MACPA 2014 Government Contractors Conference. Current Accounting Issues

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1 MACPA 2014 Government Contractors Conference Current Accounting Issues Jim Thomas Partner, September 18, 2014 Agenda 1. Current Environment 2. Regulatory Update 3. DCMA and DCAA Recent Guidance and Key Issues/Initiatives 4. Other Updates and Accounting Issues 5. Recent Court Cases 6. Q&A Slide 1 1

2 Current Environment Slide 2 Observations on the Current Environment Fewer regulatory changes are planned in FY 15 but acquisition reform is expected in the long term Future acquisition changes are expected to include affordability caps, recurring emphasis on should-cost, acquisition workforce improvements, increased competition and changes to the procurement of services and information technology systems to control overruns DCAA continues to be challenged to work through its contractor incurred cost proposal backlog Implementing risk-based incurred cost proposal audit selection process Scaled back contractor business system audit activity Proposed rule to allow contractors to engage CPA firms to conduct certain DFARS business system audits being considered; public comments were submitted September 15 Recent court cases on statute of limitations have led to an accelerated dispute resolution process with faster contracting officer decisions and settlements Slide 3 2

3 Observations on the Current Environment Contractor business systems are becoming a major compliance requirement As payment withholds are becoming routine, contractors are implementing more formal control structures to meet system criteria Government requirements for approved business systems are applied inconsistently Business system requirements are expanding to non-dod contracts (e.g., DOE) DCAA desires more access to internal audit reports, on-line records and people for purposes of producing audit leads DCMA and DCAA are increasing their focus on the pricing of commercial items and services Slide 4 Regulatory Update Slide 5 3

4 New Contractor Allowable Compensation Cost Limitation On December 26, 2013, President Obama signed two legislation items into law that addressed limiting allowable compensation costs for contractor employees: Bipartisan Budget Act (BBA) of 2013 ($487,000), and The National Defense Authorization Act (NDAA) for Fiscal Year 2014 ($625,000) Applies whenever where cost analysis is required in the pricing of contracts, subcontracts, and modifications, such as: Cost-reimbursable contracts Negotiated fixed-price contracts based upon costs, and Contract modifications requiring submission of cost or pricing data The new limitation of $487,000 became effective for contracts entered into on or after June 24, 2014 with an update to FAR Part 31 Slide 6 New Contractor Allowable Compensation Cost Limitation (continued) Compensation includes the total contractor fiscal year amount of: Wages Bonuses Deferred compensation, and Employer contributions to defined contribution pension plans Compensation does not include other fringe benefit cost such as health insurance or qualified defined benefit pension plan contributions The new rule included possible exceptions for certain technical disciplines The limitation will be adjusted based upon a broad Bureau of Labor Statistics wage cost index Slide 7 4

5 New Contractor Allowable Compensation Cost Limitation (continued) Contractors may now be subject to one, two, or three sets of allowable compensation limitations on individual contracts depending upon when the contract was established and the contracting Department or Agency The three limits are: The legacy FAR allowable cost limitation that applies to the top 5 executives within a home office or segment based upon the OFPP benchmark compensation limit ($952,308 for contractor fiscal year 2012) The DFARS allowable cost limit for Department of Defense contracts entered into after December 31, 2011 that applies the same OFPP benchmark compensation limitation to all contractor employees, and The new $487,000 limit that applies to all employees on contracts entered into on or after June 24, 2014 While permissible, maintaining and applying separate sets of billing rates may be challenging for contractors Slide 8 DOD Limiting Performance-Based Contract Payments to Costs Incurred; Will Also Require Accounting System Adequacy Determination Effective March 31, 2014, a final rule updates the DFARS requiring contracting officers to limit contractor performance-based contract payments to the costs incurred as of the date of the invoice Performance-based payments are contract financing payments made on the basis of: Performance measured by objective, quantifiable methods; Accomplishment of defined events; or Other quantifiable measures of results. The change implements DOD policy citing that the purpose of performancebased payments is to assist the contractor in the payment of costs incurred during the performance of the contract and should never exceed total cost incurred at any point during the contract Slide 9 5

