DCAA S NEW GUIDANCE ON SELECTING ICE PROPOSALS TO AUDIT

Transcription

1 GCA DIGEST (A publication of Government Contract Associates) Fourth Quareter 2012 Vol 15, No. 4 DCAA S NEW GUIDANCE ON SELECTING ICE PROPOSALS TO AUDIT The Defense Contract Audit Agency has issued new guidance that significantly affects whether your Incurred Cost Estimate (ICE) proposal will be audited. (Editor s Note. As a DCAA auditor subscriber told us, their use of the term ICE refers to Incurred Cost Electronic referring to their electronic model of the required incurred cost exhibits. However, the term ICE has taken on a meaning of its own where it is now synonymous with incurred cost or just incurred cost estimate. We use that term here.) The guidance includes sections on (1) a policy, sampling techniques and procedures to be used for selecting ICE proposals to audit (2) a Class Deviation statement from DOD stating either an audit report or a memo will meet the audit requirements of FAR (3) a checklist for determining risk of ICE proposals (4) a proforma report that will be used when an ICE proposal is not selected for audit (5) Incurred Cost Sampling Implementation Plan and (6) Frequently Asked Questions. The following is a summary of sections of the guidance we believe will be most relevant to our readers. Procedures Used to Select Audits 1. In order to establish a universe, identify all ICE proposals on hand. The universe of proposals will be established at the field audit office (FAO) level and will exclude corporate, shared services and intermediate home office ICE proposals, nonprofit and educational institutions and contractors who have 100% of non- DOD contracts. Audits that have already begun will also not be included in the universe. 2. If not already done, perform an adequacy determination on all proposals. As in the past, this adequacy determination will be based on FAR where DCAA s Incurred Costs Proposal Adequacy checklist will be used where if significant deficiencies are found, the proposal will be returned with written instructions for corrective action. 3. All adequate proposals exceeding ADV (auditable dollar value) of $250 million will be automatically audited. 4. Adequate proposals less than ADV $250 million received will be assessed for risk. The auditor will determine whether the proposals should be assessed as high or low risk using a risk assessment worksheet (discussed below). 5. All adequate ICE proposals deemed high risk will be audited. 6. All adequate low risk proposals will be randomly selected for audit based on the following sampling plan: 1% of proposals up to an ADV of $1 million or less. 5% of proposals with an ADV of $1 million to $50 million. 10% of proposals with an ADV of $ million. 20% of proposals with an ADV of $ million. A mandatory audit of this group will occur once every three years. Note this sample plan differs significantly from the prior plan requiring a one third chance of audit each year for all low risk proposals. Also of note, in order to reduce the backlog of ICE audits, all adequate ICE audits with an ADV of $1 million or less that were submitted before October 1, 2011 will not be selected for audit. 7. A Memorandum to the Contracting Officer will be drafted for all low risk proposals not selected for audit. This step replaces the traditional desk review which has been eliminated. DCAA has established a proforma memo that states, in part, no significant audit leads or concerns were identified, a mathematical verification was conducted and the proposal is signed by upper management certifying the proposal contains no unallowable costs. All proposed final indirect cost rates are identified in the memo, stating it is the ACO s responsibility of

2 Fouth Quarter 2012 GCA DIGEST determining final indirect rates. Finally, the memo states DCAA recommends the contractor adjust its interim billings on all affected contracts to reflect the settled direct and indirect costs and update its schedule of cumulative direct and indirect costs claimed and billed. In addition to the Memo, DCAA has internal administrative procedures to use for proposals not selected for audit that need not concern us. 8. If a contractor has more than one ICE proposal in the low risk group DCAA will follow the following procedures: a. If no proposals in the pool are selected, close out all proposals using the memo procedure discussed above. b. If one or more proposals are selected for audit, none of the others will be dispositioned until the audit is completed. If significant questioned costs are found, then audit all other proposals, using multi-year audit techniques. If no significant questioned costs are found, close out all other proposals using the memo procedure discussed above. Guidelines For Determining Risk Assessment Each FAO is instructed to establish whether each ICE proposal under an ADV of $250 million is high or low risk where a low risk determination is found using the following criteria: 1. An ICE audit has been performed in the past. 2. No significant audit leads or other significant risk has been identified (e.g. known business system deficiencies such as an inadequate accounting system that would have a material impact on the ICE, significant risk identified by the ACO). 3. No significant questioned dollars (called exception dollars ) in the last year audited. Significant questioned dollar amounts are: a. $15,000 on ADV proposals of less than $1 million. b. $25,000 on ADV proposals between $1-15 million. c. $55,000 on ADV proposals between $15-50 million. d. $100,000 on ADV proposals between $ million. Frequently Asked Questions In addition to the procedures described above, there is also some good clarifying comments in this section 2 where we identify the most significant below. Question 1. Will desk reviews continue? No. But those audits that are in the midst of a desk review, they will continue. Question 2. If there is a current inventory of multiyear proposals, can we audit the first year and then put the remaining proposals in the low risk pool? Yes. The auditor can use their own judgment to decide whether to conduct multiyear audits of these inventoried ICE proposals. Question 3. Will DCAA continue to issue rate agreement letters and cumulative