Government Contractor Accounting Issues and Contract Holders - A Review

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1 COMMITTEE ON GOVERNMENT BUSINESS Defense Acquisition Regulations System Mr. Mark Gomersall, OUSD (AT&L) DPAP (DARS) Crystal Square 4, Suite 200A th Street Arlington, VA Subject: Comments regarding DFARS Case 2009-D038 Dear Mr. Gomersall: Financial Executives International s ( FEI ) Committee on Government Business ( CGB ) appreciates the opportunity to comment on Defense Federal Acquisition Regulation Supplement ( DFARS ) Case 2009-D038, which proposes to define contractor business systems and implement compliance enforcement mechanisms in the form of payment withholdings under certain conditions by contracting officers in the Government. FEI is a professional association representing the interests of more than 15,000 chief financial officers, treasurers, controllers, tax directors and other senior financial executives from over 8,000 major companies throughout the United States and Canada. FEI represents both the providers and users of financial information. CGB formulates policy opinions on government contracting issues for FEI in line with the views of the membership. This letter represents the views of the Committee on Government Business. The CGB membership has participated in creating and reviewing the Council of Defense and Space Industry Associations (CODSIA) as well as the Aerospace Industries Association (AIA) comment letters being submitted regarding this proposed rule. The CGB concurs with those industry positions and recommendations. Rather than reiterating the points discussed in the aforementioned comment letters, below we offer additional commentary regarding accounting systems as well as contract withholds as addressed in the proposed rule to be considered. Comments on Accounting System Criteria The eighteen separate criteria listed in the proposed rule for what would constitute an acceptable accounting system for Government contracting purposes represent in theory what all government contractors strive to achieve. However, we are concerned that the rule as it is currently constituted could be challenging for contractors to demonstrate compliance due to the subjective nature of interpreting the criteria as drafted. This challenge would be significantly increased if there were differences of opinion between contractors and auditors on 1) whether the goal of the rule was absolute or reasonable assurance, 2) the application of materiality considerations and 3) utilization of cost-benefit analysis. As a result, we recommend that these be directly addressed in the final rule to avoid unintended consequences (e.g., higher cost of compliance than necessary).

2 Page 2 of 7 An unclear rule could cause the implementation to result in effects that are contrary to the Guiding Principles found in FAR Part 1 as noted below; FAR Part (b)(1) In order to ensure that maximum efficiency is obtained, rules, regulations, and policies should be promulgated only when their benefits clearly exceed the costs of their development, implementation, administration, and enforcement. This applies to internal administrative processes, including reviews, and to rules and procedures applied to the contractor community. FAR Part (c)(2) To achieve efficient operations, the System must shift its focus from risk avoidance to one of risk management. The cost to the taxpayer of attempting to eliminate all risk is prohibitive. The Executive Branch will accept and manage the risk associated with empowering local procurement officials to take independent action based on their professional judgment. The interplay between the objectives of internal controls, their cost and benefit, as well as the risk of control failures is a balance that industry continually addresses. This has been particularly evident in recent years by the compliance with the internal control provisions of the Sarbanes- Oxley Act of 2002 that publically traded companies must follow in connection with their internal controls over financial reporting. Industry practices coincide with the FAR Guiding principles for risk management with respect to internal control systems. In our view recently published guidance from the DCAA (Defense Contract Audit Agency) as discussed further in these comments suggests a risk avoidance approach, deeming all deficiencies that are found related system control objectives as significant. Control systems within an accounting environment may take different forms and have different attributes such as manual, automated, preventive and detective controls. The design and cost of each control should be based upon the potential risk associated with the objective that is being addressed. The lower the tolerance for risk in establishing the controls the higher the cost to develop, implement and maintain those systems. The confluence of this proposed rule together with the DCAA guidance that is focused on risk avoidance rather than risk management has the potential of significantly increasing the cost of business systems at contractors which is passed on to the Government, without corresponding benefit to the taxpayer or war fighter over the long run. With regard to some of the specific criteria included in the rule for Accounting Systems criterion number 8 requires "Periodic monitoring of the system" without a definition of what the expectation or frequency of the reviews should be with this rule. Monitoring is a fundamental and important aspect of any internal control system. As written, the rule does not recognize leading practices that are being implemented in industry through automated continuous monitoring and exception

