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Column: Can You Survive a Financial Capability Audit?
by Michael Smigocki, CPA, CVA
Senior Managing Director, Federal Strategies Group LLC
You were just notified you won a large government contract, one that can have a major impact on your future. However, the contract award is pending a pre-award financial capability audit.
Is this something that you should worry about?
Given that failure to pass such an audit can either delay or even cancel an award, it is very important that you dedicate the time and resources necessary to successfully pass such an audit.
There are a number of actions a company can take in preparation for a pre-award financial capability audit to help ensure a successful outcome. This article discusses the objectives of such audits and what a company should do to prepare and survive such audits.
DCAA audits
Financial capability audits are generally performed by the Defense Contract Audit Agency (DCAA) and are utilized by the government to determine whether a contractor is capable of financially performing under a potential or current government contract as required by FAR 9.104-1(a) and DFARS 232.072.
The audit is generally conducted prior to the award of a contract and attempts to address potential government’s concerns regarding whether the contractor’s financial situation can lead to contract performance delays and/or nonperformance.
The auditors’ focus will be on the contractor’s current financial condition and trends, near-term cash flows, and ability to obtain funds outside the normal course of operations (i.e. debt or equity financing).
Audit focus
The purpose of a financial capability audit is for the auditor to render an opinion on the contractor’s ability to perform and fulfill its obligations under government contracts. A company’s financial position and cash flows can greatly impact its ability to perform under government contracts if it does not have adequate cash resources to procure the necessary materials, pay for the necessary labor and subcontractors and fund its administrative obligations.
Since many government contracts are long-term awards, DCAA will be especially interested in future cash flow projections demonstrating the company’s ability to meet such obligations over the course of the contract. Smaller contractors are especially at risk because the award of (or a potential loss of) a single large contract can have a material impact on the company’s financial performance and cash flows.
Indicators to be examined
In its assessment of a contractor’s financial condition, DCAA will be searching for the following indicators:
- Deterioration of key financial ratios;
- Negative trends in revenues, profits or cash flows;
- Debt restructurings;
- Loan defaults and availability of credit;
- Unpaid tax liabilities;
- Off Balance Sheet transactions;
- Related Party transactions.
In addition, as part of its assessment, DCAA will perform a Z-score analysis of the contractor which is a failure predictor model to assess an overall risk rating.
Three types of opinions
After analyzing all of these factors, DCAA can issue three types of opinions:
- Unqualified opinion – no financial distress or indications of long-term problems
- Qualified opinion – contractor under some form of financial distress though management is taking actions to address
- Adverse opinion – reasonable doubt exists as to the likelihood of success for management’s extraordinary actions.
The goal for every contractor is to obtain an unqualified opinion as a result of this audit. This will ensure contract award without further delay. Receiving a qualified or even an adverse opinion can either delay or possibly cancel the award of the potential contract.
What you can do
Prior to the financial capability audit, the company should consider doing the following:
- Perform your own historical financial analysis:
Using the financial statements for the year-to-date and the most recent three years, prepare a trend analysis of its key financial ratios and financial performance. If you are unsure how to do this, you should engage your outside CPA or a consultant to conduct such an analysis.
- Prepare a “story” to overcome any negative indicators:
If negative indicators exist, prepare a story as to how management’s plans have/will overcome such issues.
- Prepare financial and cash flow forecasts:
You will need to demonstrate that the Company can handle the cash flow demands of the new potential contract.
- Secure outside debt/equity financing:
Having access to a line of credit or other equity financing can help alleviate any issues the cash flow projections may uncover.
Summary
A financial capability audit is an integral part of the government’s decision to award a contract. Failure by a contractor to properly plan for and address such an audit might cause a delay or even a cancellation of such award to a contractor.
Michael Smigocki, CPA, CVA is the Senior Managing Director of Federal Strategies Group, LLC. He can be reached via email at MikeS@FedStrat.com .
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