allowable cost worksheets (CACWS) for low risk proposals not audited? No. Auditors will issue the memo that identifies proposed rates. The ACO then has the authority to determine final rates and if they issue a final rate letter, DCAA will complete the CACWS within 60 days. Question 4. Will the low risk pool include non-dod contracts? Yes. Auditors are to determine whether non- DOD agencies will be participating (i.e. paying DCAA) in the audit but if uncertain, their contracts will be included in the ADV computation. However, proposals that are 100% non-dod will not be included. Question 5. If the CO establishes final indirect cost rates for a proposal not audited and we find significant questioned costs in a subsequent year should we go back and audit the prior year? No. A signed rate agreement is a legally binding document and cannot be changed without the consent of the government and contractor except for fraud or mutual mistake. Question 6. What if we find significant direct costs questioned and the CO has issued its indirect rate letter should we go back and audit prior year direct costs? Yes, provided the contract has not been closed. The CO can recover direct costs on the contract in accordance with FAR (g) for cost type contracts and (f) for T&M contracts. Knowing Your Cost Principles BONUS COSTS (Editor s Note. We have found that bonus expenses are one of the most common cost elements being scrutinized by auditors these days and some of the most common areas of questioned costs. Bonus expenses offer auditors two bites of the apple

3 GCA DIGEST Vol 15, No. 4 if they don t find such expenses to question as unallowable bonus costs they can still question some or all costs when added to other compensation costs that exceed survey amounts their Mid-Atlantic compensation team determine or GSA compensation caps because bonuses are one of the four cost elements of compensation. Given the interest expressed by our clients and subscribers we thought bonuses would be a good area to explore here. Our sources for this article include (1) one of our favorite texts Accounting for Government Contracts, Federal Acquisition Regulation (2) an article by Karen Manos in the Dec issue of Briefing Papers (3) the Defense Contract Audit Manual (DCAM) and (4) our own experience helping clients either challenge questioned bonus costs or helping them develop bonus policies that would be acceptable by auditors.) There are several common types of bonuses and incentive compensation that are usually allowable: incentive compensation for management employees, cash bonuses, suggestion awards, safety awards and incentive compensation based on production, cost reduction or efficient performance. In addition, deferred incentive compensation and bonuses are also allowable if they meet certain conditions discussed below. In order to be allowable, bonuses must be (1) granted under an agreement entered into in good faith between employer and the employee before services are rendered or (1) granted pursuant to an established plan or policy followed consistently to the point of implying an agreement. (Editor s Note. For some inexplicable reason, we are seeing auditors recently interpret the agreement provision as equivalent to a written agreement where there is no such provision in the FAR but nonetheless they are questioning otherwise acceptable bonus costs on that basis. DCAA management is simply accepting this revised interpretation of the requirement and one of our clients is litigating the issue.) The government has a long history of sometimes challenging bonus plans that were not strictly based on production, cost reduction or efficient performance. In recognition that this was too narrow a criteria, FAR (f) was changed to distinguish management employees from the rank and file employees. In Bell Helicopter Company (ASBCA No. 9625) the board ruled that incentive compensation for management employees need not be limited to actions based on production, cost reduction or efficient performance because management may not affect such operations performance but rather by successful operations as a whole where such success is commonly measured by the profit of the company. In recognition of this distinction, FAR (f) was changed in 2003 to delete the reference to production, cost reduction or efficient performance where accompanying comments to the new rule stated though those three elements may be good standards for allowability they should not be the only criteria for allowing incentive compensation. Some cases have addressed the allowability of specific employee plans. In one case, a plan based on longevity and other factors was questioned where the government did not believe longevity was an appropriate factor. In Lulejian and Associates (ASBCA No ) the board upheld the government s challenge on profit sharing and life insurance costs on the grounds the costs for these two elements where more than twice the amounts paid as salaries. In Cesesco Industries (ASBCA No ) the government challenged an incentive plan because a large government contract contained a provision for incentive fees where such payment was considered to be a distribution of profit but the appeals board disagreed holding the contractor was not obligated to pass the profits onto employees by means of an incentive plan and therefore the merits of the incentive plan should be judged on its own. Bonuses for closely held corporations are quite closely reviewed to ensure that those payments are not disguised dividends which are unallowed. In Digital Solutions Systems (NASA BCA 975) the Board agreed that bonuses based on profits exceeding the contractor s total profit for the year were unallowable. In Martin Marietta Corporation (ASBCA 12143) bonuses paid to induce employees to continue employment through the end of the contract were accepted by the Board because the contractor could establish that low turnover was critical and the training costs for new employees were high. Deferred Bonuses Deferred compensation is considered payment for services rendered in previous accounting periods. It does not include year-end accruals that are paid within a reasonable time after the end of an accounting period. (Editor s Note. Most auditors will consider the reasonable time period to be by the due date for federal taxes. We have been successful in extending this reasonable time period for tax payment extensions to September or October, even further when a later period can be shown to be reasonable.) Deferred bonus is considered to be unallowable if it is awarded in an accounting period subsequent to the period related to the services rendered in other words, bonuses cannot be

