Chapter 6 - Incurred Cost

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DCAAM 7640.1; DCAA Contract Audit Manual

Chapter 6

Incurred Cost Audit Procedures

Table of Contents

6-000 - Incurred Cost Audit Procedures

6-001 Scope of Chapter

6-100 Section 1- Introduction to Incurred Cost Audit Objectives

6-101 Introduction

6-102 Audit Objectives and Approach for Incurred Costs

6-102.1 Audit Objectives

6-102.2 Audit Approach

6-103 Audit Scope – Incurred Costs

6-103.1 General

6-103.2 Coordination with Field Detachment

6-104 Audit Scope – Risk-Based Sampling of Incurred Cost Proposals,

effective January 1, 2020

6-104.1 Determining Sampling Eligibility

6-105 Reserved

6-106 Reserved

6-107 Materiality in Incurred Costs Audits

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6-1S1 Supplement – Schedule of Audit Procedures

6-200 Section 2 – Special Considerations in Audit of Selected

Contract Terms

6-201 Introduction

6-202 Precontract Costs, Costs After Completion, or Costs Over Contract

6-202.1 Allowability of Costs Incurred Before Contract Date

6-202.2 Procedure Where Term of Contract Performance Period is Explicit

6-202.3 Procedures Where Contract Specifies a Completion or Delivered

Product

6-202.4 Costs in Excess of Contract Amount

6-203 Credits and Refunds on Cost-Type Contracts

6-203.1 General Audit Policy

6-203.2 Processing Adjustments for Credits and Refunds

6-203.3 Disposition of Refunds Paid by Check

6-203.4 Special Procedures for Unclaimed Wages, Unclaimed Deposits, and

Unpresented Checks

6-204 Time and Material Contracts (T&M)

6-204.1 General Policy

6-204.2 Audit of T&M Labor Costs

6-204.3 Audit of Material Costs

6-205 Technical Services Contracts

6-205.1 Introduction

6-205.2 Audit Responsibility – Technical Services Contracts

6-205.3 Audit Reports

6-206 Underruns, etc. on Incentive Contracts

6-207 Limitation on Pass-Through Charges

6-207.1 General

6-207.2 Evaluation of Regulatory Requirements

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6-300 Section 3 – Audit of Incurred Material Costs and Purchased

Services

6-301 Introduction

6-302 Audit Objectives and Scope of Audit

6-303 Reserved

6-304 Gaining an Understanding of Internal Controls Relevant to the Audit and

Walk-Through

6-305 Accounting for Material Costs

6-305.1 Audit Objectives

6-305.2 Internal Control

6-305.3 Audit Guidelines

6-306 Physical Inventories and Adjustments

6-306.1 Audit Objectives

6-306.2 Internal Control

6-306.3 Audit Guidelines

6-307 Spoilage, Excess Scrap, and Obsolete Material

6-307.1 Audit Objectives

6-307.2 Audit Guidelines – Scrap and Spoilage

6-307.3 Audit Guidelines – Excess and Obsolete Material

6-308 Determination of Material Requirements

6-308.1 Audit Objectives

6-308.2 Internal Control

6-308.3 Audit Guidelines

6-309 Make or Buy Decisions – Incurred Material Costs and Purchased

Services

6-309.1 Audit Objectives

6-309.2 Internal Control

6-309.3 Audit Guidelines

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6-310 Purchasing and Subcontracting

6-310.1 Audit Objectives

6-310.2 Internal Control

6-310.3 Audit Guidelines

6-311 Excessive Pass-Through Charges

6-311.1 General

6-311.2 Evaluation of Regulatory Requirements

6-312 Receiving and Inspection

6-312.1 Audit Objectives

6-312.2 Internal Control

6-312.3 Audit Guidelines

6-313 Storing and Issuing

6-313.1 Audit Objectives

6-313.2 Internal Control

6-313.3 Audit Guidelines

6-314 Inter-Organizational Transfers (IOT)s

6-315 Special Considerations for Auditing Purchased Services Acquired from

Service Organizations

6-400 Section 4 – Audit of Incurred Labor Costs

6-401 Introduction

6-402 Audit Objectives and Scope of Audit

6-403 Coordinating and Reporting Results

6-404 Evaluation of Labor Cost Charging and Allocation (Employee Interviews)

6-404.1 Audit Objectives

6-404.2 Analysis of Labor Charging and Allocation Process

6-404.3 Preliminary Audit Effort

6-404.4 Evaluation of the Adequacy of Internal Controls

6-404.5 Evaluation of Compliance with Internal Controls

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6-404.6 Evaluation of Conditions Influencing Contract Labor Charging

Practices

6-404.7 Determining Additional Audit Effort

6-404.8 Preinterview Analysis

6-404.9 Detailed Employee Interviews

6-404.10 Development of Findings

6-405 Floorcheck Procedures - Observations of Work Areas

6-405.1 Audit Objectives

6-405.2 Procedures for Evaluating Timekeeping Controls

6-405.3 Procedures for Performing Physical Observations

6-405.4 Access to Restricted Areas (Floorchecks)

6-405.5 Contractor Employee Work at Home (WAH) Programs

6-406 Evaluation of Payroll Preparation and Payment

6-406.1 Audit Objectives

6-406.2 Audit Procedures

6-407 Evaluation of Personnel Policies and Procedures

6-407.1 Evaluation of Management Policies

6-407.2 Evaluation of Advanced Planning Procedures

6-407.3 Evaluation Guidance

6-407.4 Evaluating Procedures for Determining Personnel Requirements

6-408 Evaluating Recruitment Costs and Practices

6-408.1 Area of Coverage

6-408.2 Audit Objectives

6-408.3 Audit Procedures

6-409 Evaluating Overtime, Extra-Shift Pay, and Multi-Shift Work

6-409.1 Audit Objectives

6-409.2 Audit Procedures

6-410 Evaluating Uncompensated Overtime

6-410.1 Introduction

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6-410.2 Audit Objectives

6-410.3 Basic Audit Procedures

6-410.4 Acceptable Accounting Methods

6-410.5 Other Possible Accounting Methods

6-410.6 Materiality Considerations

6-411 Evaluating Other Labor Systems (Standard Costs and Proprietor/Partner

Salaries)

