Unless labor costs are a small percentage of costs, internal controls over labor charging has become perhaps the greatest area of audit scrutiny by government auditors.  Evaluation of general controls has largely replaced detailed audits of individual labor transactions.  Both new and veteran contractors can generally be assured auditors will examine labor controls during one of their accounting system reviews (e.g. preaward survey, post award accounting system audits) or one of their other audits such as forward pricing, incurred cost proposals or periodic floorchecks.  Some contractors can also expect to experience a separate audit in this area.  An audit opinion of “inadequate” can lead to considerable adverse results such as suspension of billings, failure to obtain additional work, etc while a more positive opinion can provide contractors a competitive advantage over other firms.  The following article will address most of the key areas you can expect to be reviewed so you should use it as a checklist to ensure your practices are in line.  The sources of the article includes Chapter 5-900 of the DCAA Contract Audit Manual, several of DCAA’s audit programs as well as our experience as both former DCAA auditors and consultants when we are asked to conduct “mock audits” of contractors’ accounting practices.

DCAA’s stated purpose in auditing contractors’ labor internal controls, as opposed to an evaluation of reasonableness of compensation or proper utilization of labor, is to “evaluate the adequacy of the contractor’s labor system and assess control risk related to the allowability and allocability of labor costs charged to government contracts.”  Labor costs are a key focus area because they are normally a significant cost component and there are numerous opportunities for inaccuracies due to the fact labor costs are not supported by third party documentations such as invoices, purchase orders, etc., the contractor has complete control over the documents and responsibility for accuracy is diffused over the entire organization.  No matter how sophisticated the accounting software is, DCAA stresses that in order to arrive at a determination of low control risk a contractor’s system should have effective:  (1) means to monitor the overall integrity of the labor/timekeeping system (2) employee awareness and training program (3) procedures for labor authorizations/approvals (4) timekeeping to assure labor hours are accurately recorded (5) labor distribution to ensure the appropriate cost objectives are charged (6) labor cost accounting is compliant with CAS, GAAP and contract terms (7) payroll preparation and payment is appropriate and (8) procedures for labor transfers and adjustments are documented.  We will elaborate on each of these items.

1.  Internal Compliance Reviews.  There should be policies and procedures for monitoring the labor system that would include regular compliance audits that would address adequacy of written policies, employee knowledge and compliance with the policies and procedures, consistency of practices and timely follow-up to corrective actions.  The contractor can satisfy this requirement by conducting its own floorchecks, by testing a sample of labor charges for accuracy, requesting external audits or any combination.  Procedures for conducting the tests, identification of responsible personnel, and identification of documentation that adequate steps have been taken should exist.

2.  Review of Employee Awareness.  There should be adequate policies and procedures for training employees in proper time charging, indoctrination for new hires, management’s responsibility for accuracy, refresher courses for existing employees where there is documentation to verify training occurred, explanations for any penalties and demonstration of proper segregation of duties (e.g. timekeeping and payroll functions separate, supervisors accountable for contract profitability should not have opportunity to initiate changes in labor charges).

3.  Labor System Authorization/Approvals.  There should be procedures in place that  address the control and issuance of work authorizations and job assignments (e.g. segregation of duties between assignment of duties and those responsible for performance, opening and closing work authorizations) and proper work descriptions that are sufficiently detailed to distinguish between allowable and unallowable work as well as direct and indirect work.

4.  Evaluation of Timekeeping.  Whether a manual or electronic timekeeping system exists, detailed written procedures should be in place addressing accurate and complete recording of labor hours, how corrections are made, how an audit trail of corrections is maintained, approvals, prevention of unauthorized changes, etc.

5.  Evaluation of Labor Distribution.  Proper policies assuring there is accurate recording of labor costs to cost objectives is a major audit area.  These policies need to address (a) all hours worked, whether or not they were paid, to ensure that uncompensated overtime is taken into account (see May-June 2002 issue of the GCA REPORT for a detailed discussion of uncompensated overtime) (b) a summary of hours and costs allocated to cost objectives are identifiable on appropriate labor distribution reports (c) total labor hours that are reflected on the labor distribution reports agree with the total labor charges that are entered into the timekeeping and payroll systems and (d) direct and indirect labor hours can be traced to timecards and approved work authorizations.

6.  Audit of Labor Cost Accounting.  The contractor needs to have procedures in place that demonstrate labor costs are charged to the government in compliance with Cost Accounting Standards, generally accepted accounting principles and contract terms/clauses.  If relevant to your operations, areas DCAA point to are: (a) significant increases or decreases in sensitive labor accounts should be flagged and examined (b) adequate briefing of contracts should be maintained where the contractor identifies all contract terms that have government costing implications such as military standards, overtime, skill mix requirements, etc. (c) procedures should be written that require direct and indirect labor costs directly associated with unallowable costs be identified (d) procedures that ensure lump sum wages resulting from union contracts (e.g. a payment in lieu of a labor rate increase) are accounted for properly such as being deferred and amortized over period benefited (e) overtime authorization procedures are in place that are in accord with FAR 22.103 to meet, for example, delivery schedules, performance requirements or to make up for delays and (f) policies and procedures should address record retention needs that are consistent with current FAR requirements.

7.  Review of Payroll Preparation and Payment.  Segregation of duties should be addressed and steps required to assure accuracy of labor costs such as pay rates being supported by written authorization from HR, cross checks exist for verifying accuracy of names, pay rates, hours worked, extension and accounting distributions required and labor hours used for payroll purposes are based on labor distribution records.

8.  Review of Labor Transfers and Adjustments.  The contractor should have in place procedures to provide reasonable assurance that transfers or adjustments of labor distribution are adequately documented and approved.  For example, there should be a system to document, approve and review the transfer of labor costs from one cost objective to another where written justification is required for each transfer.  The contractor should also have procedures that ensure labor distribution edit errors are processed into a suspense account and billed to customers only after correction and that reports of suspense labor and edit errors are generated and provided to appropriate personnel.

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