DOD's Business Systems Rule: The Challenge Measuring Government Contractor Compliance Against Subjective Criteria and Perceived Risks

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2 DOD's Business Systems Rule: The Challenge Measuring Government Contractor Compliance Against Subjective Criteria and Perceived Risks Breakout Session #: B04 Presented by: Michael E. Steen, CPA Date: July 22, 2013 Time: 2:30 3:45

3 Acronyms CO Contracting Officer (Procurement of Administrative) DCAA Defense Contract Audit Agency DCMA Defense Contract Management Agency DOD Department of Defense EVMS Earned Value Management System IG Inspector General DPAP Defense Procurement & Acquisition Policy ICP Incurred cost proposal (or indirect cost rate proposal) GAGAS Generally Accepted Government Auditing Standards FAR Federal Acquisition Regulations DFARS Defense Federal Acquisition Regulations Supplement CAM Contract Audit Manual (DCAA) NDAA National Defense Authorization (or Appropriations) Act T&M Time and Materials Contract MMAS Material Management and Accounting System CWC Commission on Wartime Contracting 3

4 Contractor Business Systems The DFARS Interim Business Systems Rule Brief history, status & applicability & various interpretations of applicability DCMA...publicly accessible internal guidelines & interpretations (including track changes ) and subtle internal battle/disagreement with DCAA DCAA limited policies, vague planning but is relying heavily on spontaneous deficiency reports The omnipresent requirements of FAR Part Contractor Qualifications with broad applicability 3

5 Contractor Business Systems KEY Take-Away Contractor Risks Contractor Risks Hierarchy: If the DFARS Interim Business Systems Rule applies: 1. System deficiency based upon a pre-existing condition 2. System deficiency as a by-product of a secondary review/audit 3. System deficiency based upon a comprehensive review (e.g. CPSR); but low probability (Government resource issue) The other consequences.the requirements of FAR Part Contractor Qualifications (i.e. adequate accounting system) & past performance (CPARS) 4

6 Contractor Business Systems KEY Take-Away Contractor Risks DFARS Interim Rule Effective May 18, 2011 (contracts after that date); however: Numerous DCAA deficiency reports involve facts (audit fieldwork) pre-dating May 2011 or applicable to contractor processes pre-dating May 2011 potential to overlook the applicability of the rule (precisely when it became effective for a contractor) DFARS Rule maybe used for system criteria even if a contractor is not subject to the rule; e.g. small business with DOD contract with EVMS

7 Contractor Business Systems Pre-Existing Conditions DOD Press Releases (or leaks?): DOD withholds $46.5 million on F-35 Program (EVMS) Program cost estimate $395.7B (70% cost growth) DOD withholds 5% of progress payments on Shipbuilding Contractor (EVMS) Contractor non-compliant with 19 of 32 criteria NOTE: Unprecedented public disclosure of alleged system deficiencies and withholds but in each case, circumstances pre-date DFARS Business Systems Rule 6

8 DFARS Business Systems May 2011 Interim rule (public comments due July 2011) with significant changes to match 2011 NDAA, Section 893 DFARS Contract Clause and one or more of the six systems (definitions & criteria) Effective date May 18, 2011 Amend existing delivery order/task order contracts in accordance with FAR 1.108(d) or new contracts awarded on or after 8/16/2011 Compliance enforcement mechanisms = interim withholds (cost type, T&M, progress payments, & performance based payments) if CAS covered 8

9 DFARS Business Systems Intent--Improve the effectiveness of DoD oversight of contractor business systems First line of defense against fraud, waste, and abuse (CWC) Weak business systems increase Govt. RISK of: Inflated contract prices/costs Paying costs that are unallowable, unreasonable, and not allocable to the contract Inflated subcontract costs Property systems that increase risk of loss 9

10 DFARS Business Systems Applicability Covered Contractor subject to CAS under 48 CFR (CAS applies unless a contract is exempt) Objective is to exclude small business (exempt from CAS under 201-1(b)), but applies to modified CAS contractor DCMA Guidebook: Limits applicability to full CAS covered contracts greater than $50Mil (or lower value at ACO discretion) Task orders measured individually vs. aggregate 10

11 DFARS Business Systems Contractor Business Systems Clause, , will be included in the contract when Contract is subject to the Cost Accounting Standards (48 C.F.R ) and Solicitation/Contract includes any one of the following business system specific clauses: Cost Estimating System Requirements Earned Value Management System Material Management and Acctg Accounting System Administration Contractor Purchasing System Contractor Property Management 11

