Column: DCAA Penalties and Expressly Unallowable Costs

      It is about that time of year when calendar year-end contractors begin the process of preparing their annual incurred cost submissions.

      As part of this process, contractors are required to segregate unallowable costs from reimbursable costs. This process can place a significant burden on the new and/or unsophisticated contractor. Failure to properly segregate the costs can result in penalties and interest on the unallowable costs.

      As part of their incurred cost audits, the Defense Contract Audit Agency (DCAA) recently has displayed a marked increase in recommending that penalties be assessed against contractors for inclusion of “expressly unallowable costs” in the incurred cost submissions.

      In addition, DCAA appears to be expanding its definition of “expressly unallowable costs” to include costs that could be either allowable or unallowable, depending on one’s interpretation.

      This article will discuss DCAA’s process and ways contractors can minimize their risk of penalties.

Expressly Unallowable Costs

      According to DCAA, a cost principle makes costs “expressly unallowable” (and thus subject to the penalty provision) if:

1. It states in direct terms that the costs are unallowable, or leaves little room for differences of opinion as to whether the particular cost meets the allowability criteria; and
2. It identifies the specific cost or type of costs in a way that leaves little room for interpretation. FAR Part 31 and DFARS Part 231 provide a list of costs that might be classified as either allowable or unallowable, depending on the circumstances. Common expenses incurred by contractors that have been identified as expressly unallowable include public relations and advertising costs, bad debts, interest, gifts, fines and penalties, among others. These types of costs meet the definition above of “expressly unallowable.” Inclusion of these costs in the submission likely would trigger DCAA’s recommendation for penalties.

Not Expressly Stated

      While for many of the costs detailed in FAR Part 31 and DFARS Part 231 it is relatively straightforward to determine whether they are expressly unallowable, in recent months DCAA has aggressively applied the term to other costs for which it is not stated in direct terms that the cost is unallowable. DCAA has been applying the penalty provisions to these other costs, too.

      An example would be in the area of consultant costs. FAR 31.205-33 states that the costs of professional and consultant services are allowable except in certain situations. Even though the cost principle states these costs are allowable, DCAA has taken the position that costs incurred in these exception situations are “expressly unallowable” and thus subject to penalties if included in the submission.

      In many situations, the allowability of consultant costs is a matter of subjectivity; however, if DCAA questions the costs, penalties may also ensue. Technically, the Government must demonstrate that “it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable in order to prevail.”

Penalties

      FAR 42.709 requires that penalties be assessed if a contractor claims an expressly unallowable indirect cost in either its (1) annual incurred cost submission, or (2) the final statement of incurred costs. There are two levels of penalties that can be assessed including:

Level 1 – applies to costs deemed expressly unallowable. The penalty is equal to the amount of the expressly unallowable cost as well as interest.

Level 2 – applies to costs that were previously determined to be unallowable before sending in the incurred cost submission. An example of this is where a cost was deemed unallowable from a previous incurred cost audit, and yet the cost was still included in the current submission. The penalty for this situation is equal to twice the amount of such disallowed costs.

      DCAA can only recommend to the agency contracting officer that penalties be assessed; they are not the final determinant. It is up to the discretion of the contracting officer whether to formally assess or waive such recommended penalties.

Recommendations

      With the increase in penalty situations being recommended by DCAA, a contractor can do the following to minimize the risk of penalties being incurred:

1. Familiarize yourself with the cost provisions of FAR Part 31 and DFARS 231. Review the list of costs detailed in these cost principles and determine whether the company has incurred any such unallowable costs.
2. Perform an internal audit of incurred costs. Identify the transactions falling in the categories detailed in FAR Part 31 and DFARS Part 231. Review the supporting documentation to determine whether it is an unallowable cost or not.
3. Have the incurred cost submission reviewed by an expert prior to submission. Retaining an expert in government contract accounting to perform a “mock audit” of the incurred cost submission can help identify costs that may be challenged by DCAA.
4. Diligently appeal the assessment of any penalties. If this is the first time that you have been assessed penalties, be diligent in your appeal to the Auditor and the ACO. Describe the situation that led to the inclusion of such costs, how this has never occurred before, and how procedures have now been put in place to ensure that it will not happen again.

      Doing business with the Government is very different from commercial contracting. It requires an increased level of administrative functionality and expertise to avoid such penalty situations.

Michael Smigocki, CPA, ABV is the Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, forensic accounting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.

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Column: DCAA Penalties and Expressly Unallowable Costs

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