4 Fouth Quarter 2012 GCA DIGEST awarded retroactively. Of course, deferred bonuses are allowable when entitlement is based on current or future services. Even if not CAS covered, the measurement, allocation and accounting rules are covered by CAS 415, Accounting for the Cost of Deferred Compensation. Basically, CAS 415 requires (1) the assignment of costs to the period when obligations are incurred and (2) the use of the present value of future payments as a means of determining the liability in the period incurred. If the otherwise allowable bonus does not meet the conditions to be deferred recognized in a prior period than it is paid, then the cost will be considered to be incurred during the period it is paid. Decisions on deferring bonuses provide a very flexible tool for determining the timing of when the bonus is considered to be incurred. For example, if higher levels of government contracts are expected this year rather than in subsequent periods, it may behoove you to establish a deferred bonus program this year to be paid out in subsequent periods; or conversely, if higher levels of contracts are expected in subsequent periods, then you need to ensure future payments of bonuses are not deferred plans e.g. a bona fide liability this year is not established. Or, if bonus payments cannot be afforded in the current year, then it may benefit you to establish the deferred bonus program this year to allow for entitlement this year of future payments. Be sure to establish the conditions set forth in CAS 415 e.g. a bona fide obligation, etc. Elements of Essential Written Policies The most effective way of establishing the allowability of bonus costs and to challenge attempts to question the costs is to have a written policy in place before payments or deferrals are established. Though a written policy can be prepared to meet a variety of needs, we find policies that are usually accepted by auditors need to have at least the following features: 1. Identification of all bonuses for owners, officers, management and rank and file employees. 2. Except for spot or morale boosting bonuses, establish the basis for the bonus pool. For example, 5-10% of net profits, 1% of sales, etc. I find a range rather than specific numbers to be the best. 3. Establish what categories of employees will participate in each bonus pool and criteria of distribution to demonstrate a bona fide policy exists but broad enough to provide flexibility Establish that each bonus pool is dependent on the discretion of management to again provide flexibility. 5. Identify who is to approve of the bonuses. DCAA Guidelines In researching this article, we were quite surprised to see how little guidance there is in either the DCAA Contract Audit Manual (DCAM) or in DCAA s audit programs considering how extensive this area is audited. The absence of audit guidance in this heavily scrutinized area is we suspect at least a partial explanation for the wide variety of positions we see auditors take, some of which are quite creative. In the Chapter section of the DCAM addressing audits of executive compensation, bonuses are considered to be one of the elements of such compensation and the audit guidance states there should be a determination that the policies and procedures provide a description of how executive compensation levels are established, who approves these levels, and eligibility criteria and bases for how they are established. The section also addresses long term incentive plans where award periods are for two or more years with the goal of retaining key executives. So a reading of this very brief DCAA guidance indicates there should be written policies and procedures with a description of how the bonus levels are established, who must approve these levels and the criteria for eligibility. The DCAM also addresses bonuses that result from a business combination. Section states that bonuses or other forms of payments that are in excess of the employee s normal salary level or unallowable in accordance with DFARS (f)(1). However, this limitation does not apply to severance or early retirement incentive payments where such costs, if reasonable, are allowable in accordance with FAR 205-6(g). An Oldie but Goodie NEW GUIDANCE ON WHAT IS AN ACCOUNTING CHANGE (Editor s Note. Accounting changes is an important issue because most contractors need to periodically assess the way they cost and price their government contracts and make changes to

5 GCA DIGEST Vol 15, No. 4 achieve their objectives like maximizing cost recovery or being more competitive. We often find confusion by both contractor personnel and government representatives on what constitutes an accounting change which often leads to unfortunate results. For example, a contractor may not adopt a desirable practice for fear it is an accounting change requiring extensive justification when it really is not a change. Or conversely, a contractor may adopt a change and not realize it is a change requiring a justification or demonstration the government is not harmed. We have combined below both what the Cost Accounting Standards and DCAA consider accounting changes as well as more recent guidance established by the Defense Department where the new guidance represents current ideas on what constitutes an accounting change in clearer terms than found in the cost accounting standards and includes new examples intended to illustrate the concepts. We have updated a few thoughts over our prior treatment of this area.) On January 17, 2002 the Director, Defense Procurement issued guidance to assist administrative contracting officers and auditors to determine when a change occurs in cost accounting practice under the cost accounting standards. The guidance, found at follows an unsuccessful seven year effort by the CAS Board to extensively redefine what constitutes a change in a cost accounting practices. Though the guidance formally addresses accounting changes for fully and modified CAS covered contractors, in practice, the guidance affects cost accounting changes for all contractors, whether CAS covered or not. In summary form, the guidance states ACOs and auditors should use the following to determine if a change occurs: 1. An accounting change occurs when there is a change in the method or technique for determining (a) whether a cost is direct or indirectly allocated (b) the composition of the cost pools (c) the selection of the allocation base or (d) the composition of the allocation base. 2. A change has not occurred when there is the initial adoption of a cost accounting practice for the first time a cost is incurred or a function is created. 