3 Page 3 of 7 reporting in areas where those types of reviews can be applied. In recognition of the various ways in which monitoring systems can be implemented, we recommend the word periodic be eliminated from the criteria. Accounting system criteria number 12 requires the system to exclude unallowable costs in accordance with FAR and contract terms from government contracts. Contractors have established elaborate systems and controls to capture and exclude these costs. Contractors certify annually to the best of their knowledge that unallowable costs are excluded from their billings. However, based on the nature of these costs, at times they will avoid established controls. This is typically due to either human error or changes to prior interpretations and definitions in the nature of these costs by either contractors, the Government or the Courts. In establishing CAS 405 (Accounting for Unallowable Costs) the CAS Board provided guidance that this rule was to be implemented with reason. Specifically within the preambles to the publication of CAS 405 the board made the following statement: With regard to the stated concern about overzealous implementation auditors and contracting officers, the Board has previously stated that the administration of its rules, regulation and Cost Accounting Standards should be reasonable. The Board anticipates that this rule of reason will be applied in the implementation of this Standard. Thus, where a good faith effort has been made by a contractor, in the development and implementation of his cost accounting rules, procedure and practices, to provide for identification of expressly unallowable costs, it is intended that inadvertent failure to properly classify a particular item of cost will not be regarded as a noncompliance Despite this basis on which the rule was to be implemented, auditors routinely will issue CAS 405 noncompliance audit reports when they encounter these issues as part of other reviews (typically incurred cost audits) irrespective of whether the company disagrees with the auditors interpretation, or the cost represented an inadvertent error or is immaterial in amount. Previously these immaterial audit issues have been resolved between contracting officers and contractors, in accordance with the normal cadence of business activity. Under the proposed rule these previously immaterial issues may now be considered significant as they will constitute deficiencies resulting in withholds and disputes. Therefore we recommend this criterion be eliminated from the proposed rule since remedies already exist for contracting officers to protect the Government s interest through the application of the CAS (Cost Accounting Standards) administration clause, as well as the FAR (Federal Acquisition Regulation) Allowable Cost and Payment clause at , for this aspect of contractor accounting practices. Accounting system criteria number 17 introduces the subjective and undefined terms "Adequate" and "Reliable" with respect to accounting systems providing data to be used to support follow-on acquisitions (proposals). CAS (Cost Accounting Standards) covered contractors already have the requirements from CAS 401 to disclose, bid and collect costs in a consistent fashion. Effectively this criterion is tying the basis of estimates (BOEs) for proposals to the accounting system, which is in our view inappropriate. The ability to articulate the nuanced difference between accounting transactions and proposal BOE rationale is not something that should be the subject of a FAR

4 Page 4 of 7 clause or part of the terms in our contracts. This criterion will effectively eliminate a contractor s prerogative or ability to establish the level of appropriate accounting for transactions without the consent of the regulators. The proposed rule has established contractor estimating systems as one of the six business systems that would be subject to withholds. The criteria in that portion of the rule have been established to insure estimating systems are working correctly. Inserting this criterion within the accounting system in our view is redundant and should be deleted. We view inclusion of this criterion as inequitable as it could lead to potentially a double counting of a single condition as two deficiencies first in the Accounting and then second in the Estimating system effectively doubling up of withholds for that single condition. Furthermore the rule does not allow for the adjudication of disputes prior to the implementation of withholds. Accounting system criteria number 18 requires contractor accounting practices to be in accordance with CAS (Cost Accounting Standards) and GAAP (Generally Accepted Accounting Principles). Most major contractors that are subject to CAS and DCAA oversight have ongoing disagreements or disputes regarding the interpretation and implementation of the CAS in their practices. It is not unusual for the DCAA in their audit reports to cite a contractor for an inadequacy in their systems, due to the contractor implementing CAS in a fashion that is not in agreement with the DCAA view. In certain circumstances even reasonable people cannot come to an agreement, which in the case of Government contracting leads to the courts for a decision. Contractors should not be subject to the undesirable effects of contract withholds on matters of disputed interpretation which await the decision of the judiciary. In the event of an adverse decision to a contractor, the Government s position is protected through an interest assessment that would be applied to the matter at hand. In the case of these withholds in the event of an adverse decision to the Government, contractors would have suffered the undesirable effects of limited cash flow, throughout what is typically a lengthy litigation process. Comments on Risk and Materiality Considerations within Accounting systems DoD in the response to public commentary stressed the importance of materiality (item 33). DoD disagrees with the assertion that business systems will be deemed inadequate and payments held for minor deficiencies. DoD also asserted (item 4) that it is the policy of DCAA to report only deficiencies determined to be significant deficiencies or material weaknesses. However, in actual practice that assertion conflicts with published guidance issued by the DCAA, (reference December 19, 2008 MRD titled audit Guidance on Significant Deficiencies/material Weaknesses and Audit opinions on Internal Control Systems). This guidance instructs the auditor in clear terms that anything which is subject to DCAA review should be considered significant. The guidance states: It is not necessary to demonstrate actual questioned cost to report a significant deficiency/material weakness. In addition, by limiting internal control audits to major contractors, DCAA only performs audits of contractor systems that are material to Government contract costs. As a result, internal control deficiencies identified in DCAA audits will generally have an impact or potential impact

