The Owner Wants to Audit Us What Next? Presented at the 2016 Mid-Winter Seminar

Transcription

1 American Bar Association Forum on the Construction Industry The Owner Wants to Audit Us What Next? Presented at the 2016 Mid-Winter Seminar Paul S. Ficca Senior Managing Director FTI Consulting, Inc. Scott P. Fitzsimmons Partner Watt, Tieder, Hoffar & Fitzgerald, LLP Contributing Authors: Rob Gardner and Cuong Ha FTI Consulting, Inc. Eric M. Liberman Associate Watt, Tieder, Hoffar & Fitzgerald, LLP

2 January 21-22, 2016 Westin St. Francis, San Francisco, CA 2016 American Bar Association Executive Summary This paper provides a useful guide to contractors and owners regarding the construction and government contract audit process. As a contractor, receiving notice that the owner wants to audit your construction contract, particularly your first such experience, can be intimidating and leave you full of questions. Whether the owner is a federal, state, or local government entity or a private company, the primary purpose of an audit is to insure that the contractor s charged amounts comply with the contract terms. Audits can benefit the contractor by accelerating payment on amounts due. However, they can also be time consuming and require proper preparation and organization. This paper is intended to help contractors understand the construction audit process, the types of audits, the parties general rights and obligations during the audit process, government regulations, standard commercial contract audit provisions and best practices to employ when preparing for and navigating through a construction cost audit. 1 1 About the Authors: Paul S. Ficca is the global leader of FTI s Construction, Environmental and Government Contracts practice and is a Senior Managing Director. Mr. Ficca is a Certified Public Accountant, Certified Management Accountant, Certified Fraud Examiner and Certified in Financial Forensics. Mr Ficca has testified as an expert witness on construction damages, forensic accounting, and construction auditing related topics in various courts, and dispute resolution forums. Scott P. Fitzsimmons is a Partner with the law firm Watt, Tieder, Hoffar & Fitzgerald, LLP in McLean, Virginia. Mr. Fitzsimmons focuses his practice on government contracts and construction. He has represented contractors in numerous audits by government agencies including the Defense Contract Audit Agency (DCAA) and the General Services Administration Inspector General. He has also represented contractors in disputes in state and federal court and before the federal boards of contract appeals. Before joining Watt Tieder, Mr. Fitzsimmons was a law clerk for a federal judge at the United States Court of Federal Claims. Robert C. Gardner, Jr. is a Managing Director in the Houston office of FTI Consulting. Mr Gardner has over 25 years of experience providing contract and claim advisory services on aerospace and defense, construction, insurance and environmental matters involving procurements at the federal, state and local levels. Specializing in complex/developmental programs typically involving contract disputes, Mr. Gardner s work often 2

3 Discussion Overview This Paper is organized as follows: Section 1: Audits in the public sector (government contracts) Section 2: Audits in the private sector (commercial contracts) Section 3: Comparing and Contrasting Public and Private Sector Audits Section 4: Audit Sampling Methods Section 5: Best Practices Section 6: Is the Audit Part of a Dispute, Claim or Litigation? Section 7: Conclusion Lessons Learned and Contractor Don ts This Paper includes several charts illustrating the audit process: 1. Chart A presents a summary of typical audit steps for both public and private contracts. 2. Chart B presents more detailed information pertaining to public contracts. 3. Chart C presents the logic for determining the applicability of the Cost Accounting Standards (CAS) and Disclosure Statement requirements for a public contract. 4. Chart D presents more detailed information pertaining to private contracts. I. Audit Authority - What Gives an Owner the Right to Audit Your Records? Public and private sector audits can vary substantially. As presented below in Chart A, the first step begins with differentiating between public and private construction contracts. requires the investigation, identification, quantification, and presentation of root causes responsible for extra-contractual cost & schedule growth. Mr. Gardner is well versed in conducting and advising clients on contract audit matters. Cuong Ha is a Senior Consultant in the Seattle office of FTI Consulting. Mr Ha has experience working with large general contractors and government contractors on claims, damages and cost audit related matters. He has successfully developed and audit sampling methods and conducted cost audits in litigation settings. He has advised clients on cost certification in compliance with the Contract Disputes Act. Eric M. Liberman is an Associate with the law firm Watt, Tieder, Hoffar & Fitzgerald, LLP in McLean, Virginia. Mr. Liberman focuses his practice on government contracts and construction litigation. Eric also has 3 years experience working as an accountant and tax consultant. 3

4 Federal, state and local entity contracts are generally subject to audit with the owner s rights, scope, timing and resolution process determined by government regulations. For private contracts, the contract language defines the rules of the audit. Thus, less uniformity exists in the requirements and performance of commercial audits when compared to government contract audits. 4