3. A change has not occurred when there is a transfer of contract work from one segment to another provided the cost accounting practices at the segments remain unchanged When there is a change in cost accounting practice, only affected CAS-covered contracts are subject to price or cost adjustments. (However, for non-cas covered contracts you can expect resistance from DCAA if a change materially increases government payments.) What is a Cost Allocation Practice The definition of a cost accounting practice has not changed and the guidance cites 48 CFR (c): Allocation of cost to cost objectives, as used in this part, includes both direct and indirect allocation of cost. Examples of cost accounting practices are the accounting methods and techniques used to accumulate cost, to determine whether a cost is to be directly or indirectly allocated, to determine the composition of cost pools and to determine the selection and composition of the appropriate allocation base. Direct vs. Indirect Specific identification of a cost to a final cost objective (e.g. contract, subcontract, funded task or delivery order, grant) or to a business segment is a direct allocation method. Accumulating a cost in a specified indirect pool or home office pool for purposes of allocating to multiple cost objectives or segments is an indirect allocation method. A change in direct vs. indirect allocation can occur within a business segment, within a home office, between two segments, between two or more home offices or between a segment and home office. New examples of changes in the method of allocating costs direct versus indirect include: (1) if a company reorganizes its engineering group within a business segment and first line supervisors costs formerly charged to the engineering overhead pool is now charged directly to cost objectives and (2) payroll function was formally performed at Segment A and B but is now performed at the home office level this is a change for Segments A and B if the home office indirectly allocates the costs of the payroll functions to Segments A and B but is not a change if the home office directly identifies the costs of the payroll functions to A and B. Determining the composition of cost pools Functions and activities. Indirect cost pools are composed of activities (e.g. machining supervision, purchasing, security, inspection, insurance administration) and func-

6 Fouth Quarter 2012 GCA DIGEST tions that are defined as an activity or group of activities that are identifiable in scope and has a purpose or end to be accomplished. A change to the composition of a cost pool occurs when a contractor changes the functions or activities that compose the indirect cost pool. Combining indirect cost pools. When two or more pools are combined, there is a change in the composition if the functions or activities of the previously separate pool(s) are not generally the same as the functions or activities of the new combined pool. Dividing indirect cost pools. When a company divides a single indirect cost pool into two or more pools, a change occurs in pool composition because the functions and activities in the divided pool(s) are not generally the same as the functions and activities of the former single pool. For example, an accounting change has occurred when a single overhead pool includes two functions, building maintenance and security and then divides the single overhead pool into two separate cost pools consisting of maintenance or security functions. Transfer of functions. A transfer of a function or activity from one pool to another is not considered a change in pool composition if the transferring pool (i.e. the pool from which the function or activity is transferred) receives an allocable cost of the function or activity from the receiving pool. Otherwise, the transfer represents a change for the transferring pool. If the receiving pool contained that function or activity prior to the transfer then a change has not occurred. For example, the engineering overhead pool contains a production engineering supervision function while its production overhead pool does not. If the production engineering function is moved from the engineering overhead pool to the production pool a change to both pools has occurred because the engineering overhead pool no longer contains the supervision costs while the production overhead pool now contains the supervision costs. Disclosed and established practices. When determining whether a change has occurred, the ACO and auditor are instructed to focus on the disclosed and established practices that define and describe the significant functions and activities of the indirect cost pools. They are warned that the disclosed practices, whether in the form of a disclosure statement or other policies, my not identify all functions and activities. Variations in costs. Costs that are associated with a function of a pool may vary, even significantly, from one point in time to another. These variations do not result in an accounting change as long as the defined pool functions do not change. For example, if a contractor buys a building and the maintenance costs fall within the defined building maintenance function of the pool the increase in size of the pool does not affect its composition and hence no change has occurred. Determining the selection of the allocation base The selection of the allocation base refers to the base