12 DFARS Business Systems Other Criteria or Discussion: Unacceptable/disapproved system if the system has one or more significant deficiency Significant deficiency = a shortcoming of the system that affects materially the ability of officials of the DoD to rely upon information produced by the system that is needed for management purposes DCAA will report significant deficiencies in accordance with the definition in this rule and the GAGAS.the GAGAS definition is consistent with the definition in the rule DCAA Audit Policy 12-PAS-012 confuses the issue by introducing material weakness 12

13 DFARS Business Systems Other Criteria or Discussion: While the terms adequate and reliable imply a degree of subjectivity, they are sufficiently common to enable reasonable parties to agree on necessary characteristics to meet each threshold given the unique set of circumstances. The need to have effective oversight is unrelated to resources (in response to public comments that neither DCAA nor DCMA have sufficient, competent resources to timely audit/evaluate contractor compliance) NOTE: System Disapproval is One or More Significant Deficiency which will not require comprehensive audits 13

14 DFARS Business Systems Withholds: 5% of interim payments for an unacceptable & disapproved system 10% for multiple unacceptable systems Withhold applied to all contracts which contain the DFARS Business Systems clause* Contracting officers can also reduce profit or fee objectives to mitigate risk from accounting system deficiencies When the financial impact is quantifiable, DoD expects contracting officers to reduce fees, recoup unallowable costs or take legal action *Note DCMA guidelines limit the withhold to contracts >$50Million. 14

15 DFARS Business Systems Administrative Process: Contractor notified of preliminary finding (deficiency) during the system review and audit (before the auditor releases a report to the contractor and contracting officer)* Contracting Officer makes an initial determination (10 days) Contractor has 30 days to respond to the initial determination Contracting Officer has 30 days to issue final determination Contractor has 45 days to correct significant deficiencies or submit correct action plan *DCAA Audit Policy, 13-PAS-009, Rules of Engagement (April 2013) implicates contractor notification during the audit---however, auditors don t predictably follow Rule of Engagement 15

16 Distribution of Determinations The Cognizant CO shall Promptly distribute determination to approve or disapprove the Business System and withhold payments, or approve a previously disapproved system and release withheld payments to Auditor, Payment office, Affected COs at the buying activities, and Cognizant CO s in contract administration activities, including CACOs and DACOs USA Today, Wall Street Journal (not really) 16

17 DFARS Business Systems DCMA Policies & References Instruction 308 Contractor Business Systems (updated August 15, 2012 with track changes) Instruction 109, CPSR, November 28, 2012 Training Materials (126 slides, August 2011) FAQs (October 2011) Establishment of Contractor Business Systems Review Panel (September 2011) Higher level review of CO s final determination before a determination to disapprove a system (in application, this apparently involves a determination to approve a system). 17

18 DFARS Business Systems DCAA Policies & References DCAM Chapter 5 Audit Policy 12-PAS-012(R), April 24, 2102, Auditing Contractor Business Systems & Contractor Compliance with DFARS , Accounting Systems Administration Audit Policy 12-PPS-009(R), March 28, 2012: Audit Guidance on DFARS Final Rule Regarding Contractor Business Systems Audit Policy 11-PPS-011(R), July 22, 2011: EVMS Audit Responsibility Audit Policy 11-PPD-018(R), Sept 30, 2011: Purchasing Systems Internal Controls (DCMA responsibility) 18

19 DFARS Business Systems DCAA Policies & References DCAA Audit Programs 11060: Contractor Control Environment 11070: Accounting System 11090: Deficiency Report 11020: Budget & Planning System 11010: Billing System 11520: EDP/IT General Controls 13500: Major Contractor Floorchecks or Interviews DCAA Adequacy Checklists Incurred Cost Proposals Forward Pricing (bid proposals) Forward Pricing Rate Proposals (FPRA) 19

20 Q&A: DCMA Interpretation (Oct. 2011) What happens when an ACO receives a flash report from DCAA? Evaluate the flash (deficiency) report to determine if the ACO has sufficient detail to allow the ACO to issue an initial determination (which starts the DFARS administrative process & timelines) If not, coordinate with auditor to obtain more information If sufficient information will not be available until formal (comprehensive) audit is issued, then wait for audit issuance. 20

