By Stephen Swales, Partner, Aronson, LLC
For years, I have been entertained by my clients’ reactions to the thought of a Defense Contract Audit Agency (DCAA) audit. I’ve watched completely sane owners and controllers reach for their medications and lash out against the injustice that the DCAA has forced upon them. Don’t get me wrong, I understand that undergoing an audit is an additional strain on an already overburdened accounting department. That being said, there is no mystery (with one exception, which I’ll cover in this blog) to the purpose or process of these audits. The DCAA’s mission and all their authoritative documents are available to you on their website. Don’t be scared, be prepared! A DCAA audit means that you already have, or are about to receive, a government contract. Great job, team!
This blog will aid in your preparation for the three DCAA audits you are most likely to encounter.
- Accounting System Adequacy (SF 1408)
- Real-Time Labor Evaluations (Floor Check)
- Incurred Cost Submission
Accounting System Adequacy (SF 1408)
Purpose: Our federal government buys everything we as consumers buy. Certain items and services are generic enough that their price is determined readily by the open market (i.e. supplies, products, travel, commercially-available consulting services). The government procures these items through published purchasing schedules and negotiated fixed-price or time and materials contract types.
Our government also buys things we as average consumers would never buy (i.e., space crafts, military equipment, research services). The cost of these items is hard (if not impossible) to predict. The government procures these items through Cost-Plus and Flexibly Priced contracts. These types of contracts provide security to the contractors performing the work, that they will recover the cost of the work being done and make a reasonable profit.
The Accounting System Adequacy audit is required for the award of a Cost-Plus or Flexibly Priced contract to ensure that the government is only paying for the direct costs of their contract and a reasonable, as defined by Federal Acquisition Regulation (FAR), share of the contractor’s indirect costs.
Process: The Accounting System Adequacy audit is a service provided by the DCAA to the Defense Contract Management Agency (DCMA) at the request of a DCMA Contracting Officer (CO). A DCMA CO is required by the FAR to request this audit for a contractor’s initial award of a Cost-Plus or Flexibly Priced contract. A CO may also request this type of audit if:
- It has been more than three years since the last Adequacy Audit
- Cost accounting changes have been reported in the annual Incurred Cost Submission.
The CO’s request will be fulfilled by DCAA, and a DCAA auditor will be assigned to engage with the contractor and complete Standard Form (SF) 1408. This form can be reviewed on DCAA’s website.
The purpose of the check list is to ensure:
- The accounting system can segregate direct and indirect costs
- Direct costs can be segregated by contract
- Indirect costs can be segregated by indirect pools
- Unallowable costs (as defined by the FAR) are segregated and excluded from contract costing
- Proper procedures are in place so that the following are done timely and consistently in accordance with the FAR
- Timekeeping and labor distributions
- Calculation and application of Indirect Rates to contracts.
I’ve seen a few of these audits done remotely, but a majority are done by the auditor, at the contractor’s site, in an informal interview format. Many auditors will request to trace sample transactions (usually one timesheet and one vendor invoice) through the accounting system to confirm their understanding of the system and ensure that it is working as stated.
The DCAA auditor will make one of the following assessments of your system:
- Compliant – Good to go! Collect $200, or better yet, a big contract
- Non-compliant – Don’t worry, you aren’t going directly to jail. The auditor’s report will detail the deficiencies that need to be corrected for them to upgrade their findings to “Compliant”
- Compliant with a recommendation for a follow-on accounting system audit to be conducted after contract award. This does not happen often. When I have seen these, it has usually been because the contractor was in the middle of, or was planning to start, an accounting system change (if you know your system will not pass, proposing an accounting system change may be used to your advantage).
Preparation: Complete your own SF 1408. If you cannot answer “Yes” or “Not Applicable” to any questions in sections one through three, get help from a DCAA expert.
The auditor will also review your accounting policies. At a minimum you should be prepared to give them documentation that supports these basic policies:
- Compensation and bonuses
Direct vs. Indirect Costs
- Indirect Rate definitions
- Unallowable Costs.
Quadruple check that your policies are in compliance with the FAR and are still in force. If you haven’t read your policy in the last two years, pull it out and read it now. You might be surprised how quickly a policy becomes out of date and can be more harmful than helpful.
These policies do not need to be complicated or lengthy. “All employees are eligible for bonuses based on performance and at the discretion of management,” is a bonus policy that many of my clients have used to pass the Accounting System Adequacy Audit. Policies are a place where the old adage “less is more” can work well.
Real-Time Labor Evaluations (Floor Check)
Purpose: The purpose of this audit is to ensure that the contractor’s staff actually exist and are completing timesheets in accordance with a company policy that conforms to the FAR statutes. Timesheets are the foundation for distributing the cost of labor consistently across the efforts worked and ensuring that the government is paying accurately for what they are getting.
