Column: DCAA’s Pursuit of Penalties for Unallowable Costs

      There are many tens of thousands of small and mid-sized companies that provide goods and services to the U.S. Government. For some of these companies, the government is their only customer while for many others, the government is merely one of its many customers. These companies generally have very little organizational expertise and infrastructure to comply with the myriad of regulations that govern this industry.

      Regardless, the government and the Defense Contract Audit Agency (DCAA) expect contractors performing under certain types of contracts to ensure that unallowable costs are excluded from final indirect cost rate proposals (incurred cost submissions).

      Its enforcement mechanism for this expectation is that failure to do so can lead to significant penalties being imposed on the contractor, sometimes up to two times the amount of disallowed cost! This article will discuss the applicable Federal Acquisition Regulation requirements pertaining to penalties as well as how contractors should handle such situations.

      I have noticed an increased number of instances where DCAA was recommending penalties for costs they deemed unallowable as part of the incurred cost audit. In addition, it seems that the Defense Contract Management Agency (DCMA) has become less willing to waive these penalties. Because of this, contractors should consider the following strategies to handling such situations.

1. Have a mock audit performed by an independent party prior to submission.

      The best time to address whether unallowable costs, or even questionable costs, have been included in the submission is prior to submitting it to DCAA. Retaining someone who is knowledgeable of FAR 31.205 and who can look at incurred costs from an auditor’s perspective can address and resolve such issues prior to the actual audit.

2. Understand the categories of unallowable costs that trigger penalties.

      Cost Accounting Standard (CAS) 405 breaks down unallowable costs into the following categories:

• Expressly unallowable
• Costs mutually agreed to be unallowable
• Unallowable directly associated costs
• Costs designated by the contracting officer (CO) as unallowable
• Costs that are not contractually authorized.

      It is important to note that even though your company may be exempt from CAS requirements, these definitions have been incorporated into the FAR, which your company must follow. FAR 42.709-1 states that penalties apply if the indirect cost is “expressly unallowable under a cost principle of the FAR or an executive agency supplement to the FAR.”

      The takeaways from this are (1) be sure the auditor is recommending penalties for expressly unallowable costs and (2) penalties are applicable only to indirect costs, not unallowable direct costs.

3. Challenge and attempt to resolve penalties with the auditor before the final audit report is issued.

      Contractors should do everything they can to address issues of unallowable costs while DCAA is conducting its audit. It is also important to understand DCAA’s role in the process. Auditors are not the final determinant of cost disallowances or penalty assessment. Their role is advisory to the CO. The CO makes a final determination.

      As previously mentioned, DCAA has become increasingly aggressive in recommending penalties. They have taken positions that seemingly expand what is considered an “expressly unallowable” cost. The FAR defines expressly unallowable cost as a particular item or type of cost which, under the express provision of an applicable law, regulation, or contract, is specifically named and stated to be unallowable. However, DCAA has taken the position that a cost can be expressly unallowable even though the cost principle does not explicitly state that the cost is unallowable or not allowable. They have even gone as far as to recommend penalties for directly associated costs.

4. Understand the waiver provisions for the CO in the FAR.

      FAR 42.709-5 provides situations where the CO can waive such penalties. These include:

1. The contractor withdraws the submission before the government formally initiates an audit.
2. The amount of the unallowable costs subject to penalty is $10,000 or less.
3. The contractor demonstrates to the CO’s satisfaction that:

      Having a strong relationship with your CO can go a long way to having penalties waived.

      Compliance with the regulations has always been the foundation for doing business with the U.S. Government. Utilizing penalty assessment has become the latest enforcement mechanism for such compliance. Investing in internal compliance training or even outsourcing this effort can greatly reduce the likelihood of being faced with such penalty situations.

Michael Smigocki, CPA/ABV, CVA 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: DCAA’s Pursuit of Penalties for Unallowable Costs

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