One of our most popular consulting engagements is to conduct an evaluation of the contractor’s accounting system before DCAA performs either a preaward survey of the prospective contractor’s accounting system or a post accounting system evaluation of contractor’s accounting system. This is normally performed as a DCAA “mock” audit and includes the audit steps and procedures that the DCAA auditor would actually perform during the DCAA audit and we would identify system weaknesses and strengths and make recommendations to correct the inequities of the accounting system.
The preaward accounting system survey is an examination before contract award to determine the acceptability of a contractor's accounting system for accumulating costs under a prospective Government contract. The audit scope should be limited to obtaining an understanding of the design of the prospective accounting system so as to appropriately complete the SF 1408, Preaward Survey of Prospective Contractor Accounting System” and those procedures essential to reach an informed opinion as to whether or not the design of the prospective accounting system is acceptable for accumulating costs under a Government contract and has the ability to generate the specific cost information required under the anticipated contract.
An accounting system audit may be performed after contract award. The major objective is to determine if the contractor’s accounting system is adequate for accumulating and billing costs on Government contracts. It is usually performed at the request of the CO (contracting offer) when ( i ) a follow-up to a preaward survey is recommended, or ( ii ) a preaward survey was not conducted prior to contract award, and the CO determines that an audit is now required to support contract requirements. Furthermore, auditors may self-initiate a post contract award accounting system audit based on audit risk at a contractor location.
Increased Risk of DCAA Inadequacy Opinion
When performing an accounting system review DCAA previously rendered one of three of the audit opinions:
- Inadequate in Part, or
However, the “Inadequate in Part” has been eliminated by DCAA. This development is unfortunate because the majority of opinions previously issued by the DCAA were “inadequate in part.” This type of opinion permitted the contractor to make minor fixes to the system and obtain an adequate opinion upon a follow-up review by the DCAA. I’m afraid that this position has increased the risk of receiving an ‘inadequate’ opinion by the DCAA. Accordingly, it is critical to avoid the dreaded inadequate opinion because an unfavorable opinion can result in ( i ) the failure to obtain a contract award that is based on cost or pricing data; ( ii ) suspension of payments on existing contracts; ( iii) disqualification of direct billing privileges, etc.
Elements of Adequate Accounting System
The accounting system must be maintained in accordance with Generally Accepted Accounting Principles (GAAP). The auditor will conduct certain tests to make sure the contractor has, or if not, intends to have an accrual basis accounting system. It is also best if the contractor has financial statements compiled, reviewed or audited by an outside CPA firm. Furthermore, DCAA has stated that the evaluation checklist set forth under FAR Standard Form 1408 will be followed in the evaluation of preaward accounting system surveys. Accordingly, the author believes that in order to meet federal government standards a prospective contractor’s accounting system ( i ) should be based on the accrual method of accounting; ( ii ) incorporate the requirements of the Federal Acquisition Regulations (FAR), especially the provisions of FAR Part 31; and ( iii ) include the following elements inherent in an adequate accounting system that is suitable for government contracting:
- Controls for distinguishing between direct and indirect costs
The contractor must have controls to preclude the direct charging of indirect expenses and vice versa. A flowchart or similar document is most helpful in demonstrating the flow of expense transactions from say a purchase requisition to a purchase order to a receiving document and then to the vendor invoice. For service-related expenses, a formal contract, subcontract or engagement letter is helpful in determining whether an expense is direct or indirect. The charge number whether direct or indirect should be shown on the source documents at the earliest possible stage. Also, a system of review and approvals are considered essential in meeting this control requirement. Moreover, it is necessary for the contractor to prepare and maintain written policies and procedures for the identification of direct and indirect costs and these policies should be disseminated to employees preparing and reviewing relevant documents.
- Job-Cost Ledger
The contractor must maintain a subsidiary job-cost ledger or accounts receivable ledger that accumulates job costs by element of cost on a cumulative basis at a level consistent with that used by the contractor (e.g. contract, task or delivery order, or contract line item).
- Indirect Cost Rates
The DCAA auditor will determine whether indirect costs are accumulated in logical cost groupings (called pools) and the costs must be allocated on a causal or beneficial relationship with the base. The contractor should have a chart of accounts that shows how indirect costs are grouped in relevant pools and will be asked to produce a current general ledger trial balance that matches the chart of accounts. Again, it is important that the contractor formally document its cost accounting system in a written description of the contents of the pools and bases.