6-412 Evaluating Quantitative and Qualitative Utilization of Labor

6-412.1 Audit Objectives

6-412.2 Audit Procedures

6-413 Reasonableness of Compensation Costs

6-413.1 Compliance with FAR 31.205-6(b)(1), Compensation pursuant to

labor-management agreements

6-413.2 Evaluating Reasonableness of Non-bargaining Unit Compensation

in Accordance with FAR 31.206(6)(b)(2)

6-413.3 Determining Reasonableness of Non-bargaining Unit Employees

6-413.4 Determining Reasonableness of Compensation Costs

6-413.5 Fringe Benefits

6-413.6 Justification

6-413.7 Offsets – Compensation Costs

6-414 Reasonableness and Allowability of Compensation Costs for Owners,

Executives, and other High-Risk Compensation Categories

6-414.1 Introduction

6-414.2 Ownership and Substantial Financial Interest

6-414.3 Risk Considerations for Unreasonable Compensation

6-414.4 Reporting on High-Risk Employee Compensation

6-414.5 Termination Payments to Owners and Executives

6-414.6 Bonuses Resulting From Business Combinations

6-414.7 Compensation Ceilings – General Policy

6-414.8 Compensation Ceilings – General Audit Considerations

Figure 6-4-2 Application of the FAR 31.205-6(p) Compensation Cap

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6-500 Section 5 – Audit of Incurred Other Direct Costs and Credits

6-501 Introduction

6-502 Audit Objectives

6-503 Audit Approach

6-504 Scope of Audit

6-504.1 Interrelated Reviews

6-504.2 Evaluation of Bid Proposals and Contract Provisions

6-504.3 Disclosure Statements

6-504.4 Selected Areas of Cost

6-505 Audit Procedures

6-505.1 Reasonableness of Allocation of Costs

6-505.2 Allocation Methods and Consistency of Application

6-505.3 Allowability of Costs

6-506 Coordinating with Government Technical Personnel

6-600 Section 6 – Audit of Incurred Indirect Costs

6-601 Introduction

6-602 Audit Objectives

6-603 Scope of Audit

6-603.1 Types of Contracts and Government Participation

6-603.2 Reserved

6-603.3 Procedures and Internal Controls

6-603.4 Past Experience and Changed Conditions

6-603.5 Contract Terms

6-603.6 Multi-year Auditing

6-604 Evaluation of Contractor Policies, Procedures, and Internal Controls

6-604.1 Effect of Changed Conditions

6-604.2 Voluntary Management Reductions

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6-605 Indirect Cost Base Period

6-606 Indirect Cost Allocation Methods – Bases and Pools

6-606.1 General Information

6-606.2 Composition and Number of Pools

6-606.3 Allocation Bases for Overhead and Service Centers

6-606.4 Allocation Bases - General and Administrative (G&A) Expense

Other than Corporate and Home Office

6-606.5 Allocation Bases for Corporate/Home Office Expense

6-606.6 Allocations Bases for Residual Corporate/Home Office Expense to

GOCO Activities

Figure 6-6-1 Example of Corporate Expense Rates for GOCO Activities

6-607 Reserved

6-608 Indirect Costs - Transaction Testing Plan

6-608.1 General Guidance

6-608.2 Techniques for Selecting Accounts

6-608.3 Basis for Questioning Cost

6-609 Penalties on Expressly Unallowable Costs

6-609.1 Statutes and Regulations

6-609.2 General Guidance

6-609.3 Audit Requirements

6-610 Direct and Indirect Cost Verification

6-610.1 Reconciliation to Contractor Records

6-610.2 Verification of the Base

6-611 Quick Closeout - Indirect Cost Rate Calculation and Cost Distribution

6-611.1 General Guidance

6-611.2 Quick-Closeout

6-612 Indirect Cost Limitations for Basic Research Awards

6-700 Section 7 – Administrative Procedures for Establishing Indirect

Cost Rates

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6-701 Introduction

6-702 Definitions

6-703 Approaches to Established Indirect Cost Rates

6-703.1 The DoD Approach

6-703.2 The Non-DoD Approach

6-704 Effect of Contract Type on Indirect Cost Recovery

6-704.1 Cost-Reimbursement Contracts

6-704.2 Fixed-Price Contracts

6-705 Interim Billings

6-705.1 Provisional Billing Rates

6-705.2 Interim Indirect Cost Billing Adjustment

6-705.3 Indirect Cost Billing on Fixed-Price Contracts

6-706 Cost Certification for Final Indirect Cost Rates

6-706.1 Final Indirect Cost Rates

6-706.2 Reserved

6-706.3 Corporate, Group, or Home Office Expenses

6-707 Audits of Indirect Cost Rates

6-707.1 Submission of Indirect Cost Rate Proposal

6-707.2 Obtaining Indirect Cost Rate Proposals

6-707.3 Request for Audit

6-707.4 Timeliness of Final Indirect Cost Rate Audits

6-707.5 Audit Objectives and Procedures

6-708 Audit Determined Final Indirect Cost Rates

6-708.1 Actions Taken at Completion of the Audit

6-708.2 Actions Taken when Agreement with Contractor is Reached

6-708.3 Actions Taken when Agreement with Contractor is Not Reached

6-708.4 Reporting Audit Results

6-708.5 Writing the Audit Report

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6-709 Establishment of Final Indirect Cost Rates by Contracting Officer