6 DOD Limiting Performance-Based Contract Payments to Costs Incurred; Will Also Require Accounting System Adequacy Determination (continued) The requirements apply to performance-based payments for non-commercial purchases Contracting officers are required to consider expenditure profiles when negotiating performance-based payment event schedules Contracting officers are also required to consider the adequacy of an offeror s or contractor s accounting system prior to agreeing to use performance-based payments Contractors must base the request upon 1) the cumulative negotiated value of performance-based payment event(s) completed to date, or 2) the total costs incurred to date, whichever is less This change significantly increases the cost and complexity of milestone billing for DOD performance based contracts Slide 10 Final DFARS Rule - Detection and Avoidance of Counterfeit Electronic Parts May 6, In response to requirements of Sections 818 and 833 of the National Defense Authorization Act (NDAA) for Fiscal Years 2012 and 2013 the DoD has amended several sections of the DFARS to hold contractors responsible for detecting and avoiding the use of counterfeit or suspected counterfeit electronic parts in DoD acquisitions Significant changes to the DFARS include: A new subsection Cost of remedy for use or inclusion of counterfeit electronic parts and suspect counterfeit electronic parts that makes expressly unallowable the costs of counterfeit electronic parts or suspect counterfeit electronic parts and the cost of rework or corrective action that may be required to remedy the use or inclusion of counterfeit electronic parts Applies to CAS-covered contracts for the supply of electronic parts or products 11 6

7 Final DFARS Rule - Detection and Avoidance of Counterfeit Electronic Parts (continued) Exceptions if: 1. Contractor has an operational system to detect and avoid counterfeit parts and suspect counterfeit electronic parts that has been reviewed and approved by DoD pursuant to , 2. Counterfeit electronic parts or suspect counterfeit electronic parts are Government furnished property as defined in FAR , and 3. The contractor provides notice within 60 days to the Government A new subsection Contractors counterfeit electronic part avoidance and detection systems prescribes policy and procedures for preventing counterfeit parts from entering the supply chain The policy requires contractors and their subcontractors to establish and maintain an acceptable counterfeit electronic part avoidance and detection system; failure may result in purchasing system disapproval and payment withholding 12 Final DFARS Rule - Detection and Avoidance of Counterfeit Electronic Parts (continued) Detection and avoidance system criteria includes: 1. Training 2. Inspection and testing 3. Processes to abolish counterfeit parts proliferation 4. Traceability of parts to suppliers 5. Use and qualification of trusted suppliers 6. Reporting and quarantining of counterfeit and suspect counterfeit electronic parts 7. Methodologies to identify and determine if a suspect part is counterfeit 8. The design, operation, and maintenance of systems to detect and avoid counterfeit and suspect counterfeit electronic parts, and 9. Flow down of counterfeit avoidance and detection requirements to subcontractors 13 7

8 DOE Proposed Rule on Contractor Business Systems On April 1, 2014 the Department of Energy (DOE) proposed changes to the Department of Energy Acquisition Regulation (DEAR) establishing a Contractor Business Systems clause and acceptance criteria for five business systems The proposed rule essentially mirrors the DOD Contractor Business Systems clause provisions including withholding for significant business system deficiencies The five business systems are Accounting, Estimating, Purchasing, Government Property and Earned Value Management Provides contract payment withholding and release procedures Comments on the proposed rule were due June 2, DOD Commercial Item Pricing DCMA Pricing Initiative Section 831 of the National Defense Authorization Act for Fiscal Year 2013 included requirements for the DOD to develop a cadre of experts to provide commercial item price reasonableness advice to the acquisition workforce DCMA is working to establish that capability focusing advice on: Commercial item determination, and Fair and reasonable pricing Experts will advise contracting officer in their decisions Objectives include increasing decision making consistency Company-related decisions will be entered into the CBAR System The Commercial Pricing Cell will be based in St. Petersburg with regional offices around the country 15 8