5 Owner-initiated audits are not unique to government contracts. Audit clauses are also used by private companies to ensure that the owner has the right to oversee the books and records of its contractors to ensure funds are spent properly and efficiently and that charges are billed in accordance with contract terms and conditions. 1 Although government audits have a similar purpose, the structure and process of a government audit varies significantly from those performed by private companies. Section 1: Audits in the Public Sector In addressing public contract audits, the following discussion provides information on the Defense Contract Audit Agency (DCAA), the DCAA s Contract Audit Manual (CAM), the Federal Acquisition Regulations (FAR) and Generally Accepted Government Auditing Standards (GAGA). These resources are the primary guides for understanding how audits are performed in the government sector. A. Defense Contract Audit Agency (DCAA) The DCAA has long been responsible for the financial oversight of federal procurement contracts to ensure that the DoD and other agencies obtain the best value for every dollar spent. Created in 1965, the DCAA is an independent agency within the DoD and operates under the direction of the Undersecretary of Defense. 2 The DCAA s primary responsibility is to provide oversight of DoD contracts by furnishing all necessary contract audits. 3 These audits typically include reviewing and verifying the cost data of government contractors at all stages in the procurement process to evaluate the accuracy, reasonableness, and allowability of costs incurred. 4 All DCAA audits are performed in accordance with Generally Accepted Government 5

6 Auditing Standards ( GAGAS ) to ensure contractors maintain sufficient internal controls to prevent ineffective and inefficient practices. 5 As a result, the DCAA ensures prices paid by the government are fair and reasonable and that contractors are charging prices in accordance with applicable laws, regulations, standards, and contract terms. 6 Audit findings by the DCAA are typically focused on identifying areas and items of non-compliance. B. Federal Acquisition Regulations (FAR) The Federal Acquisition Regulations ( FAR ) are the principle regulations used by federal agencies in their acquisition of supplies and services. In addition to GAGAS and the DCAA Contract Audit Manual ( CAM ), the FAR and the contract provisions serve as the government auditor s primary guidelines. 7 If any federal funds are provided for state and local public contracts, the FAR regulations and audit provisions may also apply to those contracts. Local government entities often model their contract terms and conditions after the FAR and incorporate DCAA, CAM and GAGAS guidelines. 8 The DCAA and federal agencies receive their audit authority from the United States Code, 10 U.S.C. 2313, which states : (a) Agency authority. (1) The head of an agency, acting through an authorized representative, is authorized to inspect the plant and audit the records of (A) a contractor performing a cost-reimbursement, incentive, time-andmaterials, labor-hour, or price-redeterminable contract, or any combination of such contracts, made by that agency under this chapter; and (B) a subcontractor performing any cost-reimbursement, incentive, time-andmaterials, labor-hour, or price-redeterminable subcontract or any combination of such subcontracts under a contract referred to in subparagraph (A). 9 This statute grants DCAA the authority to access a contractor or subcontractor s internal financial documents for the purpose of verifying costs. 10 The statute also gives DCAA direct 6

7 authority to examine all records of the contractor or subcontractor related to (A) the proposal for the contract or subcontract; (B) the discussions conducted on the proposal; (C) pricing of the contract or subcontract; or (D) performance of the contract or subcontract where such information is needed for the purpose of evaluating the accuracy, completeness, and currency of certified cost or pricing data. 11 The FAR also provides agencies and the DCAA with audit authority. For example, FAR (b) requires that defense contracts contain the standard FAR clause found in FAR , which identifies the records to be maintained by a contractor and the government s rights to examine the contractor and subcontractors records, procedures, and practices that are relevant to the contract. Although the DCAA is responsible for performing the audit, it merely serves in an advisory role. 12 The owner is the government agency responsible for the acquisition. 13 The owner on DCAA audits is a DoD agency because the DCAA performs all contract auditing for the DoD. 14 However, the DCAA may be used by other agencies on a fee-for-service basis. Thus DCAA may be used by other agencies.. 15 Examples of these agencies include the National Aeronautics and Space Administration (NASA), the Department of Energy (DOE, the Environmental Protection Agency (EPA), the Department of Transportation (DOT), the Department of Interior (DOI), and the Department of Commerce (DOC). 16 Other agencies, such as the General Services Administration (GSA), may use its own auditors. Within GSA, auditors are assigned to the GSA Inspector General s office. The Contracting Officer ( CO ) generally has the sole authority to enter into, administer, or terminate contracts and make related determinations and findings for agency acquisitions. 17 FAR explicitly states that COs are allowed wide latitude to exercise 7