Process: This is the only DCAA audit that has any element of mystery. You will not be notified in advance of a floor check. Most government contracts for services (Time and Materials, Cost-Plus and Flexibly Priced) include a clause that grants the DCAA permission to administer these surprise audits. Employees will be selected at random and their timesheets will be reviewed to make sure they are current (at least filled out through the previous day) and correct. A smaller sample of employees will be selected to be interviewed by the auditor who will ask the employee a series of questions related to time charging practices. Senior management will more than likely be interviewed as well.
Preparation: Educate your employees by conducting your own “mock” floor checks. If you don’t already have a list of sample questions from a DCAA interview, consult a DCAA expert to obtain one and review it with your employees on a recurring basis.
Every organization has a couple of troubled employees that just can’t seem to complete a timesheet. The following tactics have helped my clients motivate these types of employees.
- Making the results of “mock” floor checks a component of the annual salary review.
- Withdraw the ability to receive Direct Deposit Pay after a certain number of timesheet infractions.
- Make it a requirement to collect their paycheck from their supervisor (or someone more feared) after a certain number of timesheet infractions.
These privileges can be returned after the employee has exhibited a consistent commitment to the timekeeping policy.
Incurred Cost Submission
Purpose: The Incurred Cost Submission is the mechanism used to finalize the indirect costs applied to your contracts in a given year. Contractors establish budgets for their indirect costs and bill the government based on these budgets as work is performed. One hundred and eighty (180) days after the end of the year, contractors billing indirect costs are required to submit this incurred cost claim that presents their financial data in a format that shows the development and application of these indirect rates to their contracts. The Incurred Cost Submission audit is conducted so that the government can obtain adequate information to accept the rates proposed by the contractor, or make adjustments and propose a different set of indirect rates to be used to finalize costs and close out the contracts.
Process: The process varies greatly depending on the size of your organization, any previous Incurred Cost Submission audit results, and the volume of submissions the DCAA needs to complete. The DCAA can and will take a risk-based approach to auditing these submissions. Audits are time consuming and expensive, and should only be done if there is a significant risk involved. If you are a small contractor, or only have a few Flexibly Priced (which includes Cost Plus) contracts, you may be deemed as low risk. In this case the DCAA may:
- Accept your rates as submitted
- Audit a sample year, and if the results are positive enough, accept the rates for a few other years.
If you aren’t lucky enough to win the no-audit lottery, the process works as follows.
- The DCAA will contact you to schedule time to conduct the audit at your site (occasionally, they may perform desk audits that are conducted remotely).
- The DCAA will provide you with a list of items they need in order to conduct the audit, including check number ranges for payroll and cash disbursements. These will be used to generate a sample set of transactions they will test during their fieldwork.
- The DCAA will conduct their Audit at your site and ask for additional data based on the results of their transaction testing.
- The DCAA will conduct an exit interview to share their preliminary findings and explain next steps in the process.
- The DCAA will write an audit report that is delivered to you, the contractor, for comment.
- The DCAA will write a letter accepting the rates as proposed or proposing a new set of rates based on their findings.
- You, the contractor, can accept the letter as is or enter into negotiations with the auditor if you believe the new rates are inappropriate.
Preparation: There are two important parts to this process:
- Preparing the best possible Incurred Cost Submission:
- Consider using the DCAA Incurred Cost Electronically (ICE) model (it can be downloaded from DCAA’s website and is very familiar to them).
- Validate that all your schedules are linked and that your numbers match throughout all schedules.
- Make sure that all unallowable expenses are appropriately handled in the submission (otherwise penalties may apply).
- Perform a “Proof of Rates” to validate that the allowable costs total from the general ledger matches the number of burden costs in the submission.
- Compile a submission folder to gather all data used and document any positions taken in preparing the submission (the submission may not be audited for many years).
- Gather documentation that supports the compensation for your owners and key executives (this is almost always something that will be challenged).
- Ensure that invoices from subcontractors use proper descriptions to support the audit process.
- Consider using the Quick Close Out procedures to remove your requirement to make a submission.
- Consider using a DCCA Consultant if you are not completely comfortable with the submission process.
- When the audit begins, make the auditor’s job as easy as possible.
- Be as respectful and as helpful as possible.
- Be open and honest.
- Gather all the data they request and deliver it in a timely fashion.
- Make yourself available to them (the best way to get the result you want is to help them get their answers as quickly and accurately as possible).
A key aspect of complying with government regulation is creating business systems that are compliant with DCAA standards and regulations. Discover even more about getting ready for the DCAA audit process with the Deltek white paper Understanding DCAA Compliance.
About the Author
Over the past 35 years, Steve has served in the government contracting community as a controller, auditor and consultant. Building on his broad, real-world expertise with FAR, cost accounting standards (CAS) and the DCAA, Steve established Aronson’s government contracting compliance practice in 1988 and continues to perform those services today. For much of his early career at Aronson, he was also instrumental in building Aronson’s government contracting-focused audit and tax practice. Prior to joining the firm, Steve worked as a controller for a middle market government contractor doing predominantly Cost-Plus work.
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