9 DCMA and DCAA Recent Guidance and Key Issues/Initiatives Slide 16 DCAA Issues Audit Guidance on Detecting Instances of Fraud in Attestation Engagements The DCAA guidance from July 2013 is the result of findings and recommendations contained in DODIG Report No. DODIG , dated March 7, 2013, titled Monitoring of the Quality of Defense Contract Audit Agency FY 2010 Audits The guidance included information gathering targeted at detecting instances of potential fraud, including management inquiries on: Whether management has knowledge of any fraud or suspected fraud Whether management is aware of allegations of fraud or suspected fraud Management s understanding about the risks of fraud relevant to the subject matter under audit The guidance also included analytical procedures to identify such things as the existence of unusual transactions and events, and amounts, ratios and trends that might indicate matters that have audit planning ramifications Slide 17 9

10 DCAA Establish Risk Pools and Prioritizes Incurred Cost Proposal Audits to Address Audit Backlog DCAA issued audit guidance stratifying incurred cost proposal (ICP) audits based upon audit dollar value (ADV) and risks ICPs with less than $250M in ADV may be classified as low risk if the last completed ICP audit found questioned costs below dollar or percentage thresholds and no other significant risk factors are known to exist Low risk ICPs with less than $1M ADV will not be audited Low risk ICPs with ADV between $1M and $250M will be subject to sampling: 1. $1M to $50M 5% 2. $50M to $100M 10% 3. $100M to $250M 20% (subject to mandatory audit once every 3 years) All ICPs with ADV greater than $250M will be audited This approach should help reduce the DCAA ICP audit backlog and accelerate contractor contract settlements and closures Slide 18 DCAA Issues Audit Guidance on Contractor Use of SAP Grouping, Pegging and Distribution Manufacturing Management Functionality On January 30, 2014, DCAA released a Memorandum for Regional Directors (MRD), Audit Alert Risk Factors Associated with Grouping, Pegging and Distribution with SAP Software (MRD 14-PPS-001) The MRD describes compliance audit risk factors associated with SAP Grouping, Pegging, and Distribution (GPD) functionality that is used by many manufacturing contractors GPD is used within a contractor s manufacturing and/or Material Management and Accounting System (MMAS) where parts and their associated costs may be moved between contracts using automated processes The MRD cited that contractor SAP GPD configuration may result in noncompliant management of production materials and assignment of costs to government contracts Slide 19 10

11 Use of SAP Grouping, Pegging and Distribution Manufacturing Management Functionality (continued) Issues identified by DCAA auditors have included: Premature billing of material costs, Billing material in excess of contract requirements Transfer of government titled materials without contracting officer approval, Lack of sufficient audit trails for tracing costs from the contractor s books and records to supporting documents, and Assigning costs to closed work orders. Contractors using SAP for manufacturing management should evaluate their systems to screen for GPD configuration issues Slide 20 Other Updates and Accounting Issues Slide 21 11

12 Other Updates President Obama issued an executive order establishing $10.10 per hour minimum wage on executive agency contractors Effective for contracts entered into on or after January 1, 2015 Subject to annual increases based upon CPI Must be flowed down to subcontractors DOD issued a final rule enhancing whistleblower protections Updates DFARS Part 203 Improper Business Practices and Personal Conflicts of Interest Prohibits contractors or subcontractors from discharging, demoting or otherwise discriminating against an employee as reprisal DOD extended IR&D expenditure reporting deadline and provided additional reporting clarification, CFY12 and 13 reports due by end of CFY14 May have to provide additional information during any audit Not expected to reconcile with incurred costs proposal submissions Slide 22 Other Accounting Issues FASB issued Accounting Standards Update (ASU) , Revenue from Contracts with Customers in May 2014 Effective starting for public entities for periods after December 15, 2016 with a one year delay for nonpublic entities Five key steps identify contract, identify performance obligations, determine the transaction price, allocate the transaction price and recognize revenue when or as performance obligations are satisfied Key issues for government contractors to assess: use of units of delivery for fixed price contracts, deferred costs, segmenting and modifications Proposed financial accounting rule on changes to the treatment of leases has been delayed Slide 23 12

13 Recent Court Cases Slide 24 Post Retirement Benefits (Northrop Grumman Corporation, ASBCA No , January 16, 2014) Northrop Grumman (NG) appealed the government s disallowance of contract costs due to NG s failure to comply with FAR Compensation for Personal Services requirements for post-retirement benefit (PRB) cost accounting Between 1995 and 2006, Northrop chose to measure, assign and fund PRB costs using the IRS DEFRA (Deficit Reduction Act of 1984) accrual methodology and not the FAS 106 accrual method as required by the FAR By comparison, FAS 106 accruals recognize more cost in earlier years and less in later years than corresponding DEFRA accrual calculations FAR (o)(3) states To be allowable, costs must be funded by the time set for filing the Federal income tax return or any extension thereof. PRB costs assigned to the current year, but not funded or otherwise liquidated by the tax return time, shall not be allowable in any subsequent year. Slide 25 13