8 business judgment and are required to [e]nsure that contractors receive impartial, fair, and equitable treatment. Correspondingly, the CO is not required to follow the findings, opinions, or recommendations of the DCAA or other auditors. 18 In practice, however, the CO will typically follow the auditor s advice unless credible evidence is brought to the CO s attention demonstrating that the auditor s concerns are unfounded, inaccurate, or insufficient. 19 If a contractor disagrees with particular audit findings, they can raise those concerns with the CO. As set forth above, the DCAA is independent of the CO and the contracting government entity. 20 Thus, the DCAA will seek to provide impartial financial information and advice relating to contractual matters and the effectiveness, efficiency, and economy of contractors operations for the agencies that use it. 21 Make no mistake, however, the DCAA and all government auditors primary objective is to protect the public fisc. DCAA audits may include the evaluation of a contractor s policies, procedures, controls and actual performance, identifying and evaluating all activities which contribute to, or have an impact on, proposed or incurred costs of Government contracts so that the agency may avoid wasteful, careless, and inefficient practices by its contractors. 22 The DCAA s general audit interests include: 1) evaluating incurred costs of government contracts, 2) evaluating contractors financial policies, procedures, and internal controls, and 3) identifying opportunities for contractors to reduce or avoid costs (operations audits). 23 The DCAA s primary audit objectives are to: 1) serve the public interest in ensuring taxpayer dollars are spent on a fair, reasonable and appropriate basis; and, 2) ensure contractors accumulate, report and bill for only costs that are allowable, allocable and required per the contract. DCAA audits are a powerful tool that agencies may use to eliminate waste and inefficiency during the administration of federal acquisitions. 8

9 C. Generally Acceptable Government Accounting Standards (GAGAS) GAGAS, also known as the Yellow Book, is a set of guidelines used by government auditors for conducting audits. 24 The term audit or yellow book audit refers to financial audits, attestation engagements, and performance audits conducted in accordance with GAGAS, 25 not to the audit of company financial statements. The most current version of the GAGAS can be found on the GAO s website at: The DCAA must comply with GAGAS when conducting its audits. 26 Generally, these standards require DCAA to evaluate and test a company s internal controls, which includes evaluating the work of the company s internal audit activity, specific controls, and business systems. 27 GAGAS also dictate the documentation of audit work. GAGAS determines what comprises appropriate, relevant, and sufficient evidentiary matter that the DCAA should review and rely upon for audit findings, 28 and it contains requirements and guidance to assist auditors in making objective evaluations. 29 D. DCAA Contract Audit Manual (CAM) The CAM is the DCAA s audit manual. It provides DCAA auditors with technical audit guidance, audit techniques, audit standards and technical policies and procedures and is applicable to all types of contracts. The CAM dictates that the auditor must use professional judgement in: 1) selecting the procedures and techniques best suited to the audit objectives; and, 2) determining the audit scope. 30 The electronic version of the CAM is regularly updated, with a current version available at: CAM specifically cautions auditors to use good judgment and rationale in deciding what contractor records should be sought and explains that auditors must consider the 9

10 audit objective, the risk, and materiality of an error or misstatement in the area being audited and the effect on the audit opinion when following GAGAS procedures. GAGAS, therefore, provides a framework for conducting high quality audits with competence, integrity, objectivity, and independence, and lead[s] to improved government management, better decision making and oversight, effective and efficient operations, and accountability and transparency for resources and results. 31 This also means that there must be a reasonable basis for requesting and auditing company records. E. DCAA s General Audit Interests Fundamentally, DCAA serves the public interest by offering honest, objective, and independent audits. 32 As the GAO notes in its report titled DCAA Audits: Widespread Problems with Audit Quality Require Significant Reform: Serving and honoring the public trust are critical when performing government audits. Auditors increase public confidence when they conduct their work with an attitude that is objective, fact-based, nonpartisan, and non-ideological with regard to audited entities. Auditors should be intellectually honest, independent and free of conflicts of interest in discharging their professional responsibilities. 33 The DCAA examines the totality of the contractor s operations to ensure adequate internal controls exist to reduce wasteful, careless, or inefficient practices. 34 DCAA auditors evaluate contractor records, books, and other data that contributes to proposed or incurred costs of government contracts. 35 According to the CAM, the audits focus on practices relating to accounting, estimating, and procurement; the evaluation of contractors management policies and decisions affecting costs; the accuracy and reasonableness of contractors cost representations; the adequacy and reliability of contractors records for Government-owned property; the financial capabilities of the contractor; and the appropriateness of contractual provisions having accounting or financial significance

11 The CAM further specifies that auditors should develop sufficient evidence by gathering materials that are: (1) reasonable as to nature and amount, (2) allocable and measurable by the application of duly promulgated cost accounting standards, (3) generally accepted accounting principles and practices appropriate to the particular circumstances; and (4) in accordance with applicable cost limitations or exclusions as stated in the contract or in FAR. 37 Of course, auditors are instructed by the CAM to base their professional opinions and conclusions on their actual knowledge of the contractor s classification and expenditure practices. 38 Auditors are encouraged to learn and understand the contractor s accounting nomenclature, chart of accounts, accounting manuals, and financial statements. 39 Also, to express a valid opinion, auditors must physically examine and test the contractor s records, including job cost records and indirect cost rates. 40 Because an auditor s primary goal is to oversee agency procurement to ensure accuracy and efficiency, the DCAA reports any matters that need improvement. 41 Specifically, the DCAA will signal evidence of excessive contract prices or profits or indications of overcharges or inadequate compensation to the government agency. 42 Auditors conduct this analysis by verifying the costs asserted in the contractor s request for adjustment or claim by tracking them back to source documents, such as timesheets and vendor invoices. 43 If issues are discovered, the CO in some situations may use the DCAA s reports to reduce the contract price should the audit disclose certified cost or pricing data that was incomplete, inaccurate, or not current. 44 F. DCAA s Major Areas of Emphasis The CAM places significant emphasis on a contractor s ability to track costs accurately, 11

