Column: Update on DCAA’s Pursuit of Penalties on Expressly Unallowable Costs

      In recent years, the Defense Contract Audit Agency (DCAA) has becoming increasingly aggressive in their pursuit of penalties against contractors who sought reimbursement for expressly unallowable costs.

      These penalties were sometimes up to twice the amount of the disallowed cost and DCMA has been reluctant to waive these penalties. This resulted in some hefty penalties being paid by contractors.

      However, after some recent court cases, DCAA has had to clarify the situations in which penalties could be imposed. Their guidance on what constitutes expressly unallowable costs has changed, as has the guidance DCAA has provided its auditors concerning such costs. This article will discuss these changes as well as the treatment of certain categories of expenses that a typical contractor may encounter.

      It is DCAA’s expectation that contractors will exclude expressly unallowable costs from its billings and final indirect cost rate proposals. Its primary enforcement mechanism for this expectation is the ability to recommend penalties to be imposed upon the contractors. However, there had been inconsistency amongst audit offices, and even individual auditors, as to what constituted an expressly unallowable cost and thus subject to penalties. Guidance recently released by DCAA has incorporated the impact of these court cases and provided much clearer definitions of expressly unallowable costs.

Expressly Unallowable Costs

      DCAA states that a cost is “expressly unallowable” (and thus potentially subject to penalties) if:

1. The cost principle 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.

      The government must show that the cost was unreasonable, under all the circumstances, for a person in the contractor’s position to conclude that the costs were unallowable.

Selected Areas of Cost

      The following are selected areas of cost that many contractors may encounter and the updated guidance by DCAA as to its treatment as expressly unallowable:

1. Compensation for personal services: Compensation costs for certain individuals receive special consideration by DCAA. These include owners of closely-held corporations, members of limited liability companies, partners, sole proprietors or members of their immediate families. Under the new guidance, only the portion of their compensation that constitutes a distribution of profits is considered an expressly unallowable cost, and thus subject to possible penalties.

2. Public relations and advertising costs: All public relations and advertising costs whose primary purpose is to promote the sale of products or services of a contractor by stimulating interest in a product or product line are considered expressly unallowable costs. These include costs associated with trade shows and other special events.

3. Relocation costs: Relocation costs incident to acquiring a home in a new work location are expressly unallowable and subject to penalty for existing employees or newly recruited employees who were not homeowners before the relocation.

4. Selling costs: Selling costs is a very generic term that attempts to describe all efforts to market the contractor’s products or services. While selling costs are generally an allowable expense, contractors have used this account in the past to attempt to receive reimbursement for unallowable costs addressed in other areas of the FAR. As such, under the new guidance, selling costs that do not fall within one of the following categories are expressly unallowable and subject to penalty:

• Advertising;
• Corporate image enhancement;
• Bid and proposal costs;
• Economic planning costs;
• Direct selling.

5. Employee welfare. Expressly unallowable employee welfare costs include:

• Employee’s participation in company sponsored sports teams or employee organizations designed to improve company loyalty, teamwork or physical fitness
• Tickets to shows or sports events;
• Memberships in social, dining, or country clubs or other organizations.

6. Self-insurance: If purchased insurance is available, any self-insurance charge plus insurance administration expenses in excess of the cost of comparable purchased insurance plus associated insurance administration expenses is expressly unallowable.

      Contractors should establish procedures to ensure that these categories of expenses (as well as other expressly unallowable costs) are segregated from billings and/or final indirect cost rate proposals.

Conclusion

      DCAA’s incurred cost audits continue to be a fact of life for many contractors. Performing under cost reimbursable or other flexibly-priced contracts exposes the contractor to incurred cost scrutiny by the Government and possible penalties being assessed when seeking reimbursement of expressly unallowable costs. If DCAA does attempt to assess penalties, it would benefit the contractor to ensure that the costs meet the updated definitions of “expressly unallowable.”

Michael Smigocki, CPA, ABV is the Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, 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: Update on DCAA’s Pursuit of Penalties on Expressly Unallowable Costs

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