Determination

6-709.1 Actions Taken at Completion of the Audit

6-709.2 Reporting Audit Results

6-710 Indirect Costs Advanced Agreements

6-711 Expediting Settlement of Indirect Cost Rates

6-711.1 Expediting Settlement of Indirect Cost Rates on Completed

Contracts

6-711.2 Expediting Settlement of Indirect Cost Rates on Terminated

Contracts

6-711.3 Cumulative Allowable Cost Worksheet (CACWS)

Figure 6-7-1 Memorandum for The Administrative Contracting Officer

Figure 6-7-2 Schedule of Potential Expressly Unallowable Costs

Figure 6-7-3 Schedule of Home Office Expense that are Potentially

Expressly Unallowable Costs

6-800 Section 8 – Assist Audits of Incurred Costs

6-801 Introduction

6-802 Subcontract or Inter-Organizational Transfer Incurred Costs

6-802.1 Definitions

6-802.2 Basic Responsibilities

6-802.3 Preparation of Subcontractors’ Cost Proposal

6-802.4 Prime Contractor Audits of Costs Proposed by Subcontractors

6-802.5 DCAA Audit of Subcontractors’ Proposed Costs

6-802.6 Release of Subcontractor Data to a Higher-Tier Contractor

6-803 Inter-Organizational Transfer Billings

6-803.1 General Information

6-803.2 Audit Procedures

6-803.3 Audit Reports

6-804 Corporate, Home Office and Service Center Audits

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6-804.1 Audit Responsibility

6-804.2 Audit Procedures

6-804.3 Cost Accounting Standards (CAS)

6-804.4 Audit Reports

6-805 Offsite Locations (including overseas locations) Using One Audit

Approach

6-805.1 Audit Responsibility

6-806 Difference of Opinion between DCAA Offices

Figure 6-8-1 - Pro Forma Assist Audit Request

6-900 Section 9 – Notice of Cost Suspensions and Disapprovals under

Cost –Reimbursement Contracts

6-901 Introduction

6-902 General Guidance for Suspensions and Disapprovals of Cost

6-903 Types of DCAA Forms 1

6-903.1 Regular

6-903.2 Blanket

6-904 Form 1 Preparation

6-905 Acknowledgement and Distribution of DCAA Forms 1

6-906 Deductions on Public Vouchers for Suspension Disapprovals

6-907 Follow-up Action on Suspensions and Disapprovals

6-908 Contractor’s Request for Reconsideration of Claims with Disapproved

Costs

Figure 6-9-1 DCAA Form 1

6-1000 Section 10 – Responsibilities for Processing and Approval of

Interim and Completion/Final Cost-Reimbursement Voucher

6-1001 Introduction

6-1002 General Information

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6-1003 Responsibility for Recommendation of Approval of Interim Public

Vouchers

6-1004 Contractor Preparation and Submission of Claims for Reimbursement

6-1005 Determination of Allowable Costs Under Cost-Reimbursement

Vouchers

6-1006 Processing Completion/Final Vouchers

6-1006.1 Receipt-Completion/Final Vouchers

6-1006.2 Timeliness of CFAO Review and Approval-Completion/Final

Vouchers

6-1006.3 Additional DCAA Final Voucher Support

6-1006.4 Supplemental Requirements for Maryland Procurement Office

Contract Close-out

6-1007 Quick Closeout Procedures

6-1008 Distribution of Public Vouchers

6-10S1 Supplement – Billing System Examination Considerations for

Contract Types

6-000 Incurred Costs Audit Procedures **

6-001 Scope of Chapter **

This chapter presents general guidance on auditing costs incurred under the broad

types of contracts and functional areas of cost incurrence. Chapter 5 provides guidance

on systems and internal control structure audits; Chapter 7 provides more specific

guidance on auditing selected areas of cost; and Chapter 8 covers specific

requirements of the Cost Accounting Standard Board rules, regulations and standards.

Section 6-100 includes guidance on the integration of incurred cost audit procedures

required by Chapters 1 through 8.

6-100 Section 1 - Introduction to Incurred Cost Audit Objectives **

6-101 Introduction **

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a. This section provides introductory guidance on the contract audit objectives and

approach for incurred costs, including general considerations that apply under all types

of contracts and for all cost categories.

b. In conducting incurred cost audits, observe any operations security (OPSEC)

measures required by current DoD contracts or requests for proposals, in accordance

with 3-205.

c. FAR 42.703-1, states that a single agency shall be responsible for establishing

final indirect cost rates for each business unit. In addition, FAR 42.703-1, 10 U.S.C

2313(d) and 41 U.S.C. 4706(e) specify that contracting officers determine whether a

previously conducted audit of indirect costs meets the current audit objectives for

indirect costs on executed contracts, subcontracts, or modifications. If data can be

obtained from an existing source, Federal Agencies are not to conduct duplicative

audits of indirect costs (see 1-303e).

d. FAR 42-705 provides the requirements for establishing final indirect rates on the

basis of contracting officer determination procedures (FAR 42.705-1) or auditor

determination procedure (FAR 42.705.2). For purposes of satisfying FAR 42-705-

1(b)(2) and FAR 42-705-2(b)(2)(i) audit requirements for incurred cost proposals,

Defense Procurement and Contracting (DPC) authorized a Class Deviation – DCAA

Policy and Procedures for Sampling Low-Risk Incurred Cost Proposals, dated July 24,

2012. This deviation instructs the DoD contracting officers to rely on either a DCAA

audit report (attestation examination engagement) or a DCAA memorandum (advisory

service) to satisfy the requirements of FAR 42-705.