12 especially costs pertaining to labor. 45 Through both an analysis of contractor internal controls and the collection of appropriate and sufficient evidence to support their findings, the DCAA seeks out indicators of inefficiency and waste. 46 Once the DCAA has fully examined the contractor s data and records, it develops a report to address these issues and provides guidance as to how the government agency should respond. 47 The DCAA also seeks to support its professional findings and conclusions with physical, documentary, and testimonial evidence. 48 According to the CAM, evidence is required to be both sufficient and appropriate. 49 The CAM describes appropriateness as: [T]he measure of the quality of the evidence that encompasses its relevance, validity and reliability in supporting audit objectives and related findings. In assessing the overall appropriateness of evidence, auditors should assess whether the evidence is relevant, valid, and reliable. (1) Relevance refers to the extent to which evidence has a logical relationship with, and importance to, the issue being addressed. (2) Validity refers to the extent to which evidence is based on sound reasoning or accurate information. (3) Reliability refers to the consistency of results when information is measured or tested and includes the concepts of being verifiable or supported. 50 Sufficiency, on the other hand, is described by the CAM to be a measure of the quantity of evidence used to support the findings and conclusions related to the audit objectives. 51 In order to meet its sufficiency objective, the DCAA is required to gather enough evidence to persuade a knowledgeable person that their findings are reasonable. 52 All audits in the DCAA, therefore, must be appropriate and sufficient to support final audit conclusions. 53 G. Contract Amount and Type Determine Verification Requirements As presented on Chart A, the amount of a government contract is relevant to the contractor s certification requirements. On all contracts or contract modifications greater than 12

13 $700,000, the contractor is required to certify that all of its cost and pricing data is accurate, complete and current under FAR In addition, FAR (c)(2)(iv) requires cost analysis to include appropriate verification that the offeror's cost submissions are in accordance with contract cost principles and, when applicable, the CAS (see Chart C). The Truth in Negotiations Act (TINA) also requires contractors to submit cost or pricing data if the procurement is above the TINA threshold ($700,000) and none of the exceptions to cost or pricing data requirements apply. 54 Thus, contracts requiring certification are frequently audited. The type and focus of DCAA s audits will vary based on the contract type. For example, many DCAA audits on firmfixed price contracts take place during the proposal stage rather than in the incurred cost stage. The reverse is true for cost reimbursable contracts. The allowable costs properly included in the final pricing of cost-plus contracts are generally determined after they are incurred and audited. 55 H. Scope of an Audit What can the Government Review under the Law? According to the Audit and Records Negotiation clause in FAR , the DCAA has a broad right to access contractor records. 56 Not only can the DCAA access cost records associated with a particular procurement contract under audit, it can also access contractor policies, procedures, systems, management reports, personnel, minutes of its board of directors meetings, charters, and bylaws. 57 Additionally, the DCAA has access to contractor employees under GAGAS, using detailed employee interviews and labor floor checks to assess the adequacy of a contractor s internal controls and the propriety of its recorded labor charges. 58 The DCAA does not have unbridled access to all contractor records. In its Grumman Aircraft Engrg. Corp. decision, the Armed Services Board of Contract Appeals stated that an auditor certainly has no right to roam without restriction through all the contractor s business 13

14 documents which have no connection with the Government contract. 59 Thus, the boards of contract appeals and courts will examine (a) the statutory, regulatory, or contractual authority of the auditor to access the records being sought, (b) the relevance of the materials to the underlying audit, and (c) the scope of the request to determine whether the DCAA may access certain contractor records. 60 As a result, the DCAA may not obtain records and data entirely unrelated to the contract being audited. DCAA audits can take many forms with a variety of objectives. For example, given the DCAA s interests, there are 67 Audit Programs currently identified in the DCAA s Directory of Audit Programs. 61 We advise any auditee facing a DCAA audit to be clear what type of audit is being conducted, review these published audit programs in advance of the audit taking place and seek qualified assistance from legal counsel and/or consultants well-versed in the conduct of government audits. I. Pre-Award and Post-Award Audits As presented in Chart B below, the DCAA s scope on pre and post award audits includes: 1) business systems, 2) management policies and procedures, 3) accuracy and reasonableness of the contractors forward pricing and incurred cost representations, 4) adequacy and reliability of records and accounting systems, and 5) contractor compliance with contractual provisions having accounting or financial significance, such as the Cost Principles (FAR Part 31), the Cost Accounting Standards (CAS) Clause (FAR ), and the clauses pertaining to the Truth in Negotiations Act (TINA) (FAR through 13). 62 The CAS and disclosure statement requirements are illustrated on Chart C. Chart B, set forth below, identifies the significant focus for audits, including pre-award audits: 14