21 Estimating System Risk Estimating System review or Flash* proposal specific observations Scenarios triggering deficiency reports: Bid proposal: audited by DCAA or DCMA? Forward pricing rate proposal (potential FPRA) OR Previous audit reports asserting estimating system deficiencies * Note that flash reports are now deficiency reports the end result is similar although more troublesome for contractors 21

22 Estimating System Criteria Clear responsibility for cost estimates & budgets 2. Organization & duties of people responsible for cost estimates & budgets 3. Sufficient training, experience, and guidance 4. Data sources & estimating methods & rationale 5. Adequate supervision 6. Consistent application 7. Error detection & correction 8. Avoid duplication & omission 22

23 Estimating System Criteria Historical experience 10. Appropriate analytical methods 11. Integrate information 12. Management review 13. Internal review 14. Update cost estimates timely 15. Ensure reasonable subcontract prices 16. Sound proposals adequate to reach fair & reasonable price 17. Adequate system description Clear responsibility for cost estimates & budgets 23

24 Estimating Deficiency Significant or Not? Deficiency fails to meet one or more Systems Criteria ACO consults with auditor or functional specialist Multiple/systemic failures or isolated? Has the contractor already fixed the immediate problem? the system? Who determines and how? Do the specific facts meet the definition of a material deficiency? 24

25 Estimating System Deficiencies: Significant or Insignificant? Scenario: Contractor failed to timely detect and correct errors ((d)(4)(vii))..with multiple proposal revisions Contractor failed to maintain a consistent approach and adhere to established policies and procedures ((d)(4)) The deficiency materially affected the ability of DoD officials to rely on cost and pricing data in original proposal ((a)(4)) (which DoD official?) Timely contract award and use of expiring funds were threatened (but was DCAA partially to blame---reference to various adequacy checklists) 25

26 Estimating System Deficiencies: Significant or Insignificant? The criteria: (d)(4)(xvi): estimating system provide estimating and budgeting practices that consistently generate sound proposals that are compliant with the provisions of the solicitation and adequate...for fair and reasonable price: DCAA: Contractor failed to support employee experience (7-20+ years) with validated HR data (personnel files) Contractor failed to propose escalation (3% per year) into component parts (merit pay, COLA, impact or attrition) Contractor did not support Business Segment with Home Office Proposals (for allocations to Business Segments) 26

27 Q&A: DCMA Interpretations What if the Contractor s System was deemed inadequate in part before the Business Systems Rule was published? CO must closely review the system deficiencies previously identified and determine whether they are significant, in consultation with auditor or functional specialist. If determined to be significant, follow the procedures outlined in the Contractor Business Systems Clause If determined not to be significant, approve the system..say what?.how will the ACO now determine this to be insignificant when it was previously reported (by DCAA) as significant? 27

28 Q&A: DCMA Interpretation What if contractor had a disapproved system prior to the effective date of the new Business Systems Rule? Can the ACO immediately begin withholding on a contract that is awarded with the new Business Systems clause? No. You must first follow the steps outlined in the Business Systems clause before instituting a withhold under the clause. This also assumes that the contract contains the system specific clause for the specific system at issue. 28

29 Deficiencies: Significant or Not? DCMA Interpretation Scenario: Significant or not? Clause: Cost Estimating System clause (DFARS )(d)(4)(vii): Provide for detection and timely correction of errors Audit Report: During negotiations, contractor failed to discover numerous errors until the final TINA sweep. Correction of these errors took several months (Really???) Impact PCO worked overtime to award contract before funds expiration. 29

30 Accounting System Included in all new cost, incentive, T&M,, labor hour contracts & FFP contracts with progress payments based on cost or percentage or stage of completion (a)(1): Defines acceptable accounting system Complies with laws & regulations Accounting system & cost data are reliable Minimizes risk of misallocations & mischarges Consistent contract allocations & charges (a)(2): Defines accounting system & significant deficiency (c): Accounting system shall provide for 18 criteria 30