6-102 Audit Objectives and Approach for

Incurred Costs **

6-102.1 Audit Objectives **

The auditor's primary objective is to examine the contractor's cost

representations, in whatever form they may be presented (such as interim and final

public vouchers, progress payments, incurred cost proposals, and termination claims),

and to express an opinion as to whether such incurred costs are reasonable, allowable,

and applicable to the contract as determined under generally accepted accounting

principles and cost accounting standards applicable in the circumstances, and not

prohibited by the contract, by statute or regulation, or by previous agreement with, or

decision of, the contracting officer. In addition, the auditor must determine whether the

accounting system remains adequate for subsequent cost determinations which may be

required for current or future contracts. The discovery of fraud or other unlawful activity

is not the primary audit objective; however, the audit work should be designed to

provide reasonable assurance of detecting abuse or illegal acts that could significantly

affect the audit objective. If illegal activity is suspected, the circumstances should be

reported in accordance with 4-700.

6-102.2 Audit Approach **

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a. Incurred cost audits are usually performed on a contractor-wide basis. This

approach recognizes the efficiency of addressing the adequacy of management and

financial systems and controls combined with transaction testing across all business

activities as opposed to contract by contract audits. Only in certain low-risk situations

would DCAA audit individual contracts, such as an audit of a small-dollar contract at a

multi-million dollar corporation where the small contract represented the company's only

business with the Government.

b. For large contractors and contractors with significant negotiated firm-fixed-

price contracts, audits of relevant business systems will be performed on a cyclical

basis based on a documented risk assessment and form the foundation for determining

the nature and extent of transaction testing necessary on individual incurred cost audits.

See Chapter 5 for guidance on audits of contractor's business systems.

c. For smaller contractors, separate audits and reports on individual contractor

business systems may not be necessary. An understanding of the contractor's relevant

internal controls may be gained at the time of the final indirect cost audit or during

individual contract audits. The auditor's understanding of controls gained from these

audits should be documented in the permanent file.

d. Regardless of the audit approach, in all audits emphasis will be on determining

the overall acceptability of the contractor's claimed costs with respect to:

(1) reasonableness of nature and amount;

(2) allocability and capability of measurement by the application of duly

promulgated Cost Accounting Standards and generally accepted accounting principles

and practices appropriate to the particular circumstances; and

(3) compliance with applicable cost limitations or exclusions as stated in the

contract or the FAR. To ensure the application of the appropriate cost principles,

auditors must consider the dates the contracts were awarded. The FAR Cost Principles

Guide (available on the DCAA intranet, under Library) provides a history of each cost

principle from the inception of the FAR and enables the auditor to determine the

applicable cost principle at a particular point in time.

e. Auditing incurred costs at multi-segment contractors where an incurred cost

proposal covers more than one contractor location requires cognizant auditors to ensure

that audit responsibilities at each location are clearly defined to ensure appropriate audit

coverage and reduce the potential for duplication of audit effort The lead FAO will

generally be the segment where the proposal is certified and should promptly notify any

impacted FAOs of the costs they are responsible for auditing, if any. FAOs cognizant of

segment locations should initiate assist audits from off-site locations as necessary.

FAOs cognizant of off-site locations should not self-initiate audits of incurred costs.

FAOs should consider using the One Audit Approach (OAA) as the preferred method on

all assignments within the same contractor organization (e.g. business segments,

related divisions, offsite locations, etc.) with similar operations and business systems

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and where the assist portion of the audit is material to the requesting office's submission

or system being evaluated. The OAA method allows the requesting FAO to incorporate

audit procedures performed by the assisting FAO into its working papers without a

traditional assist audit. In using the one audit approach, assisting offices will not issue

an audit report or memorandum to the requesting office. Rather, the assisting auditor(s)

should be added to the CaseWare assignment and input working papers directly into

the audit package, unless the assisting office is Field Detachment. See 4-1005-1(f) and

6-805.

6-103 Audit Scope - Incurred Costs **

6-103.1 General **

a. The procedures and audit guidance presented in this chapter are applicable to

all contract audits. However, the auditor must exercise professional judgment in

selecting which procedures and techniques are appropriate in the circumstances. The

scope of work necessary is a matter of audit judgment considering the contract auditing

and reporting standards in the context of a variety of factors which might be involved in

a particular audit. See Chapter 3 for these factors.

b. When designing the audit procedures for audits of incurred costs, the auditor

should consider the guidance in Chapter 6 Incurred Cost Audit Procedures, and

Chapter 8 Cost Accounting Standards in addition to the general guidance in Chapters 1

through 4. See 4-104 for guidance on providing notice to the ACO of the audit.

c. If the contractor has received a significant amount in Federal awards from a

non-DoD agency, and the non-DoD agency is unwilling or unable to reimburse DCAA

for its portion of DCAA’s incurred cost audit services, this may constitute a limitation on

the scope of audit, and auditors should follow the procedures in 15-102.2.

6-103.2 Coordination with Field Detachment **

a. In planning the audit, the regional or corporate audit directorate FAO should

determine if audit assistance is required from the Field Detachment auditors. This may

be determined by considering prior audit experience with the contractor and through

discussions with the contractor at the entrance conference. If the regional or corporate

audit directorate FAO does not have access to Federal awards because they are

classified, audit assistance from the cognizant Field Detachment FAO should be

requested.

b. When regional or corporate audit directorate, and Field Detachment FAOs

have joint audit responsibilities, the objective is to achieve a comprehensive,

coordinated, and integrated incurred cost audit. Annual coordination meetings should

be held between the FAOs to determine their respective responsibilities (see 6-405.4a).

c. Coordination with Field Detachment FAOs cognizant of the classified contracts

at the prime/upper-tier contractor and subcontractors may be necessary based on the

significance of subcontract/Inter-organizational Transfers (IOTs) costs proposed on