15 15

16 Chart C, below, sets for the CAS Coverage based on contract type and amount: 16

17 A pre-award survey or audit typically involves the DCAA s evaluation of a prospective contractor's ability to perform a proposed contract. Audits pertaining to a contractor s financial capability, adequacy of the contractor s accounting system and adequacy of the contractor s proposal can be expected, particularly for contractors who are new to public contracting. We direct the reader for further guidance concerning pre award audits to: DCAA Manual No , INFORMATION FOR CONTRACTORS, 2012 DCAA s Pre award Survey of Prospective Accounting System at: ecklist.pdf. DCAA s Adequacy of a Contractor s Pricing Proposal Checklist at: 63 One test worth mentioning and shown on Chart B relates to the adequacy of the contractor s accounting system and the exclusion of unallowable costs. A contractor s cost accounting system must exclude costs charged to government contracts that are not allowable pursuant to FAR Part 31, Contract Cost Principles and Procedures, or other contract provisions. For example, the FAR identifies some costs as expressly unallowable: e.g., bad debts (FAR ); contingencies (FAR ); contributions or donations (FAR ); and entertainment (FAR ), and requires that they be excluded from proposals and billings. While these costs may be legitimate business expenses, they will not be accepted by the government as allowable contract costs. 64 For any contractors new to the government contracting arena, these types of pre-award audits may generate a need to consult with legal counsel and consultants well-versed in cost systems designed to properly segregate costs. 17

18 J. Allowable Costs 65 and Indirect Cost 66 FAR sets forth the factors to be considered when determining whether a cost is allowable, which include: (i) reasonableness, (ii) allocability, (iii) standards promulgated by the Cost Accounting Standards Board (CASB), if applicable, otherwise, generally accepted accounting principles and practices appropriate to the particular circumstances, (iv) terms of the contract; and, (v) any limitations set forth in this subpart of FAR. The Allowable Cost and Payment clause, FAR , requires a contractor to submit a final incurred indirect cost proposal together with supporting data within six months after the end of each fiscal year. The receipt of an adequate proposal by the audit office starts the audit process. This proposal should include a signed "Certificate of Indirect Costs" in accordance with FAR a copy of which may be found at FAR The DCAA conducts audits on: prime contracts, subcontracts, modifications, final price redeterminations, equitable adjustments, and terminations for audit to determine compliance with government statutes. Per the CAM, all incurred cost proposals are evaluated and put either into high or low risk categories with one-third of all low-risk proposals and 100% of all high-risk proposals to be audited. 67 Audit selection also considers such factors as contract type and dollar value of the contract, adequacy of accounting and estimating systems, and the number of instances and amount of defective pricing found in prior audits. Failure to comply with FAR , the Allowable Cost and Payment clause requirement to provide an adequate proposal, will result in a DCAA recommendation for the CO to make a unilateral determination on the contractor s final indirect cost rates or contract costs. K. Penalties for Mischarging 68 The manipulation of contract costs may subject offending individuals to criminal 18

19 penalties under 18 U.S.C. 1001, which reads: Whoever, in any matter within the jurisdiction of the executive, legislative, or judicial branch of the Government of the United States knowingly and willfully (1) falsifies, conceals or covers up by any trick, scheme, or device a material fact; (2) makes any materially false, fictitious or fraudulent statement or representation; or (3) makes or uses any false writing or document knowing the same to contain any materially false, fictitious or fraudulent statement or entry; shall be fined under this title or imprisoned not more than five years, or both. L. Incurred Cost Audit Evaluation 69 During the course of the audit, the auditor should discuss findings with the contractor as they arise - the contractor is expected to provide feedback on these findings on a timely basis. Continued coordination between the contractor and the auditor should ensure the timely resolution of audit findings and facilitate an efficient and effective audit process. After completing the audit, the auditor should provide the contractor with the results of the audit in writing and seek the contractor s agreement or comments. Since significant audit findings should have been discussed during the audit process, an exit conference should provide a summary of issues and resolutions. The contractor should be given the opportunity to respond to the audit findings, and any contractor comments should be included in the final report. If agreement with the contractor is not reached, DCAA should forward its audit report to the cognizant CO who is expected to then resolve the disagreement. Section 2: Private Contract Audits The private sector does not benefit from the uniformity and well-established guidelines of government contract audits; however, the purpose of an owner-initiated audit remains the same 19

