Subcontractors’ Accounting Systems Face Scrutiny By Glenda Tysinger In the past, a contractor could expect an accounting system audit only prior to the award of its first cost reimbursement type contract. Today the requirement to have an accounting system approved by DCAA or a reputable firm prior to award has expanded to other contract types as well. DCAA Audits Why is there an increase in DCAA preaward audits? The July 26, 2010, appearance of Patrick J. Fitzgerald, director of DCAA, before the Commission on Wartime Contracting in Iraq and Afghanistan, provides some good insight. About 120 contractors hold more than 300 prime contracts with contract ceiling amounts of $93.2 billion. As a part of the audit process, the prime contractor’s policies and procedures are reviewed to ensure that the proposed subcontract costs are fair and reasonable. DCAA reported that all of the estimating systems audited were inadequate and said the estimating practices were deficient for ensuring fair and reasonable subcontract prices. FAR 42.202(e)(2) clearly states that it is the prime contractor’s responsibility to oversee its subcontractors. In one instance cited by DCAA, upon examination of the subcontractor’s records, it discovered that approximately 40% of the proposed direct costs of the subcontractor were unsupported. Additionally, when DCAA reviewed lower-tier subcontractors, it found that their direct costs were supported with only rough estimates of costs and absolutely no supporting detail. DCAA provided numerous other examples of inadequate accounting system support for both prime and lower tier subcontracts. As a result, Mr. Fitzgerald asserted that: Prime contractors must be held accountable for establishing fair and reasonable subcontract prices. Prime contractors have the responsibility to manage their subcontracts and have a fiduciary responsibility to monitor the subcontractor performance and control costs. Large Prime Contractors Requirements Large prime contractors fear that the actions of subcontractors may cause them to violate FAR 52.203-13, Contractor Code of Business Ethics and Conduct. Large primes are protecting themselves by requiring all subcontractors to have an approved accounting system prior to award of a subcontract. A small business subcontractor should hire a reputable firm to have such an audit conducted and to approve their accounting system. American Recovery and Investment Act of 2009 Additionally, the Recovery Act places more scrutiny on how American dollars are spent. The reporting required includes: *Government Contract and order number *Amount of Recovery Act funds invoiced *List of all significant services performed or supplies delivered *Program or project title *Description of the overall purpose and expected outcomes or results of the contract, including significant deliverables *Assessment of progress towards completion of the contract *Description of the employment impact of funded work *Names and total compensation of each of the five most highly compensated officers of the contractor Contracts being let under ARRA are requiring the contractors to undergo accounting system audits and to ensure they are meeting the above requirements. Accounting System Requirements For non-major contractors, there are 12 key elements that are required; no exceptions. The accounting system must demonstrate the ability to: *Segregate direct costs from indirect costs (FAR Part 31); *Accumulate contract costs by cost element by contract, project, task or cost objective for each cost element (labor, materials, subcontracts, other direct costs, fringe, overhead, G&A and other indirect costs); *Maintain an adequate timekeeping system; *Maintain labor and accounts payable distribution systems; *Account for unallowable costs and exclude from billings, claims, and proposals; · *Both direct and indirect costs must be controlled by the general ledger; *Pre-contract costs are captured separately; *Maintain homogeneous indirect cost pools and allocate indirect costs to contracts, projects, tasks or cost objectives based on a beneficial, causal and equitable bases; · *Make interim accumulation of costs on the books of account, at least monthly; *Track costs by contract line item and; *Provide reliable historical accounting data. The audit focus has shifted to determining if the accounting systems of both prime and subcontractor systems can be relied upon prior to contract award. This approach assumes it is more cost effective to minimize the likelihood of contractor overbillings prior to award as opposed to recovering overbillings after they have occurred. Small business subcontractors must now have an adequate accounting system that: *Properly tracks and segregates costs; *Has a billing and timekeeping system; *Has adequate internal controls; *Performs accounting in accordance with GAAP. Good luck on your next DCAA audit! Glenda Tysinger is a Senior Manager with Federal Strategies Group, LLC. She provides government contract and management consulting, accounting and DCAA audit services to the government contracting industry. She can be reached via email at GlendaT@FedStrat.com.