measure (e.g. direct labor dollars, direct labor hours, direct material costs, total cost input or a resource consumption measure like computer usage or square footage). A change in the selection of the allocation base is a change in accounting practice. Determining the composition of the allocation base A change in the composition of the allocation base occurs when (a) a change in the elements of the base or (b) a change in the activities that are included in the base. However, a volume change in the base (e.g. addition or deletion of a contract or a business segment) does not, in itself, represent a change. The elements include not only the type of base (e.g. direct labor) but the composition of that type (e.g. direct labor dollars plus overtime premium or fringe benefits). A change in the elements making up the base is an accounting change. For example, a change from a direct labor dollar to a direct labor dollar plus overtime premium is a change in the composition of the allocation base. The composition of the base also encompasses the activities of the base (e.g. systems engineering, design engineering, fabrication) that are in some way related to the activities in the pool. A change in the activities is a change in the composition of the base. For example, a change from a machining direct labor dollar allocation base to an assembly direct labor dollar base is a change. However, as we have seen, volume fluctuations do not represent a change so, for example, a contractor that purchases a new segment and adds it to its home office allocation base does not change the composition of the home office allocation base. 6

7 GCA DIGEST Vol 15, No. 4 Initial Adoption of an Accounting Practice or Elimination of a Cost or Cost of a Function is Not an Accounting Change CFR (a) states the initial adoption of a cost accounting practice is the first time a cost is incurred or a function is created. (Editor s Note. We have often been successful in asserting a change in treatment of a cost that was immaterial in the past and then becomes material is tantamount to adopting a new incurred cost and hence is not an accounting change.) Alluding to the controversy over whether an organization change represents an accounting change, when a function is transferred between segments, between home offices or between a segment and home office this does not constitute the creation or elimination of a function for either the segments or home offices. Similarly, the merger of two or more segments does not constitute the creation or elimination of a function. For example, if a contractor establishes a new security function then this would be a creation of a new function. However, if the security function was transferred from one segment to another this would not be creation of a new function for the one segment nor the elimination of the function from the other segment. Transfer of Contract Work The transfer of work on a contract from one existing business segment to another is not a change in accounting practice as long as the cost accounting practices at the segments do not change. When work is transferred from one segment to another, the contract often will not incur the same costs as originally estimated. Instead the contract will incur costs in accordance with the cost accounting practices of the segment where work was transferred. The contract may incur the costs of the transferred work under a different indirect cost pool (e.g. Segment A s overhead pool instead of Segment B s overhead pool) or a different cost element (e.g. intra-company transfers). This is considered a business decision in how the work will be performed (similar to a make or buy decision), not a change in the cost accounting practices of either segment. As long as the cost accounting practices of the segments remain the same no change has occurred. After all, the established cost accounting practices of the two segments were consistently used to estimate and accumulate each segment s costs. Affected CAS-Covered Contracts Affected CAS-covered contracts are those contracts on which the cost accounting practice change occurred. Affected contracts are only those that are subject to contract price or cost adjustments. Contracts may be impacted by events other than cost accounting practice changes (e.g. volume changes or contract performance changes). When the practices do not change for these contracts, they are not subject to contract price or cost adjustments. For example, a contractor merges two indirect cost pools containing basically similar functions and activities. Pool A uses a direct labor dollar allocation base and Pool B uses a direct labor hour base and the combined pools uses a direct labor dollar base. Yes, there is a change in the selection of the allocation base for those contracts in the allocation base for Pool B but no change for those in the base of Pool A. Hence the affected CAS covered contracts are those only in the allocation base of Pool B and they are the only ones subject to a price adjustment. Additional Material on Accounting Changes The 2002 change included new examples of changes contractor may make that either will or will not be considered a change in a cost accounting practice. Examples of changes that do not meet the definition of an accounting change include: 1. Contractor allocates separate pool costs on a direct labor base, are combined into a single cost pool with a direct labor base. 2. Contractor combines two indirect cost pools with similar functions and activities where allocation base does not change. Two indirect pools representing similar activities, one for Product A and one for Product B both with a direct labor base are combined into a single manufacturing pool with the same direct labor base. 3. Contractor separates a single indirect cost pool into two indirect pools having similar functions and the allocation base stays the same. A single indirect pool allocating on total engineering test labor is separated into two pools where the base for pool E is allocated on direct test labor from one department and pool F is allocated on direct test labor from another department. 7

