By Michael Smigocki, CPA

The fallout from the historic collapses of Enron and WorldCom continues to impact the government contracting industry.

At the time they went bankrupt, the government was left scrambling to fulfill the contracts each held. This has impacted both publicly-traded and privately-held contractors. The publicly-traded contractors are currently suffocating from the internal control documentation and testing requirements imposed upon them by Sarbanes-Oxley, while privately-held contractors are experiencing increased scrutiny from Defense Contract Audit Agency in the form of financial capability audits.

Financial capability audits have been around for awhile, primarily as an aid in the decision to award a contract. The government believes that by increasing the frequency of these audits (at least annually) and ensuring that all contractors receive them, the likelihood of an Enron/WorldCom situation would be greatly diminished. The question is, do government auditors, who are well-trained in the areas of FAR, CAS, allowability and allocability matters, have the skill sets necessary to assess financial performance of a contractor and the likelihood of negative contract performance issues due to financial problems?

As a contractor, there are several items you should be aware of both before the government performs one of these audits, as well as during, to ensure a favorable outcome. Understanding the purpose of the audit, as well as the procedures/techniques that will be utilized, will greatly assist in the process.

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 obligation under government contracts. The government lets many contracts for multiple years. While a contractor’s financial condition at the time of award might be adequate, this situation can certainly deteriorate as time progresses.

An internal study performed by DCAA revealed that a majority of their field offices were not performing financial capability risk assessments, especially for non-major (small) contractors where the likelihood of problems is greater. As a result, DCAA headquarters issued a directive to the field offices to perform these risk assessments on contractors at least annually.

In its assessment of a contractor’s financial condition, DCAA will be searching for the following indicators of potential problems:

•Deterioration of key financial ratios

•Negative trends in revenues, profits and cash flows

•Debt restructurings

•Loan defaults and availability of credit

•Unpaid tax liabilities

•Off-balance sheet transactions (this is what sank Enron) and

•Related party transactions

As part of its assessment, DCAA will perform a Z-score analysis of the contractor, which is a known failure prediction model that takes into consideration many of the above-mentioned items.

Upon completion, DCAA can issue three types of opinions in their report:

•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 likelihood of success for management’s extraordinary actions.

The goal for every contractor is obviously to attain an unqualified opinion. Receiving a qualified or especially an adverse opinion can have a detrimental effect on the company’s ability to obtain new contracts as well as continuing performance under existing ones.

Sometime prior to a financial capability audit, a contractor should prepare its own trend analysis of its key financial ratios and its financial performance. If you are not sure how to do this, sit down with your outside CPA to perform this analysis and to understand what the results mean. If the trends are unfavorable, having a clear understanding of the reasons why, as well as management’s plans for addressing these issues, are imperative for the audit.

Financial and cash-flow projections should be prepared that reveal the impact of management’s plans on future performance of the company. These projections can be the difference between receiving a more favorable opinion.

Financial capability audits and risk assessments are now part of the government contracting landscape. There will be instances where the auditors performing these audits do not have the training and background to make such financial assessments of contractors. Anything a contractor can to do to aid the auditor in this understanding, as well as to prepare its story and analysis in advance, will ensure a much smoother audit.

Michael Smigocki, CPA, CVA is the managing director of the National Government Contractor and Technology Group of American Express Tax & Business Services. The group provides accounting, tax, regulatory and management consulting, M&A advisory, litigation support and expert testimony to the government contracting and technology industries. He can be reached via email at Michael.A.Smigocki@aexp.com.