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classified contracts in the incurred cost proposal. If there are significant classified

contracts/subcontracts, the regional or corporate audit directorate FAO should

communicate with Field Detachment to determine if an assist audit is necessary.

d. The scope of the incurred cost audit may be limited when a significant amount

of contractor expenditures under Government contracts is excluded from the scope of

DCAA’s audit. This scope limitation may exist when DCAA auditors (including Field

Detachment auditors) do not have access to or cannot rely upon the work of other

Government auditors related to certain restricted or classified information. Depending

upon the significance of the excluded costs, these situations may warrant the issuance

of a qualified audit opinion or disclaimer of opinion (see 10-208.5).

e. DCAA FAOs will rely on the work of other DCAA offices (including Field

Detachment) without making reference to the work performed by that office in the audit

report (refer to 4-1005.2d). The regional or corporate audit directorate FAO must fully

coordinate with the cognizant Field Detachment FAO regarding the manner in which

any Field Detachment assist audit findings may be presented in the FAO’s incurred cost

audit report. Consideration must be given to security concerns and the probable need

to present the audit findings without reference to the classified nature of the awards,

and without reference to the Field Detachment.

6-104 Audit Scope – Risk-Based Sampling of

Incurred Cost Proposals, effective January 1,

2020 **

a. Adequate incurred cost proposals (ICPs) with Sampling ADV of $1 billion or

greater will be audited each year.

b. Adequate ICPs with Sampling ADV less than $1 billion will be assessed for

sampling eligibility, with the exception of those that meet the criteria listed below:

(1) The following types of proposals / assignments are excluded from the risk-

based sampling process:

● Corporate/Intermediate Home Office (IHO)/Shared Services

● 100% subcontract only

● Field Detachment (FD) direct cost only assignments

● Assignments on the Operations Investigative Support Division (OIS) do not

sample list.

● ICPs that contain 100% reimbursable contracts for agencies that do not

participate.

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(2) If the ICP is not randomly selected for audit, a risk-based sampling

memorandum will be issued to the contracting officer indicating the ICP was eligible for

sampling and not selected for audit.

6-104.1 – Determining Sampling Eligibility **

a. Sampling ADV less than $5 million. ICPs with sampling ADV less than $5

million that meet all of the following criteria are eligible for sampling:

• There were no significant questioned costs in the last completed incurred

cost audit, and

• There are no Department (ACO, PCO, COR, DCAA, etc.) concerns with a

significant impact on the ICP.

(1) If the ICP does not meet the criteria above, RAM / CAM approval is

required prior to commencing an audit of ICPs with sampling ADV less than $5 million.

b. Sampling ADV of $5 million but less than $100 million. If all of the following

criteria are met, the ICP is eligible for sampling:

• There were no significant questioned costs in the last completed incurred

cost audit;

• There are no Department (ACO, PCO, COR, DCAA, etc.) concerns with a

significant impact on the ICP; and

• The contractor does not have a pre-award accounting system survey that

resulted in an unacceptable opinion, or a disapproved accounting system

based on a postaward accounting system audit.

c. Sampling ADV of $100 million to $250 million. The proposals with sampling

ADV in this range must be audited every 5

year. The ICP is eligible for sampling if all

of the following criteria are met:

• The last four incurred costs years were not closed with a low-risk memo or

a risk-based sampling memo;

• There were no significant questioned costs in the last completed incurred

cost audit;

• There are no Department (ACO, PCO, COR, DCAA, etc.) concerns with a

significant impact on the ICP; and

• The contractor does not have a pre-award accounting system survey that

resulted in an unacceptable opinion, or a disapproved accounting system

based on a postaward accounting system audit;

• The contractor does not have any business system deficiencies relevant to

the incurred cost year subject to audit;

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• The contractor does not have any significant accounting practice changes in

the year subject to audit; and

• The contractor had not experienced any significant organizational changes

in the year subject to audit.

d. Sampling ADV of greater than $250 million to $500 million. The proposals with

sampling ADV in this range must be audited every 4

year. The ICP is eligible for

sampling if all of the following criteria are met:

• The last three incurred costs years were not closed with a low-risk memo or

a risk-based sampling memo;

• There were no significant questioned costs in the last completed incurred

cost audit;

• There are no Department (ACO, PCO, COR, DCAA, etc.) concerns with a

significant impact on ICP;

• The contractor does not have a pre-award accounting system survey that

resulted in an unacceptable opinion, or a disapproved accounting system

based on a postaward accounting system audit;

• The contractor does not have any business system deficiencies relevant to

the incurred cost year subject to audit;

• The contractor does not have any significant accounting practice changes in

the year subject to audit; and

• The contractor had not experienced any significant organizational changes

in the year subject to audit.

e. Sampling ADV of greater than $500 million to less than $1 billion. The proposals

with sampling ADV in this range must be audited every other year. The ICP is eligible

for sampling if all of the following criteria are met:

• The last incurred costs year was not closed with a low-risk memo or a risk-

based sampling memo.

• There were no significant questioned costs in the last completed incurred

cost audit;

• There are no Department (ACO, PCO, COR, DCAA, etc.) concerns with a

significant impact on the ICP;

• The contractor does not have a pre-award accounting system survey that

resulted in an unacceptable opinion, or a disapproved accounting system

based on a postaward accounting system audit;

• The contractor does not have any business system deficiencies relevant to

the incurred cost year subject to audit;

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• The contractor does not have any significant accounting practice changes

in the year subject to audit; and

• The contractor had not experienced any significant organizational changes

in the year subject to audit.