8 Fouth Quarter 2012 GCA DIGEST 4. Contractor changes the method of performing a function but does not transfer the function to another pool. Costs of preparing payroll is included in a segment s G&A pool and after the change an outside company prepares payroll whose costs remain in the segment s G&A pool. 5. Contractor transfers performance of a function from one pool to another that already contains the activity. While both the segment and home office prepares payroll, the contractor transfers payroll function from the segment to the corporate home office. The memo also contains examples of changes that do meet the definition of a change to an accounting practice. These include: 1. Contractor changes its allocation from an intermediate cost pool to specific identification to another. Contractor transfers security costs from an intermediate pool allocated to fabrication and total assembly pools based on direct labor and directly charges security to the fabrication and assembly pools. 2. Contractor combines two pools not allocated on a base of similar activities. A company accumulates manufacturing overhead in pool J and uses a manufacturing direct labor base and accumulates engineering costs in pool K using an engineering direct labor base are combined into one pool using both a manufacturing and engineering direct labor base. 3. Contractor separates a single pool into two where the two pools are not allocated on a similar base. A single manufacturing overhead pool allocated on direct fabrication and assembly labor is split into a fabrication overhead pool allocated on direct fabrication labor only and an assembly overhead pool allocated on a direct assembly labor base. 4. In a merger, overhead pools of similar activities are combined but the selection of allocation base is different than before. Segment A allocated its manufacturing overhead on a direct labor dollar base and Segment B on a direct labor hour base and when the two pools are combined after a merger, the allocation base is direct labor dollars. 5. Contractor separates a single indirect pool into two having similar functions but the allocation bases are different. A single pool is divided into two pools (K&L) 8 with similar activities and pool K uses an employee headcount base while pool L uses a direct hour base. PAYMENTS UNDER T&M CONTRACTS CONTINUES TO BE A CONFUSING ISSUE (Editor s Note. Payment of subcontractor labor hours under time-and-material contracts continues to be a hot topic in contracting circles. A month does not pass without a client or subscriber asking us about what they should propose or charge the government for subcontractor labor costs. Though contracting parties are free to arrange their own payment scenarios contracting terms are often silent on how subcontractor effort is to be billed to the government so the following addresses that. We came across an interesting article by Richard Johnson and Richard Snyder of Smith, Pachter, McWhorter PLC in the January 2012 issue of the Government Contract Costs, Pricing and Accounting Report that traces the historical regulations, DCAA guidance and case law on this evolving and confusing issue and argues that the latest case - Serco - that prohibits charging contract labor rates for subcontractor labor effort is flawed and should not be followed.) The regulations and clauses related to subcontractor payments under T&M contracts contained significant ambiguities going back to the Defense Acquisition Regulation (DAR) provisions preceding the introduction of the Federal Acquisition Regulation in The DAR regulatory guidance contained no mention of how subcontract labor hours were to be treated. However, the Payments clause lumped all subcontracts into the materials category where there was no distinction made between subcontracts that supply labor hours for the labor portion of the contract and subcontracts that are incidental to performance of the central labor-hour task of the contract. The Payments clause of the DAR provided that the cost of subcontracts shall be reimbursable costs hereunder Reimbursable cost in connection with subcontracts shall be limited to the amount paid to the subcontractor in the same manner for items and services purchased directly for the contract (out of pocket cost plus applicable handling charge). The regulations covering T&M contracts were largely unchanged with the initial publication of the FAR in It did expand on handling charges stating it included all appropriate indirect costs allocated to direct materials in accordance with the contractor s usual

9 GCA DIGEST Vol 15, No. 4 accounting procedures and added that the amounts cannot be included as handling charges if they were taken into account when computing indirect rates applicable to direct labor rates. The new FAR Payments clause at FAR was also largely unchanged from the DAR version except now applicable G&A costs were to be explicitly applied to material and subcontract costs and that letting, administration or supervision costs could not be applied to material costs if they were included in the indirect costs added to direct labor rates. Though additional changes were made to the Payments clause in 1997, 2000, 2002 and 2005 none altered the substance of terms applicable to subcontract payments and those provisions provided the initial judicial interpretation in the following Software Research Associates case discussed below. In 1982 the Air Force awarded SRA a T&M basic ordering agreement (BOA) for engineering services in support of a radar warning system. The BOA included fixed labor rates for four categories of technicians, ranging from $43 to $72 per hour. The specific provision defined direct labor as all effort expended in performance of orders in the listed categories and stated the contractor through its personnel shall perform the associated engineering efforts Direct material/ parts/subcontracts were defined as those items that are incidental to the accomplishment of the engineering services. SRA used both its own engineering personnel and contractor personnel who it engaged under hourly rate agreements of $30-$50 per hour. SRA did not inform the CO of the mix of individuals working on the contract where its invoice identified the names of the individuals working and the contract rates for each category of effort without distinguishing