5 Page 5 of 7 to Government contract costs that is material. Therefore, a contractor s failure to accomplish any applicable control objective should be reported as a significant deficiency/material weakness. The Internal Control Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is the most widely used framework in the U.S. for designing and implementing effective internal controls. COSO recognizes that resources always have constraints, and entities must consider the relative costs and benefits of establishing controls. COSO also acknowledges that an internal control system, no matter how well conceived and operated, can provide only reasonable not absolute assurance to management and the board The clear record as published by the DCAA headquarters guidance is an expectation of perfection, which is contrary to not only the COSO internal control framework, but also to the commentary from DoD in the proposed rule and existing language in FAR Part (c)(2). This divergence of interpretation between good business practice, the published policy of DoD and the DCAA will create inefficiency in the process and add unnecessary cost to contractor systems not commensurate with the risk associated with deficiencies as they are perceived by the DCAA. Therefore we recommend that materiality and significant deficiency be defined in the proposed rule to avoid unintended consequences in implementation. Comments on punitive remedies within Subpart (g) Mitigating the risk of accounting system deficiencies on specific proposals Within the commentary in the Federal register on this proposed rule (item 32) regarding the Legality of Withholds, the point is made that: DoD is relying on the temporary percentage withholds, not as a penalty for a deficiency, but as representing a good-faith estimate sufficient to mitigate the Government s risk, where the actual amounts are difficult to estimate or quantify. However Subpart (g) in this proposed rule introduces a punitive step whereby contracting officers can permanently decrement profit or fee on a proposal. A Contracting Officer could also unilaterally adjust contract prices where reopener clauses have been mandated on proposals under this new regime. Given the subjective nature and the application of judgment that will be applied in the Contracting Officers decisions for this rule, there should be additional language inserted into this subpart that would require the auditor s or functional specialist s report to the contracting officer to describe the deficiencies in sufficient detail to allow a full understanding of the deficiencies and the potential adverse impact to the Government. This report should estimate a discrete potential dollar impact of each cited deficiency, so the risk to the government can be quantified and assessed on an individual basis. The auditor should be required to list the criteria on which he based his conclusions. In the absence of this further requirement on the auditor or functional specialist, this subpart should be deleted from the final rule as it will lead to unnecessary disputes and is punitive to contractors beyond other measures already included in this rule.

6 Page 6 of 7 Comments on contract withholds in the revised proposed rule. The CGB appreciates the reduction in withhold rates in this proposed rule from the prior version. However, the lack of dollar limitations at the contract level will clearly lead to withholds that grossly exceed the amount required to protect the interests of the U.S. Government. The proposed rule also fails to provide oversight when contracting officers direct withholds and do not evaluate corrective action plans in a timely manner. In order to ensure consistency and equitable treatment of contractors we recommend that the value withheld at the contract level be limited to $100,000 until authorization is received from DCMA headquarters to go beyond the limit. Furthermore DCMA headquarters authorization should be required at each of the following subsequent withhold thresholds: $250,000, $500,000, $1,000,000 and every million thereafter. The requirement to receive approval to go beyond specified limits will protect the contractor in situations when DCMA and DCAA lack the resources to perform reviews of corrective action plans or risk assessments in a timely manner. There would be benefit to a higher level approval as it would provide an escalation avenue to contractors when relations at the local level are strained. The approval of withholds above $100,000 by headquarters should be based on evidence that actual risk or harm in excess of the limit exists. An approval process will also provide DCMA headquarters with better insight on amounts being withheld which will ensure equitable treatment of contractors, helping to avoid Contract Dispute Claims, and identify situations when contractors may be at financial risk. The proposed rule also does not clearly address how contractors recover withheld amounts associated with a business system deficiency that is corrected but not before a deficiency in another business systems is identified. To avoid the potential for perpetual withholdings the proposed rule needs to provide guidance for releasing withholds in situations when deficiencies on multiple business systems overlap and the timing of corrective action plans differ. If perpetual withholds are experienced, and no actual harm takes place, industry believes there will be a basis to require prompt payment interest penalties as the exemption provided by law was intended for withholds taken for a limited time Comments on Applicability of Withholds by Contract Type: Within the FY 2011 National Defense Authorization Act, there is specific language with respect to the applicability of this proposed rule by contract type. Section 893(f)(3) defines a covered contract as follows: (3) The term covered contract means a cost reimbursement contract, incentive type contract, time and materials contract or labor-hour contract that could be affected if the data produced by a contractor business system has a significant deficiency. Accordingly the proposed rule must be adjusted to specifically exclude those contract types including Firm Fixed Price Contracts that have been discretely excluded by the Authorization Act. In closing the CGB has concerns that the proposed rule as written will lead to an increase in the cost of business systems without a commensurate benefit for that investment. The lack of due

7 Page 7 of 7 process, undefined terms, and the subjective and qualitative nature of this rule will manifest with irreconcilable differences of opinion between contractors and the Government potentially increasing disputes and litigation in this area. We appreciate your consideration of these matters and welcome the opportunity to discuss any and all related matters. FEI staff and business leaders from FEI s member companies are available to speak on any of these issues. If you or your staff should have any questions feel free to contact Matt Miller, Senior Director, Government Affairs at Sincerely, Paul J. Cienki Chairman FEI Committee on Government Business