Accounting & Finance

Accounting Practices for Government Contractors (Part 2)

December 11, 2017
Deltek, Inc
Deltek

This is the second in a two part blog series about accounting practices for government contractors. In the first blog we reviewed accounting principles, practices and how various costs are defined and handled in government contracting.  In this second blog we take a look at the contract types for government contracting and how revenue recognition is handled. 

Three Different Contract Types

There are three major contract types for government contracting, with many variations. This variety provides the flexibility necessary to accommodate the diversity of goods and services required by the federal government, from copier paper to aircraft carriers.

Firm-fixed price (FFP) contracts

When you purchase a couch it’s a firm-fixed price contract. One party pays the other a fixed amount for the agreed-upon goods or services. FFP contracts provide incentive for the contractor to control costs and perform effectively, with little administrative burden. An FFP is most suitable for acquiring commercial products, supplies, or services, so long as there are reasonably definite specifications, and the contracting officer can establish a fair and reasonable price at the outset.

As its name implies, an FFP contract means the price can’t be adjusted because of the costs incurred by the contractor. If it ends up costing you more to produce the good or service than you sell it for, those dollars come out of your profits.

Cost-type contracts

There are three main types of cost-reimbursable contracts where little risk is carried by the contractor:

  • Cost-Plus-Fixed-Fee (CPFF): This reimburses actual costs to the extent prescribed and a fixed-fee that doesn’t change unless changes in scope are negotiated. This contract type offers no overall incentive to keep costs down, so it is often discouraged.
  • Cost-Plus-Award-Fee (CPAF): This provides for reimbursement of actual cost, plus a base fee amount fixed at the inception of the contract, plus an award fee amount that the contract may earn in whole or part during contract performance. The fee is sufficient to provide motivation for excellent performance.
  • Cost-Plus-Incentive-Fee (CPIF): This contract has a fee that is adjusted by formula in accordance with the relationship between the total allowable costs. There is a negotiated target cost, a target fee, a minimum and maximum fee, and the fee adjustment formula. The final fee is determined in accordance with the formula at the end of the contract, and will exceed the target fee only when total allowable costs are less than the target costs.

Time and material contracts

Time and material (T&M) contracts provide for payment for direct labor hours worked at specified and negotiated fixed hour rates (fully loaded rates that include direct labor, indirect costs, and profit) plus any materials at cost and, if authorized at negotiation, indirect costs applicable to the material costs.

Labor hour contracts are essentially the same as T&M, except any materials involved aren’t supplied by the contractor.

Revenue Recognition Practices for Government Contracting

Revenue is earned as work is performed on a government contract, but billing schedules can vary depending on contract terms. The most common approaches for revenue recognition in government contracting are percentage of completion and cost incurred multiplied by a profit percentage.

Percentage of completion

This is used primarily on fixed-price contracts. The project manager will develop an estimate of costs required to complete the project. This estimate is added to the total actual cost incurred to date, giving estimated total cost at completion (EAC). The total actual cost incurred is divided by the EAC, giving you the percentage of completion. Here’s the formula:

Revenue = % of completion x total contract price

Cost incurred times a profit percentage

The profit percentage is a ratio of the total contract fee to estimated total contract costs. This approach, most commonly used with cost-type contracts, requires you to calculate target rates and actual rates. Also known as provisional, budget, or billing, target rates are established by agreement with the government (forward pricing) before the start of the fiscal year.

Actual rates are your year-to-date calculations. There is often a variance between the costs calculated using target rates and those using actual rates. The variance may impact both your income statement and balance sheet.

How the Contract Is Funded

Because the government prefers to fund contracts in increments, your award will contain both a contract value and a funded value. The contract value is the total potential worth of the contract. The funded value is the portion of the contract appropriated to date by your customer through various vehicles and modifications. It’s the limit available to the contractor until additional money is released.

Modifications issued to a government contract are classified as either bilateral (signed by the contractor and contracting officer) or unilateral (signed only by the contracting officer). Modifications are used for various purposes, including:

  • Adjusting the value of the contract or the funding
  • Shifting the scope or terms of the contract
  • Altering the contract for administrative reasons
  • Terminating or suspending the contract

Billing the Government

Billing the government can be a complex, multi-step process. Before you can stuff an invoice into an envelope, you need to be sure that you’ve properly calculated the billable amount and structured the invoice in accordance with your contract.

Carefully read the terms of your contract award for the specific format of the invoice you’ll need to prepare. Failure to comply could result in a delay of your payments, and few contractors can afford to jeopardize their cash flows. Many contracts will note specific government forms — you’ll see them referred to as Standard Forms (abbreviated SF). Some examples are the DD Form 250, SF 1034/1035, and SF 1443.

Technical Detail: The DD Form 250 is the Material Inspection and Receiving Report. It applies when your Department of Defense contract includes the DFARS 252.246-7000, Material Inspection and Receiving Report clause. It is used by the DOD to acknowledge contract compliance and may also be used by the contractor to submit an invoice.

SF 1034, Public Voucher for Purchases and Services Other Than Personal, is utilized by contractors to invoice under cost reimbursement or T&M contracts. SF 1035, Public Voucher for Purchases and Services Other Than Personal – Continuation Sheet, provides the requisite supporting detail. Often, the SF 1035 is also used to communicate any other information required by the terms of the contract.

Certain fixed price contracts will allow for progress payments based on costs incurred by the contractor. Progress payment requests may be made on the SF 1443, Contractor’s Request for Progress Payments. Generally, you will be instructed not to use the SF 1443 for your final payment request.

Note that cost-type contracts are billed to the government at target, or provisional, rates throughout the life of the contract. Provisional rates must be retroactively adjusted to represent the costs actually incurred during the period. If the final rate is greater than the provisional, the contractor may be able to recover additional government funds. A lower final rate, though, means that the contractor owes the variance back to the government.

An Important Tip: It is critical that your accounting system be able to store these multiple rates and compute the billable amount for each contract in a timely manner. It must be able to evaluate the allowability of costs, whether they exceed any ceilings associated with the contract, what labor category is connected with each employee, and a variety of other factors. Without such automation, you risk getting bills out the door late and, even worse, with a high probability of error.

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Deltek, Inc
Deltek