company and contracting personnel. DCAA audited the contract at completion of the work and issued a report stating SRA erroneously charged the consultant effort at contract rates and alleged SRA reaped a windfall profit computing it at the difference between what SRA paid its consultants at and the contract rates it charged the government. The Appeals Board first addressed the windfall argument by setting up a comparison between the consultant rates adding SRA s engineering overhead and G&A rates and profit versus the contract rates. The Board justified this stating if the consultants were employees they would have been paid the same rates as the consultant rates where then SRA would have been entitled to the indirect rates and profit add-ons. Though the 9 authors state such a comparison was questionable it stated the Board ruled the fully burdened consultant rates were higher than the contract rates and hence there was no windfall. It also faulted DCAA and the government for not quantifying the alleged windfall. The authors comments on the case were: (1) the finding of no windfall was central to the Board s ruling that there is no logical reason to have appellant compensation for their work on a basis different from that of its regular employees when this does not produce a windfall (2) the board went on to opine that the work of the consultants was central to the effort which was indistinguishable from their employee counterparts and were not incidental within the meaning of the special provision of the contract and (3) SRA should be compensated for these services on the same basis as for services performed by its regular employees i.e. at the direct hourly rates. Though its method of comparison was questionable, the authors stress that the underlying rational of the decision is that performance by consultants or subcontractors should not make a difference in the fixed rate labor-hour portion of a T&M contract. DCAA Guidance On April 9, 2004, DCAA issued an audit guidance memorandum which in part addressed T&M orders under General Services Administration Schedule contracts. In one paragraph addressing services performed by contractors employing subcontractors and referring to the FAR clause DCAA noted the GSA had instructed contractors employing subcontractors for labor hours to bill for those hours at the prime (schedule) contract rates. However, DCAA argued that the Payment clause provided otherwise stating that FAR (b)(4)(ii) specifically limits the reimbursement of costs in connection with subcontracts to the amount paid by the prime contractor. DCAA s opinion caused great apprehension among contractors, especially small contractors who believed the lower payments by the government to primes meant they would use far less small business subcontractors for the labor-hour portion of T&M contracts. This state of ambiguity was probably the chief motivator of subsequent efforts to clarify the T&M Payment clause. In May 2004 the DAR Council initiated a review and took the position that all subcontractors should be limited to reimbursement at actual costs. The GSA disagreed arguing that contractors should be per-

10 Fouth Quarter 2012 GCA DIGEST mitted to bill subcontractor labor at the prime contract labor rates if the contract specifically provided for it. A proposed rule on Sept. 26, 2005 essentially followed the approach outlined by the GSA after stating the need for increased clarity acknowledging the T&M Payments clause did not address subcontractor costs in spite of the fact that such costs are often a significant part of work performed. Comments on the proposed rule stressed that prohibiting or even limiting the billing of subcontract labor at contract rates would unfairly impact small businesses by discouraging subcontracting by large service contractors where basically only DCAA objected to the GSA approach stating it would incentivize prime and subcontractors to be less cost effective and efficient. A final rule was published in the Federal Register on Dec 12, 2006 that declined to accept DCAA s position. It noted that prior FAR language caused significant confusion and included subcontract labor as part of the definition of labor (in the prime contract), if the subcontracted labor meets the requirements of the prime contract for labor hours. The Serco Case Given the fact that 2006 regulatory change stressed that prior FAR provisions did not address subcontracts and the Payment clause was ambiguous and confusing the authors state you would think that pre-2006 regulations would not materially assist the appeals board. However, in the Serco case, the board relied on these earlier regulations and payment clause. Serco involved two T&M contracts for database management services for the Pension Benefit Guaranty Corporation (PBGC), a government agency. Serco billed PBCG for subcontractor work at the labor rates specified in the contract where it initially accepted them. A post payment audit resulted in a claim for $84,769 alleging Serco improperly billed subcontract costs where the amount reflected the difference between the contract hour rates and the rates charged by the subcontractor. Serco argued (1) the parties had entered into a fixedprice contract and had the right to bill labor hours at the fixed hourly rate (2) the subcontract employees should be treated as temporary to permanent and billed at Serco s labor rates since it intended to hire them and (3) the Board should follow the decision in Software Research Associates. The Appeals Board rejected all of Serco s arguments as literary legerdemain. It stated that the only fixed price component of the contract was 10 the hourly rates for direct labor hours and deemed Serco s plan to hire the subcontractors as irrelevant. As for the SRA case, the board rejected Serco s interpretation distinguishing it on the basis that it involved the 1972 version of the T&M payment clause and because the employees involved in that case were consultants, not subcontractors. The authors state that central to the decision was the boards finding that in the earlier case the contractor had not realized a windfall where the authors state such a finding misunderstood the prior board s windfall analysis where in the earlier case the