20 to assure the owner and the project stakeholders that they are billed correctly and that work is performed in accordance with the contract terms. In the commercial world standard form contracts and provisions exist that are commonly used and developed by organizations such as the American Institute of Architects (AIA) and the International Federation of Consulting Engineers (FIDIC); however, ultimately every standard form contract is subject to edits with the audit provision language generally being unique to each project. A. Fixed-Price Contracts As presented in Chart D below, the first step in the audit process is to identify the contract s pricing terms, i.e. fixed price, cost reimbursable, unit price, or other form of pricing. Although fixed-price contracts are least likely to be audited, contracts often contain a Changes clause - audit provisions may apply to certain cost and pricing data submitted to support a change order request. B. Cost Reimbursable Contracts Cost reimbursable-type contracts in the private sector typically have audit provisions allowing the owner to audit the contractor s costs. These provisions define the scope, parameters, timing and rules related to: 1) accounting records or source documentation; 2) level of proof of costs; 3) description of the audit process; 4) definition of cost and rates for certain items such as labor or equipment; 5) definition of allowable and unallowable costs; 6) contractor record-keeping and reporting requirements for job cost and progress reporting; 7) definition of any audit restrictions that may apply with respect to disputes, litigation and discoverability of certain documents; 8) definition and identification of fixed unit rates, lump sum components, agreed percentages or other agreed-upon special rates for costs related to items such as: changed 20

21 work, subcontractor markups, etc.; 9) record retention requirements, and; 10) definition of the owner s rights to audit subcontractors. Chart D provides a general overview of the audit process for private contracts: 21

22 It is generally advantageous to the owner and contractor to have a clear understanding of the parties audit expectations and requirements set forth in the contract. Following are some of the typical types and categories of costs addressed in audit provisions: Labor o Craft or Touch Labor o Support Labor Materials Subcontracts General Conditions / Field Office Overhead Equipment: Contractor-Owned, Third-Party Owned, Job-Owned Change Orders Home Office Overhead / G&A Fee Verification of the contracted scope of work Section 3: Comparing and Contrasting Public and Private Sector Audits Although many differences exist between public and private sector audits, the two types of audits have several similarities as set forth below: A. Similarities Public and private audits share a common goal of ensuring that the owner is not being overcharged and is billed correctly in accordance with the contract s terms and conditions. In other words, the owner wants to be ensured that all costs being billed by the contractor are allowable. FAR states that the factors to be considered in determining whether a 22

23 cost is allowable include: (i) reasonableness; (ii) allocability; (iii) standards promulgated by the Cost Accounting Standards Board (CASB), if applicable, otherwise, generally accepted accounting principles and practices appropriate to the particular circumstances; (iv) terms of the contract; and, (v) any limitations set forth in this subpart of FAR. Although FAR provides some qualifying CASB and FAR language to the definition of allowable, an ultimate determination of allowability will rest on whether the costs are: 1) reasonable; 2) allocable, i.e. pertaining directly to the contract; 3) consistent with GAAP and appropriate to the circumstance; and, 4) consistent with the contract. These factors are generally reviewed by a private sector owner when considering allowable costs. A cost is considered reasonable under the FAR if, in its nature and amount, the cost does not exceed that which would be incurred by a prudent person in the conduct of competitive business. Reasonableness of specific costs must be examined with particular care in connection with firms or their separate divisions that may not be subject to effective competitive restraints. No presumption of reasonableness shall be attached to the incurrence of costs by a contractor. If an initial review of the facts results in a challenge of a specific cost by the contracting officer or the contracting officer s representative, the burden of proof shall be upon the contractor to establish that such cost is reasonable. 70 In the private sector, a need to determine whether a cost is reasonable is important and referenced multiple times in AIA Form Contracts; however, reasonable is not defined. 71 Both public and private audits recognize the importance of auditing cost reimbursable contracts over fixed-price contracts. Similarly, both types of audit recognize the importance of auditing change order work and claims on fixed-price contracts. Both types of audits also share similar audit process logistics. The process usually begins with a formal notice from the owner 23

24 which is then followed by an entrance meeting with the auditor. Interim meetings may be held with the auditor, an audit close out meeting is held, and the contractor is given the opportunity to formally respond to the auditor s findings. Ultimately, if the auditor determines that unallowable costs have been incurred and billed, those costs may result in adjustments to the contractor s billings or refunds to the owner. Similar to the government, private owners often place requirements on the contractor s job cost accounting, reporting, time keeping standards, and financial and resource capabilities. Finally, both public and private audits will focus on the same types and categories of contractor s costs presented above in Section 2. B. Differences The rules and regulations governing contracts, contractors, and audits in the public sector, i.e. the FAR, DCAA, CAM, etc., generally do not apply to private contracts. Thus, but for contract provisions dictating the terms and conditions of an audit, few principles other than standard accounting practices exist for private project audits. In light of the multiple types of public audits (DCAA identifies 67 audit programs), a contractor who regularly practices in the public sector is almost guaranteed of being audited in some form. Contrarily, the private sector has fewer types of audits. For example, pre-award audits, which test the adequacy of the contractor s accounting system and financial capability to perform, are not common in the private sector. Private owners may require that contractors implement job cost and time keeping controls; however, they generally do not require these controls to be implemented before a contractor submits a proposal. A formal certification by the contractor that all of its cost and pricing data contained in a proposal is accurate, complete, and current does not typically occur in the private sector. Yearly 24