6-105 Reserved **

6-106 Reserved **

6-107 Materiality in Incurred Cost Audits **

6-107.1 Materiality Concepts

a. Materiality is defined as misstatements, including omissions, individually or in

the aggregate, that could reasonably be expected to influence relevant decisions of

intended users. Materiality considers both qualitative and quantitative factors. The

relative importance of these factors when considering materiality in a particular

engagement is a matter of the auditor’s professional judgment.

b. The auditor should design and perform audit procedures on material balances

regardless of assessed risk in order to support the audit opinion. However, the

evaluation of risk affects the nature, timing, and extent of procedures performed on

these material balances. Risk also provides a justification for performing audit

procedures on amounts that have a dollar value less than quantitative materiality.

c. Materiality requires the use of two separate thresholds: quantified materiality to

identify significant cost elements, and adjusted materiality to identify significant

accounts recorded in the significant cost elements. Quantified materiality represents

the total amount the subject matter can be misstated without misleading the users of the

information. Adjusted materiality is less than quantified materiality and is applied to

accounts within the cost elements. For purposes of selecting accounts for audit testing,

adjusted materiality can be stated as a reduction of quantified materiality by 20 percent

to 80 percent based on auditor judgement.

• The significance of indirect costs is based on quantified materiality and the

contribution of those costs to the total subject matter of audit. However,

the application of adjusted materiality is revised for the government

participation of significant indirect costs.

• The contractor’s method of accumulating costs does not limit the use of

materiality but may require the audit team to use additional analysis (e.g.

data analytics) to properly summarize the cost information for the

application of materiality and sufficient design of audit procedures.

• The auditor should consider quantitative and qualitative materiality factors

when evaluating the identified noncompliances’ impact on the audit

opinion.

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d. The audit team should identify the qualitatively and quantitatively material cost

elements and accounts in order to support the audit opinion. The use of qualitative or

other risk factors to identify significant cost elements and accounts should be based on

objective factors (e.g., history of questioned costs, documented concerns of contracting

officer, etc.). Absent these objective factors, the auditor is expected to adhere to

quantitative materiality thresholds. The auditor should document the justification for

deviating from the numeric materiality thresholds.

6-107.2 Calculating the Quantitative Materiality Threshold

a. Quantitative Materiality Threshold: The formula for calculating the quantitative

materiality threshold for use during the annual incurred cost audit is computed based on

the total subject matter of audit amount, and is presented below:

1. If the total subject matter of audit is from $1 to $1,000,000,000 use the

formula:

Materiality Threshold = $5,000 * ((Total Audit Subject Matter / $100,000) ^ .75)

2. If the total subject matter of audit is greater than $1,000,000,000, the

materiality threshold will be 0.50 percent of the total subject matter of audit.

b. The total subject matter of audit represents the information on which the

auditor provides an opinion (i.e., assurance), or conclusion and is generally equal to the

Auditable Dollar Volume (ADV) calculation with the costs related to assist audits added

back to the total. Also, adjustments applicable to ADV such as closed contracts are

also reduced for the ‘total subject matter of audit’ because closed contracts are not

included in the audit opinion.

6-1S1 Supplement - Schedule of Significant Audit Areas **

Objectives Purpose Reference

Evaluate summaries of the

contractor’s total annual

contract costs by major cost

element (material, subcontracts,

intracompany charges, and

credits, etc.), and verify that the

auditable contract costs

reconcile to contractor

accounting records by cost

element (typically using work-in-

process or other contract

control accounts in the general

ledger).

To provide an overview and

order-of-magnitude frame of

reference for direction of audit

effort and other audit

planning/performance

considerations, and to verify

that the auditable costs

claimed or to be claimed on

Government contracts tie into

the amounts produced by the

accounting system in the

contractor’s official books and

records.

6-610.1

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Maintain/update permanent files

for new or changed contractor

organizations, operations,

policies, procedures, internal

controls, software programs,

and accounting methods that

influence the nature, level, and

accounting treatment of costs

being charged to Government

contracts. Update

documentation of contractor

contract briefing system or

update auditor-prepared briefs.

To provide an efficient and

effective repository of current

audit information. Permanent

file maintenance should help

identify the need for further

audit and analysis, and help

in determining the accounting

methods that influence the

nature, level, and extent of

further testing required in

specific cost accounts,

functions, operations, and

departments.

3-302.1

3-302.2

4-405

Evaluate applicable tax returns,

financial statements, and other

publicly available data of the

contractor.

To highlight possible areas to

reduce the extent of DCAA

audit effort that might

otherwise be required.

3-204.16c

Analyze the contractor’s general

ledger, trial balance, and other

income/accounting adjustments

(for example, unusual and/or

sensitive journal entries).

To help identify any income

and credits which the

Government may be entitled

to obtain or share, and to

evaluate the exclusion of any

adjustments not reflected by

the contractor in Government

contract costs.

6-608.2d(5)

6-608.3b(1)

Evaluate changes in procedures

and practices for charging

direct/indirect cost for

consistency with generally

accepted accounting principles,

the applicable cost principles

per contracts, and any

applicable CAS requirements.

To verify that changes in

charging direct/indirect cost

do not have the effect of

improperly shifting costs

among cost objectives or

circumventing cost targets or

ceilings of certain contracts or

other significant cost

categories.

6-404.6b(4)

6-407.2

6-504.1

6-603.4

6-604.1

Evaluate the contractor’s labor

cost distribution.

To test overall integrity of

labor cost records at the

general ledger and cost

ledger levels, and to reconcile

payroll accruals and

disbursements, making sure

that distribution entries trace

to and from the cost

accumulation records.

6-406.1

6-406.2a(6)

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Evaluate adjusting journal

entries and exception reports

for both direct and indirect

costs. Evaluation for direct

costs should include labor,

ODCs, purchased services, and

material (including subcontract

costs and intracompany

charges.)

To identify adjustments

and/or exceptions that require

further audit analysis and

explanation.