- General ledger
The accounting system should provide for the accumulation of contract costs under applicable general ledger control accounts. This is a test that should be conducted before DCAA begins the audit. Here the total of elements of cost (i.e., direct labor direct material, etc.) should be added and reconciled with the applicable general ledger control account. For example, direct labor posted to each contract in the job-cost ledger must equal the same direct labor account posted to the general ledger.
- Timekeeping System
SF 1408 requires “a timekeeping system that identifies employees’ labor to the appropriate cost objective” (e.g. contract, subcontract, relevant task or delivery order, IR&D/B&P project, cost pool, etc.). This requirement is supposed to be simple but it causes contractors the most headaches both in getting employees to comply and generating negative findings during floor checks by auditors.
Labor costs are a significant cost in the production of any goods and services. Unlike other costs, labor cost is not supported by external documentation or physical evidence to provide an independent check or balance. Employees have complete control over the documents or devices of original entry (i.e. timecards, timesheets electronic methods, or other means of recording their labor charges). The responsibility for accuracy rests with every employee in the organization. Consequently, the risk associated with the accurate recording, distribution, and payment of labor costs is almost always significant. Therefore, a disciplined timekeeping system is crucial to controlling, properly classifying, and accurately recording labor costs.
The first step in establishing an effective timekeeping system is to develop written instructions to insure that the company’s policies, practices and procedures are followed consistently. These instructions should include a requirement that:
- All employees, regardless of their position in the company, maintain a timecard, timesheet, or other means of recording their labor time and charges
- The information be recorded in ink or some other permanent means
- Employees enter their labor data at least on a daily basis
- Employees record all time worked whether paid or not
- Employees sign their timecards or timesheets at the end of each pay period
- Timecards or timesheets are approved and signed by the employee's supervisor
- Labor Distribution
The SF 1408 mandates a labor distribution system for proper assignment of direct and indirect costs. The labor distribution reports summarize labor charges by employees and cost objectives. Therefore, the preparation of this report is an important step in the internal control process. Contractors need to determine that labor distribution reports reconcile to the payroll register each period and that they reconcile to corresponding general ledger control accounts. A reconciliation of the total labor hours/costs reflected in this report to the total labor hours/costs entered in the timekeeping and payroll systems attests that the direct and indirect labor charges represent actual paid or accrued costs and that such costs are accurately recorded in the general ledger and the subsidiary job cost ledger. The labor accounting system must be supported by an accurate timekeeping system as explained above in this article.
- Monthly Posting
DCAA auditors are instructed to make sure contractors post direct and indirect contract costs at least monthly to the books of account (e.g. general ledger, job cost ledger, labor distribution reports and other subsidiary reports). GAAP needs to be followed so that year-end postings of certain costs such as depreciation, defined benefit pension costs, accounts payable, employee leave accounts, etc. will be estimated and posted monthly and then adjusted to actual costs at year end.
- Exclusion of Unallowable Costs
Every contractor must exclude unallowable costs, as defined in FAR Part 31 and specific contract terms. Contractors should establish accounts in their general ledger to identify and segregate unallowable cost. Accounting personnel must become knowledgeable of FAR Part 31 cost principles and auditors will need to make sure the contractor has a plan to identify and exclude unallowable costs from contractor billings. . It also provides for monetary and other penalties to be assessed if expressly unallowable or mutually agreed to be unallowable costs are included in a billing or claim that is ultimately paid to the contractor. A written policy and procedure on treating unallowable costs is considered essential.
Remember, the critical objective is to receive an adequate opinion from the DCAA. But, due to the increased risk associated with receiving the dreaded DCAA inadequate opinion we believe that the benefits of having an independent consultant perform a mock audit could be substantial because it would ( i ) identify system weaknesses prior to the DCAA audit which would afford the contractor sufficient time to take corrective action; ( ii ) supports the perception that you maintain strong internal controls since a key element of such controls includes independent monitoring of the system; and ( iii) significantly enhance the probability of receiving an adequacy opinion from the DCAA.