25 submissions of a contractor s incurred contract costs also are atypical and not required in the private sector. Finally, the legal penalties for overcharging a public owner can be much more severe than in the private sector. Section 4: Audit Sampling Methods One element of an audit with which a contractor should be familiar is the use of sampling and the methods used by auditors to sample a contractor s financial records. When performing a cost audit, an auditor may have neither the time nor the resources to review a contractor s entire financial record. Instead, the auditor may review only a sample of the total job costs. The FAR recognizes statistical sampling as a valid approach to identifying unallowable costs. FAR , Accounting for Unallowable Costs, is presented at the end of this Section. Sampling relies on inferential statistics and helps the auditor draw conclusions about the entire population of costs without analyzing every cost transaction and all the related supporting source documentation. In inferential statistics, an auditor uses random selection to make an unbiased observation about a population. The least complex and most widely used type of sampling is simple random sampling, wherein each item in the population has the same probability of being selected. Simple random sampling provides an unbiased result since each cost item has the same chance of being reviewed regardless of the item s individual attributes. Alternatively, auditors may elect to use a more methodical approach during the design of a statistical study. For instance, with systematic random sampling, a random starting point is selected, and then every kth item of the population is selected (where k is calculated as the population size divided by the sample size). Systemic random sampling is useful when each item in a population is not already numbered and the numbering process would be a time 25

26 consuming task, such as when selecting labor costs to audit based on a list of craft laborers assigned to the project. This process also has the advantage of removing the potential for human bias in the selection of items to include in the sample. As a result, the systematic random sample provides a sample that is highly representative of the population. When a population is divided into smaller groups based on some attribute, stratified random sampling can be used to guarantee that each group, or strata, is represented in the sample. Each strata can then be subjected to simple random selection to collect a sample. In the case of a construction audit, costs can be stratified based on type of cost, such as labor, vendor, or equipment. When designing a statistical study, a common question is How many items should be in the sample? If a sample size is too large, time and money are wasted collecting excessive data. Similarly, if a sample size is too small, the resulting conclusions may not represent the population as a whole. When choosing an appropriate sample size, 3 considerations should be analyzed: (1) the level of confidence desired; (2) the margin of error tolerated; and (3) an estimate of the population proportion. Another form of sampling commonly used in the course of an audit is judgmental sampling. Judgment sampling is a non-statistical approach that gives an auditor more control over the sample selection to gain an understanding of the costs subject to audit. Conclusions drawn in a judgment sample generally cannot be applied to the population as a whole. For many audits, a large percentage of costs can be covered by judgmentally sampling a small number of high-dollar transactions, and can often requires less work while obtaining the same results as a more involved, random statistical sample. As such, it may be prudent for an auditor to stratify the costs subject to audit in different ways to gain a better understanding about the 26

27 reasonableness of costs incurred. One method of doing so is by organizing the total individual project costs in order of value from highest to lowest and reviewing the costs in order until the auditor reaches the dollar value coverage desired. This method allows the auditor to save time by reviewing only the largest dollar value items. Another commonly used stratification is to review costs by vendor, starting with the vendors with the highest project costs, until the auditor reaches the desired coverage level. A significant advantage of judgmental sampling is that the auditor spends less time on immaterial items which may otherwise be included in a random sample. Section 5: Best Practices Set forth below are best practices a contractor should follow when preparing for and responding to an audit: A. Take the Audit Request Seriously Regardless of how benign the owner s notice of an audit may sound, it should be taken with the utmost seriousness, with upper management being made fully aware and notified that the audit is a top priority. B. Establish an Audit Response Team An Audit Response Team should be established with a team leader being identified. The team leader should identify and include subject matter experts on the team, at a minimum (particularly in the public sector) from Contracts, Procurement, Subcontracts, Finance, Legal, Human Resources, Project Management, and Accounting. If the audit is in the public sector and it is the contractor s first cost audit, the contractor is encouraged to either identify and include 27

28 someone within their organization who has previously been through a government cost audit or retain an outside government contracts accounting expert to participate on the team. C. Assemble the Audit Response Team Before the Audit Entrance Conference Review the audit notice letter and contract audit provision language with the team and discuss any key areas of concern or audit risk. The contractor s audit team must be aware of the contract s general audit requirements and the contractor s responsibilities. A pre-meeting will help the team members organize their documents. If the owner s audit notice letter does not specify the scope of the audit, it is appropriate to request clarification before the start of the audit. The internal audit team can then prepare to assist the auditor in reviewing the requested information. D. Ensure that an Audit Entrance Conference Occurs If the owner does not schedule an initial meeting or entrance conference the contractor must request one. Make it clear to the owner that it is imperative such a meeting occurs before the audit begins. The contractor should always designate someone to take notes or minutes of any meetings with the auditors for internal reference. During the audit entrance conference, the contractor must ensure clarity with the owner regarding: a. Scope of the audit: ask as many questions as you like. The more detail, the better for the contractor to develop a clear understanding of the auditor s scope. b. Contractor s internal audit response team. Introduce everyone on the team and demonstrate to the auditor the efforts thus far in assembling the team to assist the auditor. Make clear to the auditor that all communications need to go through the contractor s audit team leader. c. The audit process protocol regarding communications. Establish how the owner s information requests are to be provided. d. Discuss with the auditor(s) any limitations on information that the contract audit provision language may define and obtain the auditor(s) position(s) on such. 28