board mischaracterized the consultant s base costs plus indirect and profit amounts as actually paid. The authors state the Board s decision rests on two bases: a plain meaning of the Payment clause argument and the windfall finding where both are wrong. As the FAR case history makes clear, there was no plain meaning of earlier ambiguous T&M payment clauses prior to the clarification made in As for the windfall finding, the board confused a purely hypothetical comparison of loaded consultant costs with fixed contract labor rates. In Serco, had the board performed a similar analysis as that conducted in SRA they might have reached the same conclusion. The authors conclude the Serco case is flawed and should not be followed. NEW DEVELOPMENTS ON OTHER TRANSACTION AUTHORITY The Departments of Defense, Energy, Transportation and NASA have all funded technology development and prototype projects in 2011 and 2012 using Other Transactions Authority (OTA). These projects ranged from single companies to small consortiums of various organizations working on systems ranging from materials to unmanned aerial vehicles and software for airspace management. The projects required a combination of design, fabrication, testing and simulation capabilities. The OTA is often used to facilitate the participation of small and medium sized firms new to government contracting to be able to innovate rapidly and avoid most FAR and related requirements. We are seeing signs of significantly more such opportunities in 2013 where we have asked a colleague, Paul Masson, who helps establish and operate these projects, to write an article on the basics of OTA since many contractors are unaware of these opportuni-

11 GCA DIGEST Vol 15, No. 4 ties and the basic rules governing them. Paul is Managing Director of Strategic Alliances Resources Network (StarNet, LLC) a consulting and management services firm that specializes in forming and operating public/ private, technology partnerships. StarNet s network-ofexperts have directed over a dozen such partnerships since StarNet, LLC is based in San Francisco, California and Paul can be reached at Background Congress reconfirmed its support for use of Other Transactions Authority (OT) in a series of statutory updates and oversight reviews in late 2011 continuing through to the fall of Eight Federal entities led by NASA and the Department of Defense have a unique authority permitting them to engage in customized funding arrangements and collaborations with third parties, primarily for the purpose of undertaking applied research and technology development projects. These transactions are not subject to procurement laws and regulations, such as CICA, TINA, FAR nor to OMB circulars that apply to assistance transactions such as grants and cooperative agreements. The authority is used primarily for prototype development or public/ private partnership projects. There is now a well-developed body of practice and DCAA audit guidance. The OT authority can be especially valuable for contractors seeking to advance Prototype Development and Testing, Technology Systems Projects and Multi-party R&D Projects Source and Use of Other Transactions Authority Other transactions is not defined at the acquisition statutory level. It is a term used to describe an authority available to selected Federal organizations necessary to achieve a given objective that cannot be achieved using procurement (Federal Acquisition Regulations) or collaborative agreements (Chiles Act). The authority is granted separately to Federal Departments and select agencies. The Executive Branch through the OMB, on a case-by-case basis, can also delegate the authority to achieve a national mission objective. The term comes from a section of NASA s enabling legislation (National Aeronautics and Space Act of 1958) that provided the agency authority to (Sec. 203(c)(5)): (5)...to enter into and perform such contracts, leases, cooperative agreements or other transactions as may 11 be necessary in the conduct of its work and such terms as it may deem appropriate, with any agency or instrumentality of the United States, or with any State, Territory, or possession, or with any political subdivision therefore, or with any person, firm, association, corporation or educational institution... NASA received its authority in 1958, and designates such transactions as Space Act Agreements. NASA has codified the use of such transactions in an internal management instruction (1050.9) and handbook for implementation ( B). NASA uses its other transactions authority for unfunded, reimbursable and funded agreements. NASA has significantly expanded use of the authority to fund private sector development of space vehicle systems to provide a launch alternative to NASA s recently retired Shuttle program. The authority permits major vehicle developers to negotiate flexible terms and offer simpler contracting to downstream suppliers. The DOD originally received its OTA authority which was limited to ARPA in 1989 via the DOD Authorization Act. The authority has been renewed and extended to all DOD organizational units in subsequent Authorization acts. A primary purpose of OTA for DOD is to enhance the state of the art, demonstrate technology, transfer technology, establish industrial capabilities, and otherwise advance national capabilities so that the United States technological base will be capable of supporting the most advanced defense systems in the future. The authority is also described according to its relevant section of the Authorization Act, such as Section 845 of the 1994 DOD Authorization act which specified use of the authority by ARPA to utilize other transactions to carry out prototype projects that are directly relevant to weapons or weapons systems. DOD policy is to use the authority when procurement contracts, grants, or cooperative agreements were not feasible or appropriate. Benefits Other transactions offer distinct benefits as a business vehicle to customize a business arrangement with participating agencies. The customization is permitted by the following features: Accounting guidelines- Other transactions are not subject to FAR or OMB cost principles. Generally accepted accounting principles can be used where