31 DFARS Accounting System Criteria 1. Sound internal controls 2. Segregation of direct from indirect costs 3. Accumulate direct costs by contract 4. Accumulate direct costs to intermediate & final objectives 5. Accumulate costs in general ledger 6. Reconcile subsidiary ledgers to general ledger 7. Approve/document adjusting entries 8. Periodic monitoring of system 9. Timekeeping system for employees 10. Labor distribution system for charging direct & indirect labor 11. Monthly posting of books of account 12. Excludes unallowable costs (FAR Part 31 & other contract provisions) 13. Identify costs by CLIN & units if required by contract 14. Segregate preproduction from production costs 15. Cost accounting info required by contract clauses & to readily calculate indirect cost rates from books of accounts 16. Billings can be reconciled to cost accounts for current & cumulative amounts claimed & to comply with contract 17. Adequate, reliable data for pricing follow-on acquisitions 18. Compliance with CAS & GAAP

32 Unfortunately DCMA has stated: DCAA, We Need You! 32

33 Accounting System Deficiencies: Significant or Not? Clause: Accounting System Administration clause (DFARS ): (c)(16): Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms. Scenario: Audit Report: Contractor s accounting system does not ensure that only costs eligible under the Progress Payments clause are included in progress payment requests. & Contractor is receiving progress payments which exceed the amount for which the Contractor is eligible. Other info from the clause: Accounting system means the Contractor s system for accounting methods, procedures, and controls to present accurate financial data for specific areas such as billing ((a)(2)) 33

34 Accounting System & Incurred Cost Proposal (ICPs) Allowable Cost and Payment Clause May 2011 Adequate final indirect cost rate proposal (ICP) submitted within 6 months of end of contractor fiscal year Written understanding of final indirect cost rates (rate agreement letter) Within 120 days of rate agreement, submit a completion voucher for contracts physically complete in the applicable year (government recourse is unilateral modification and accounting system deficiency) Contractor must rebill and retroactively adjust to rate agreement rates within 60 days of rate agreement letter Completion (close-out) invoice shall include settled subcontract amounts and rates. The prime contractor is responsible for settling subcontractor amounts..and providing the CO with status of subcontractor audits 34

35 DCAA Incurred Cost Audits Connecting the Dots to DFARS Business Systems ICP Adequacy (including any home office or corporate ICPs) Records retention, access to records and personnel Billed vs. allowable costs (overpayments) Auditable subcontracts (prime contractor role) Auditor wildcards (documentation, reasonableness) Quadruple Jeopardy for unallowable cost 1. ICP audit cost disallowance 2. ICP FAR Penalty 3. Separate CAS 405 Noncompliance 4. Separate accounting system Inadequacy

36 DCAA Incurred Cost Audits Connecting the Dots to DFARS Business Systems Criteria #18 Accounting Business Systems = compliance with Cost Accounting Standards DCAA Audit Policy 11-PAC-021, 12/14/2011 stressing CAS noncompliance identified in other than a CAS compliance audit and separately reported Incurred cost issues with accounting system implications: Professional & Consulting costs documentation Travel-lowest cost airfare, fly-america statute Business meetings documentation

37 DCAA Audits with Accounting System Implications DCAA Audit of Contractor Control Environment (11070) Sort of verifying contractor compliance with FAR Requests for access to internal employee disciplinary information, employee interviews = ready-made issue of denial of access to records Ignores the actual regulatory requirements in terms of to whom a contractor reports (mandatory disclosure) Favorable results= no audit report; unfavorable results = deficiency report 42

38 EVMS Criteria (7)(iii)(2)(ii): Disapprove the system in accordance with , EVMS, when initial validation is not successfully completed within the timeframe approved by the CO, or the CO determines that EVMS contains significant deficiencies with 16 high-risk guidelines BUT ACO shall use discretion in disapproving the system based on significant deficiencies on the remaining 16 guidelines based on input received from functional specialists and the auditor NOTE: EVMS appears to be the only Business Systems Rule which has criteria which are not critical or high risk ; hence, failure to comply is not automatically a system disapproval. 38

39 EVMS High-Risk Organization Guidelines 1. Define authorized work elements 3. Integration of planning, scheduling, budgeting, work authorization, and cost accumulation processes Planning and Budgeting 6. Schedule authorized work to sequence it and identify task interdependencies 7. Identify products, milestones, & technical performance goals to measure progress 8. Establish & maintain time-phased budget baseline 9. Establish budgets for authorized work with significant cost elements 39