6-305.3a(1)

6-404.6b(6)

6-608.2c(2)

Evaluate auditable type

subcontracts and intracompany

orders issued by the contractor

under auditable type

Government contracts and

subcontracts, and request any

needed independent assist

audits.

To protect the Government’s

interests concerning the

ensuing costs.

6-310.1

6-802.2d & j

6-802.4a

6-802.5

6-803

6-805

6-806

Trace claimed pools and bases

to accounting records.

To determine that the claimed

indirect cost pools and

allocation bases under

Government contracts

reconcile to amounts in the

contractor’s official books and

records.

6-610

Evaluate the current year’s

indirect cost accounts and prior

years’ costs and budgetary

estimates.

To identify changes in cost

accounting practices,

reclassifications of costs, and

areas with substantial

increases or decreases in

cost incurrence that require

further audit analysis and/or

explanation.

6-608.2(c)

Evaluate selected indirect cost

accounts or transactions, such

as sensitive accounts, new

accounts, accounts with large

variances, etc.

To obtain sufficient evidence

to support an opinion on the

allowability, allocability, and

reasonableness of the costs.

6-608.2

Evaluate the contractor’s

indirect cost allocation bases

for consistency with generally

accepted accounting principles,

the applicable cost principles

To assure that allocation

bases are equitable for

allocation of indirect costs to

intermediate and final cost

objectives.

5-1010d,

6-606

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per contracts, and any

applicable CAS.

Evaluate the accuracy of the

contractor’s rate computations

for distributing interim and final

indirect costs to intermediate

and final cost objectives.

To confirm that contractor’s

rate computations are

accurate for distributing

indirect costs to Government

contracts.

6-611.1a

6-200 Section 2 - Special Considerations in Audit of Selected Contract

Terms **

6-201 Introduction **

This section states guidance and special considerations in the audit of selected

contract types.

6-202 Precontract Costs, Costs After

Completion, or Costs Over Contract Amount

This paragraph states guidance for the audit of reimbursement vouchers covering

precontract costs, costs incurred after completion or delivery dates specified in a

contract, or costs incurred in excess of the contract amount. See 6-1008 for general

guidance on the review and approval of interim public vouchers.

6-202.1 Allowability of Costs Incurred Before Contract Date **

Precontract costs are defined in FAR 31.205-32. Such costs, which otherwise

meet the tests of allowability, may be approved for reimbursement by the auditor. If the

precontract costs are subject to an advance agreement, the auditor should determine

whether the costs incurred meet the conditions of the agreement. However, if there is

no advance agreement, the auditor should ascertain whether the precontract costs meet

all the tests of FAR 31.205-32 and are allowable to the same extent they would have

been allowable if incurred after the effective date of the contract. The auditor should

obtain the assistance of the Plant Representative/ACO and, where appropriate, the

PCO in reaching this decision whenever necessary to clarify the facts and conditions for

incurring precontract costs.

6-202.2 Procedure Where Term of Contract Performance Period is Explicit

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A contract may provide that it expires on a specified date, unless terminated

before that date, and obligates the contractor to devote a specified level of effort for a

stated time period [see FAR 16.306(d)(2) and FAR 52.249-6(a)]. The auditor shall not

approve for reimbursement any costs incurred by the contractor subsequent to the

expiration date stated in the contract, or in excess of contract limitations.

6-202.3 Procedure Where Contract Specifies a Completion or Delivered

Product **

A completion or delivered product specified in a cost-type contract normally

commits the contractor to complete and deliver the specified product within the

estimated cost. In the event the work cannot be completed within the estimated cost,

the Government may require more effort without an increase in fee [see FAR

16.306(d)(1)]. Also, under FAR 52.249-6(a), the contracting officer could terminate the

contract prior to full expenditure of the estimated cost. However, unless the contract is

terminated, or exceeds stated contract limitations, the contractor is normally obligated to

continue to perform under the contract up to the estimated total contract cost.

Therefore, questioning costs based only on the fact that they were incurred after the

performance period would be inappropriate.

6-202.4 Costs in Excess of Contract Amount **

The auditor will not approve any costs claimed by the contractor in excess of the

estimated total amount stipulated in the contract. Such excess costs will be

disapproved by the issuance of a DCAA Form 1.

6-203 Credits and Refunds on Cost-Type

Contracts **

This paragraph states the procedures to be used:

(1) in adjusting allowable contract costs for applicable credits, and

(2) for the collection and disposition of such credits which are refunded by the

contractor.

Deduction for Government Accountability Office (GAO) notices of exception is

covered in 6-909.

6-203.1 General Audit Policy **

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A complete listing of types of credits is not practicable; however, some examples

of miscellaneous income items and other credits are discussed in 6-608.2d(5).

a. It is not anticipated that any major difficulties will ordinarily be encountered in

making the necessary accounting adjustments to allowable contract costs for the

applicable credits and refunds discussed in this section. In a few cases, however,

because of the timing of disclosure or receipt of these credits, special procedures may

be necessary which are discussed in detail in this section.

b. The contractor's accounting procedures should provide for periodic review and

the processing of equitable adjustments to operating cost to cover miscellaneous

income items and credits, such as wages; unclaimed deposits for tools, safety

equipment or clothing; unclaimed payroll deductions for purchases of U.S. Savings