29 e. Understand if on-site work is needed and, if so, establish daily close-out meetings with the auditor(s). f. Understand if employee interviews will be required and, if so, request that the auditor provide names of those persons in advance so appropriate arrangements and preparation with persons to be interviewed can occur in advance. E. Post Entrance Conference Meeting with Internal Audit Response Team After the Entrance Conference, convene a meeting with the internal audit team to answer any questions and to make sure the team understands the following: a. All communications and documentation with/from the auditor should go through the audit team leader. The audit team leader should keep records of all information provided and is encouraged to ask legal counsel and the audit team if there are questions before providing the auditor with information. b. The auditor(s) should always be escorted and not be allowed to perform walk arounds without someone (preferably on the audit team) acting as an escort. While escorting the auditors, the contractor should always pay attention to what questions the auditor(s) are asking, take notes, and relay them to the audit team leader. c. All documents provided to the auditor(s) should be marked Confidential & Proprietary. This provides added protection for the contractor in limiting the auditor s distribution of any material. Consider whether a confidentiality agreement is necessary. d. Make clear that all communications with the auditor(s) should be documented for internal reference and to avoid misunderstandings and then forwarded to the audit team leader. e. Do not provide more information than is requested. It is important that only information that is relevant and responsive to the auditor s questions be provided. Do not provide information that is not requested. For example, the contractor should redact information which is not required under the audit or investigation. Again, if the team leader has any questions on what to provide, seek legal counsel or other expert advice from someone with prior experience on the audit team in this process. f. Be as responsive and as timely as possible to the auditor s requests. F. Request a Closing Conference Normally, the owner will hold an exit conference at the conclusion of the audit. If not, the contractor should request an exit conference. After completing the audit, the auditor should 29

30 provide the contractor with the results of the audit in writing and seek the contractor s agreement. From the government s viewpoint, significant audit findings should have been discussed during the audit process, and the exit conference should merely be a summary of issues and resolutions. The contractor will be given the opportunity to respond to the audit findings and any contractor comments will be included in the final report. 72 G. Responses to Audit Reports In the public sector, if the audit report results in adverse findings such as the identification of disallowed costs, the contractor may: (1) request the CO, in writing, to consider whether the unreimbursed costs should be paid and to discuss the findings with the contractor; and/or, (2) submit to the CO a claim for disapproved costs in accordance with FAR 33.2 (Disputes and Appeals). If a formal claim is filed, the CO will usually make a decision within 60 days. If the contractor disagrees with the CO s final decision regarding a claim, the contractor may appeal the decision to the Boards of Contract Appeals (ASBCA) or the Court of Federal Claims. 73 H. Other Non-Owner Audits Although beyond the scope of this Paper, the contractor should be aware of other nonowner initiated audits such as: Department of Labor and Office of Federal Contract Compliance Programs (OFCCP) Audits and Labor audits (ICE I-9, certified payroll compliance). Section 6: Is the Audit Part of a Dispute, Claim or Litigation? DCAA auditors may not be trained investigators and will not lead criminal investigations into contractor operations. However, their findings may be used by government investigators, which means the DCAA s unusual inquiries into specific business practices or procedures may indicate a government investigation is about to occur. 74 DCAA auditors are instructed to look for 30

31 indicators of fraud. In fact, the CAM specifically outlines the auditor s responsibilities for preventing, detecting, and reporting fraud, improper practices, or other unlawful activity. 75 In particular, auditors are required to initiate an investigative referral when they become aware of circumstances that raise a reasonable suspicion of fraud or other unlawful activity. 76 In terms of contractor-based claims against the government, auditors are prohibited from acting as agents or attorneys for the prosecution of claims against the United States. 77 They also may not aid or support contractors in any way that goes beyond their official duties. 78 The auditors at DCAA, however, may advise contractors as to types of costs that are considered allowable and unallowable under the law or terms of the contract. 79 Additionally, they may also orally express an opinion as to the acceptability of a specific item of cost upon request. 80 Section 7: Conclusion Lessons Learned and Contractor Don ts This Section addresses the audit Don ts for contractors - a result of lessons learned that have been observed through years of audit experience. Accordingly, we hope these recommended Don ts will help you avoid the pitfalls of companies and clients who previously were involved in audits: Don t: 1) Minimize the importance of an owner s notice to audit, regardless of how benign it sounds or how well you think the job is going, 2) Wait until the last minute to prepare for an audit entrance conference, 3) Leave an auditor unattended to wander wherever he/she wants to go, 4) Provide the auditor with information that hasn t been properly reviewed, 5) Provide the auditor information beyond what was requested or outside the scope of the audit, 31