40 Purchasing System Criteria Adequate system description 2. Applicable subcontracts contain all flow-down clauses 3. Clear lines of responsibility & authority 4. Purchased orders (POs) based on authorized requisitions 5. Document history of purchase transactions 6. Consistent make-or-buy policy 7. Competitive sourcing which excludes debarred or suspended contractors 8. Evaluate price, quality, delivery, technical & financial capabilities of competing vendors 9. Justification & cost or price analysis for sole or single source award 40

41 Purchasing System Criteria 10. Adequate cost or price analysis & tech evaluation to ensure fair & reasonable prices 11. Document negotiations in accordance with FAR Seek, take, & document discounts 13. Select proper contract type & prohibit cost-plus-percentage-of-cost subcontracts 14. Subcontract surveillance to ensure timely delivery of acceptable product & to notify Government of potential subcontract problems that may impact delivery, quantity, or price 15. Justify subcontract changes that affect cost or price 16. Notify the Government of all subcontracts with flow-down clauses that allow for Government audit 17. Policies on conflict of interest, gifts, and gratuities 18. Perform internal audits, training, & maintain policies to ensure integrity of the purchasing system 19. Policies to ensure POs & subcontracts contain mandatory flow-down clauses required by FAR, DFARS, & prime contract provisions 20. Org. & admin. structure for procurement of required quality materials & parts at the best value from responsible & reliable sources 41

42 Purchasing System Criteria 21. Selection processes ensure most responsive & responsible sources for furnishing required quality parts & materials & to promote competitive sourcing among dependable suppliers 22. Adequate price or cost analysis on purchasing actions 23. Ensure proper types of subcontracts are selected & that there are controls over subcontracting, including surveillance 24. Ensure Contracting Officer is notified in writing if Contractor changes subcontracts after award to >70% of total cost of work performed & verify Contractor added value or any subcontractor increases value of lower-tier subcontracts to >70% (limitation on excess pass-through costs) 42

43 Purchasing System Significant or Insignificant? Scenario: Significant or not? Clause: Contractor Purchasing System Administration (DFARS ) (c)(7): Use competitive sourcing to the maximum extent practicable, and ensure debarred or suspended contractors are properly excluded from contract award. CPSR Report: On three occasions over six months, the Contractor awarded purchase orders to subcontractors who were on the list of debarred or suspended contractors without documentation as required by FAR

44 Property Management System Criteria (a) Definitions: Defines acceptable property management system, property management system, and significant deficiency (b) General: Failure to maintain an acceptable property management system may result in system disapproval & withholding of payments (c) System Criteria: Same as in FAR (f) 44

45 Business Systems & DCAA Audits Public Statements to Date DCAA Director & Other Sources: As with all other DCAA audits, expect requests for walkthroughs which demonstrate compliance with applicable criteria Feedback to Contractor as prescribed by the rule and DCAA s Rules of Engagement DCMA policy on feedback During exit conference, ACO not to discuss intent to approve or disapprove the system DPAP spokesperson: Expect that system deficiencies will be identified in audits other than business systems DCAA will determine materiality within the meaning of the new rule and government auditing standards (GAGAS) 45

46 The Policy Overview The Cognizant Contracting Officer (ACO) in consultation with DCAA and/or Functional Specialists shall Determine the acceptability of the contractor s business systems Approve or disapprove the systems Pursue correction of significant deficiencies Withhold Payments in accordance with the requirements of , Contractor Business Systems, until significant deficiencies are corrected Follow-up contractor corrective actions 46

47 The Process Summarized Receipt of Audit/Functional Specialist Report If no significant deficiencies, approve system If significant deficiencies exist ACO issues Initial determination Contractor Response Received ACO Evaluation and consultation with auditor or functional specialist ACO Issues Final Determination Approving System or Disapproving System, requiring correction, and initiating withholding against contract payments (5% per system, not to exceed 10% total on any contract) 47

48 Beyond DFARS Business Systems FAR Part 9 Contractor Qualifications FAR Part General Standards FAR Part Procedures FAR Part Pre-award Surveys Review of accounting system prior to contract award (required for a cost-type contract) Use SF 1408 to document accounting system survey NOTE: Prime contractors must document subcontractor qualifications but DCAA auditors do not limit expectations to flexibly priced, T&M, LH, FFP with progress payments. 58

49 Redstone GCI Contact Information Contact Information: Redstone Government Consulting, Inc. Offices Huntsville, Alabama 101 Monroe Street Huntsville, Alabama Telephone: Mike Steen, CPA Director Cell phone:

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