14 Post Retirement Benefits (continued) Between 1995 and 2006, Northrop regularly filed CASB Disclosure Statements, Part VII, stating that it accounted for PRB costs in accordance with DEFRA The government routinely review Northrop s Disclosure Statement revisions without citing any FAR or CAS PRB accounting non-compliances However, they also routinely noted in various terms that the review did not constitute a blanket approval of the disclosed practices, for example: instances of noncompliance not detected during this review may be discovered during future review of your cost accounting practices. These disclosed practices shall not by virtue of such disclosure be deemed proper, approved, or agreed to practices for pricing proposals or accounting and reporting contract performance cost data. After becoming aware of NG s use of the non-compliant DERFA accrual in 2006, the DCAA calculated the cumulative amount of untimely funding and unallowable costs to have been $378M, later reduced to $253M Slide 26 Post Retirement Benefits (continued) The contracting officer issued a final determination citing the unallowable PRB costs on April 9, 2008 Northrop challenged the final determination with a certified claim to DCMA on May 20, 2010 and when denied, appealed to the Armed Services Board of Contract Appeals (ASBCA) The ASBCA ruled in favor of the government and concluded that there is no dispute that the DEFRA method did not comply with GAAP requirements. This case highlights that Disclosure Statement audits are not conclusive with respect to the acceptability of cost accounting practices Slide 27 14

15 Environmental Cleanup Costs (Lockheed Martin v. U.S., U.S. District Court, April 22, 2012) Lockheed Martin was responsible for remediation of the environmental impacts associated with solid rocket propellant and motor manufacturing at three Lockheed Propulsion Company sites between 1954 and 1975 The solid rocket propellant and motor manufacturing activities were conducted under various government contracts Waste disposal practices at the sites led to ground water contamination As of 2014, Lockheed had spent $287M on site environmental response costs and estimated another $124M in future costs Asthecostwereallowableundergovernmentcontracts,itwasestimatedthat Lockheed had recovered approximately 72% of its costs incurred related to the environmental response efforts Lockheed brought an action against the government under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) seeking past and future costs to remediate the sites Slide 28 Environmental Cleanup Costs (continued) Under CERCLA, potentially responsible parties (PRPs) can be assigned financial responsibility for environmental response costs The Court assigned partial liability for future response costs to the government in the amounts of 29%, 24% and 19%, respectively across the three sites The Court denied Lockheed relief on the prior response costs as they had already recovered a large portion of those costs on their contracts, although any credit would have off-set current and future rates Future Lockheed costs remain allowable and allocable to contracts This case demonstrates the potential for contractors with on-going environmental clean-up liabilities created in connection with government contract performance to obtain partial relief Slide 29 15

16 Access to Records (U.S. ex rel. Harry Barko v. Halliburton Company, et al., U.S. District Court, District of Columbia, No. 1:05-CV-1276, March 6,2014) Whistleblower case where the plaintiff-relator moved to compel KBR to produce internal audit and investigation documents for case discovery KBR opposed the production of those documents based upon attorney-client privilege and the attorney work-product doctrine The Court ruled that KBR failed to demonstrate that the attorney-client privilege applied as the investigations were undertaken pursuant to regulatory law and corporate policy rather than for the purpose of obtaining legal advice The Court ordered KBR to produce the documents concluding that the investigation was not conducted in anticipation of litigation but was conducted in the ordinary course of business On appeal, the U.S. Circuit Court of Appeals overturned the District Court s ruling (Kellogg Brown & Root, Inc., et al., U.S. Court of Appeals, District of Columbia Circuit, No , Jun. 27, 2014) Slide 30 Questions & Answers Slide 31 16

17 Jim Thomas (703) This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, [insert legal name of the firm], its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it All rights reserved. In this document, "" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 17