settlement proposals.
Subcontractor Claims and Disputes With the Government. Under the Contract Disputes Act a “contractor” has the right to have a claim against the government be considered by the contracting officer and appeals hear by agencies boards of appeal or the U.S. Court of Federal Claims.It is quite common for a subcontractor to believe it has sustained damages by government action but since the CDA and the FAR “Disputes” clause (FAR 52.233-1) use the term “contractor” subcontracts generally do not have a right to seek and collect damages because they are not in privity with the government. Accordingly, where the subcontractor seeks relief from the government it can proceed indirectly through the prime contractor in one of two ways: first, the prime contractor must sponsor and certify the subcontractor’s claim where the certification reflects the prime contractor’s belief there is “good ground” for the claim and second, a prime contractor filing a claim can include a component for its liability to a subcontractor. It should be noted that in an old 1943 case of Severin v. United States the government held the prime contract is not entitled to collect for the subcontractor when it has no liability for the subcontractor’s costs. Later cases put the burden on the government to prove there was no liability.
There are rare exceptions to the general “no-direct right of action” rule for subcontractors in CDA cases. First, the subcontractor will have a direct right of action where the contract terms state that parties indeed to give the subcontractor the right to direct appeal but since the FAR prohibits the COs from consenting to such an arrangement this circumstance is practically non-existent. Second, privity for CDA purposes will exist where the contract provides that the contractor will act as a purchasing agent for the government. Third, subcontract privity will be present when the government so circumvents the authority of the contractor that the contractor becomes a mere agent of the government. For example when the Small Business Administration awards an agency a contract under the “8(a) program” the agency subcontracts with an 8(a) firm the firm amy take direct action against the government.
The author provides a summary checklist:
General Comments
Contingent costs are initially unrealized costs. They are costs that may or may not actually be incurred in the future. Examples of contingent costs are service costs, warranty costs, insurance, indemnification and bonding costs as well as potential lawsuit liabilities. FAR 31.205-7 addresses “contingencies” as a generic costs and defines it as a possible future event or condition arising from presently known or unknown causes, the outcome of which is presently indeterminable.
Allowability. FAR 31..205-7(b) provides that contingency costs are generally unallowable for historical costing purposes because such costs deal with costs incurred and recorded in contractors’ books of accounts. It does provide for exceptions to this rule citing terminations costs as an example. Inclusion of contingency costs in claims and even incurred costs submittals as well as termination settlement proposals may be appropriate if they involve “minor unsettled factors in the interest of expediting settlement.”
Certain contingency costs are generally allowable for purposes of making cost estimates for either cost type or fixed price work. The FAR follows generally accepted accounting practices in distinguishing between two categories of contingency costs. The first category consists of contingencies that arise from presently known and existing conditions whose effects are reasonably foreseeable. Common examples of such costs are anticipated costs of rejects or defective work where costs of salvage and rework can be included in cost estimates. The Board of Contract Appeals has overturned challenges to use of a factor for warranty costs on the grounds they could be known based on exiting conditions (ASBCA No 12538). Historical data are usually relied on – so, for example, rejects occurring on similar contracts or provision of similar goods and services can be known and used as a basis for estimating the costs of rejects on the current contract.
The second category consists of contingencies that arise from conditions either known or unknown but whose effect cannot be sufficiently measured to provide equitable results to either the contractor or the government. Most lawsuits are considered examples of this second category where they are excluded from routine cost estimates. If inclusion of the contingency costs are included in cost estimates, the burden falls on the contractor to demonstrate they are of the first category. Also, though the second category of costs are excluded from routine cost estimates they may be separately estimated to negotiate an appropriate contractual coverage of costs (e.g. contract re-opener clause) though such action is usually a tough sell.
Service and Warranty Costs
Service costs arise from contractual obligations to provide, for example, installation and training. When not considered inconsistent with the contract terms, these costs are allowable. Warranty costs resulting from contractual provisions to correct product defects, replace defective parts and make refunds in the event of inadequate performance is allowable. You should expect to receive audit scrutiny to provide assurance that “double counting” is not occurring where there is a duplication of recovery first as a cost of production and then as a separate cost. For example, production cost estimates should exclude service costs from the production cost history when the proposal estimates separate service costs.
CHECK DCAM. Service and warranty costs can be a direct contract charge, indirect period cost or an indirect cost allocated on a reserve basis. As a direct charge, the cost must be included in the contract cost estimate as another direct cost and then allocated specifically to that contract. As an indirect period cost, the costs of all warranties are estimated for the period and included in the appropriate indirect cost pool. As actual costs are incurred, the costs are associated with the same cost pool. As an indirect cost allocated on a reserve basis, the estimated annual costs are either charged directly to cost objectives or to an indirect cost pool with a corresponding credit to a reserve for warranties. When actual costs are incurred, the charge is made to the reserve account.
When evaluating proposals, auditors can be expected to verify that a warranty was either requested by the contract solicitation or required by regulation. The auditors commonly check for inconsistencies between government and commercial product warranties, examine historical warranty cost data, try to identify trends that might have an impact on future warranty costs and review historical costs to assure that product and warranty costs have been segregated. To assure there is an equitable allocation auditors also review warranty costs by product line to determine the relationship between the costs and the government purchases.
In 1983 Congress passes legislation to require extensive use of warranties in purchasing weapon systems. Before 1983 warranty provisions were generally limited to other than cost type contracts and DOD still holds this position. Because of the problems in estimating and negotiating warranty costs many fixed price contracts still do not contain warranties, reasoning that the cost is too great to be justified by the benefit.
Insurance and Indemnification
Though we have addressed insurance costs in considerable depth in a previous issue we thought we would provide some summary information in this section since insurance costs are an important subset of contingency costs. Allowability criteria is as follows:
Bonding Costs
Bonding costs occur when the government requires assurance against financial loss to itself or to others due to an act of default by a contractor. In addition, a contractor may require similar assurances from subcontractors. These bonds include bid performance, payment, advanced payment, infringement and fidelity bonds are generally allowable if required by the contract or if required by the general conduct of the business.
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