(Editor’s Note.  We thought the new change to the audit program we reported above would provide a timely opportunity to review the audit steps nonmajor contractors can expect from audits of their incurred cost proposals.  The guidance should provide useful information for newer contractors as well as a good review and checklist for all contractors to anticipate areas of audit scrutiny. In reviewing the guidance, even we learned of new audit steps e.g. profit margins on T&M contracts, a bit less focus on internal controls, looking for income and credit items that should be reflected in the proposal.)

The Defense Contract Audit Agency issued a new audit program, effective July 18, to be used in audits of incurred costs proposals of nonmajor contractors.  The major preliminary steps to be taken are:

1.  Verify the contractor’s calculation of flexibly priced contract percentages against schedule of direct costs by contract.
2.  Identify non-DOD contracts subject to audit and make sure there is approval from the non-DOD customer to bill for the audit. If there is no approval, the audit scope and auditable dollars should be reduced.
3.  If there is significant subcontract effort, determine if a subcontract audit is needed.
4.  Review the files for prior audits to identify adequacy of the accounting system, potential audit leads or key audit findings. Also consider the impact of floorchecks and other observations made.
5.  Determine if the submission includes significant corporate allocations, shared services, auditable subcontracts or intracompany orders that may require an assist audit.
6.  For ADV less than $15 million, document the understanding of the contractor’s internal control structure and assessment of control risk.  For ADV greater than $15 but less than $90 million, document understanding of the contractor’s internal controls by completing the Internal Control Questionnaire (ICQ). Consider risk factors identified in the ICQ e.g. recent business combinations, defined benefit pension plans. (Editor’s Note.  This area of documenting adequacy of internal controls represents one of the greatest differences between auditing nonmajors and major.)
7.  Document the audit work to be performed that will support reliance on computer-based data.  For ADV less than $15 million, tracing computerized transaction amounts to source documents is sufficient. If sufficient work is not to be performed, the audit report should be qualified.
8.  Review the contractor’s prepared brief or brief significant contract terms that affect allowability of costs.
9.  Compare the submitted expense pool accounts and bases with prior year’s amount to identify significant changes from year to year. Also identify sensitive accounts (e.g. lobbying, consulting).
10.  For ADV greater than $15 million, perform a profit margin test on T&M/Labor Hour contracts by comparing total contract billed amounts to total actual contract costs reported.
11.  Consider fraud risk indicators that may be relevant (its not a bad idea to become familiar with this section of the DCAA Contract Audit Manual, Figure 4-7-3).
12.  Conduct an entrance conference.

Types of reconciliations and analysis of costs to be expected are:

1.  Reconcile the costs claimed by major cost element to the contractor’s job cost ledger and other accounting system records.  Follow up on major differences.
2.  Trace the amounts of base and pool costs to the general ledger.
3.  Test the contractor’s reconciliation of booked to billed costs.
4.  Evaluate adjusting and closing journal entries to identify unusual or sensitive entries that may affect direct or indirect costs.
5.  Identify and analyze the universe of general ledger and trial balance income and credit adjustments to find income or credits to which the government may be entitled to.

Major cost elements to be reviewed are: (Though direct costs were usually not audited in the past, we are seeing more and more auditors reviewing these costs.)

• Labor
1.  Verify total labor costs have been incurred and paid by testing the contractor’s reconciliation of IRS Form 941 payroll totals with totals in related labor cost distribution records.
2.  Select a sample of labor transactions.  If a floorcheck has not been conducted during the year(s) under audit, conduct at least an abbreviated one.
3.  Select a sample of T&M or Labor Hour contracts, if they are significant, and test if claimed hours, rates and employee qualifications comply with contract provisions.

• Direct Material
1.  Select a sample of material transactions for testing if material costs are significant. If a material observation has not been performed in last year(s) conduct a test (e.g. tracing material costs through the accounting system to source documents).

• Subcontracts and Intracompany Costs

Audit effort will depend on whether there were assist audits and the significance of the costs.
1. If assist audits were received compare allowable costs in the reports to amounts claimed and review significant differences.
2.  Select a sample of remaining costs for testing.

• Other Direct Costs
Based on risk assessment, select a sample of ODCs for transaction testing.

• Indirect Expenses and Cost of Money
1.  Verify executive compensation in excess of applicable ceiling amounts have been excluded.  (Editor’s Note.  Since this is the first item in the audit program, it is not surprising that survey results show executive compensation to be the number one topic of audit scrutiny.)
2.  Review contractor’s IRS Form 941 for year(s) under audit to obtain employee taxes withheld and employer matching payroll taxes to determine total payroll taxes owed were paid.
3.  Select a sample of indirect cost transactions based upon risk assessment.
4.  Evaluate voluntary deletions and questioned costs for directly associated costs that need to be excluded.
5.  Evaluate the contractor’s indirect cost allocation base(s) and verify the base properly reflect the appropriate cost accounting period and that the indirect costs allocated to final cost objectives are commensurate with “benefits received.” The program alludes to DCAM 6-606 as a reference for this last item.
6.  Cost of money.  For ADV greater than $15 million, verify the amounts on the CASB-CFM form reconciles with balance sheet and other source documents. 

Concluding Steps are:

1.  Conduct an exit conference and provide audit results to the contractor.  The contractor’s reaction should be obtained for inclusion in the final audit report.  (Editor’s Note. We cannot stress enough the importance of both a revealing exit conference that identifies all questioned costs and any perceived weaknesses in accounting practices and an examination of the draft audit report.  You may need to explicitly request the draft report but it is critical to review because it is very common to have “surprises” surfaced in the report that were not discussed earlier.  If you want to challenge the audit finding, it is important to have well reasoned written comments at this stage – if well presented we have frequently seen questioned costs and adverse opinions withdrawn at this stage in the process, eliminating the need to either go up the DCAA chain or confer with the ACO not to mention appeals later.)
2. If the contractor agrees with the audit results, prepare a rate agreement letter and prepare (or have the contractor prepare) the cumulative allowable cost worksheet.
3.  If the contractor does not agree with the audit results and the rates are audit determined, prepare a Form 1 in accordance with DCAM 6-900. (Editor’s Note. Since its highly desirable to avoid issuance of a Form 1, you can either eliminate or at least delay it by either appealing up the DCAA chain or arranging discussion(s) with the ACO.  At that level, it is quite common to arrive at mutually agreeable compromises that can prevent its issuance.  We recommend using our free “Ask the Experts” service to our subscribers to discuss the validity of DCAA’s position and what alternatives are available to avert issuance of the Form 1.)

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