Bonds; and unpresented checks other than payroll. Payment of these funds to the state

under escheat laws constitutes an actual expenditure and satisfies the refund

requirement. Where no escheat laws are applicable, consideration must be given to the

ownership of the credits and unclaimed items to determine whether an adjustment is to

be made. The Government is not entitled to credits attributable to amounts paid by

employees or withheld from their salaries if the amounts were not initially charged either

directly or indirectly to the cost of Government contracts and, accordingly, not

reimbursed by the Government. If amounts were initially charged to operations and

equitably shared by the Government, adjustments should be reflected either in an

income account which is deducted from an applicable indirect cost category or else as a

deduction directly to the account originally charged. Where a contractor is engaged in

work under Government flexibly-priced contracts on a relatively consistent basis, the

foregoing periodic adjustment procedure should normally result in equitable

consideration of these credit items. Where, however, such consistency is not present,

consideration should be given to the direct costing of significant credits and refunds to

the specific contracts under which they were generated as the best means of ensuring

that the Government obtains the full benefits to which it is entitled.

c. As an alternate to the adjustment of costs for credits and refunds, the

contractor may refund the amount by a check, drawn to the order of the Treasurer of the

United States. This procedure is in fact required when the refund applies to a contract

that has been financially settled since, as a condition precedent to final settlement of a

contract, the contractor is required to execute an assignment of credits, refunds, and

rebates. Such assignment provides that credits, refunds, and rebates, whatever their

origin, attributable to contracts which have been financially settled, should be refunded

by the contractor to the Government by check drawn to the order of the Treasurer of the

United States. The refund check, together with the details pertaining to the

transactions, shall be submitted by the contractor to the ACO by the provisions in the

Assignment of Credits, Refunds, and Rebates.

6-203.2 Processing Adjustments for Credits and Refunds **

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a. During the period of contract performance, credit adjustments made in the

contractor's accounting records as a deduction from reimbursable contract costs will

normally be reflected in public vouchers submitted for that same period.

b. In the event the contractor fails to make the necessary deductions from current

contract costs for applicable credits or to make refunds therefore, the auditor shall effect

recovery by the issuance of DCAA Form 1 and deduct the amounts from current

reimbursement claims.

c. When the credits cannot be recovered by deductions from the public vouchers

to which they would normally pertain and the contractor declines to make a refund, the

auditor will process a DCAA Form 1 set-off deduction from the public voucher(s)

submitted by the contractor under any other cost-reimbursement type contracts under

the auditor's cognizance. The DCAA Form 1 should show the contract and

appropriation to which the credit is applicable. However, it should be noted that where a

contract so provides, public vouchers payable to an assignee may not be subject to

reduction or setoff for any indebtedness of the assignor arising independently of the

assigned contract.

d. In those cases where the applicable contract is closed and collection of credits

cannot be effected by the auditor under any of the procedures in subparagraphs a.

through c. above, a report should be made to the ACO. The report will identify the

contracts, the amount of the credits, their origin, and state the reasons why recovery

cannot be accomplished by the auditor through refund or deduction.

6-203.3 Disposition of Refunds Paid by Checks **

The auditor should generally not accept checks from contractors for credits due

the Government. Contractors should be advised to submit such checks directly to the

paying office, with a copy to the ACO, together with a copy of the details comprising the

credit, such as the listing prescribed in 6-203.4c., which should agree in total with the

amount of the check. Any checks received by the auditor should be transmitted

immediately to the ACO together with the required listing.

6-203.4 Special Procedures for Unclaimed Wages, Unclaimed Deposits, and

Unpresented Checks **

a. Where the balances of unclaimed payroll deductions for U.S. Savings Bonds

are insufficient to purchase bonds, Treasury Department instructions permit, but do not

require, contractors to transfer the balances to the Treasury Department to be held in

custody for the account of the employees concerned. Unless the contractor makes

these transfers, such amounts will be included in the cost adjustments described below.

b. Many states have enacted escheat laws governing the disposition of

unclaimed wages, unclaimed deposits, and unpresented checks after the expiration of

stated periods of time. Escheat laws generally provide for payment of these unclaimed

amounts to the state. This subject has resulted in some confusion and several court

cases, particularly in regard to disposition of these items where the creditor and debtor

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are located in different states. It has now been determined, however, that the Federal

Government is entitled to recover such unclaimed amounts only if:

(1) they represent sums due to persons or firms whose last known addresses

were in states which do not have escheat laws, and

(2) if, in addition, the escheat law of the state in which the contractor is

located does not provide for the payment of the amounts to its own (state) account.

Accordingly, where the auditor ascertains credits are due the Government under

the foregoing criteria, he or she will discuss the matter with the contractor and ensure

that adjustments or refunds are made by the contractor or that DCAA Forms 1 are

issued for the applicable amounts.

c. At the time credit adjustments or refunds are processed, the contractor will

prepare and retain separate listings of the former employees entitled to the unclaimed

amounts, and of the payees of unpresented checks which are covered by the credit

adjustment or refund. The listings must be in sufficient detail to permit audit verification

of each named payee in the event claims are made to the Government at a later date by

virtue of subsequent payments. These lists will be verified by the auditor on a selective

test basis as deemed appropriate. Separate lists will be submitted for each category of

unclaimed items and for unpresented checks.

d. Subsequent to the Government's recovery from contractors for unclaimed

wages, unclaimed deposits, and unrepresented checks, claims may be made by the

persons entitled to such funds. These claims should be presented to the contractor and

not to the Government, as the latter has no contractual relationship with the claimants.

e. In the case of reimbursements claimed by contractors for any payments made

to such persons, a certified invoice, valid receipt of the payee, and any other pertinent

information must be submitted with the claim to identify the payment with the applicable

item on the listing mentioned in 6-203.4c. In such instances the amounts claimed will

be cross-referenced to the public vouchers from which the credit deduction was initially

made and, after verification, will be approved by the auditor for reimbursement.

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f. In the event that the contract to which the claim relates has been financially

settled, the contractor's claim, together with the documentation described in

subparagraph c. above, should be submitted after verification and approval by the

auditor, to one of the following as appropriate:

Finance Center,

U.S. Army,

ATTN: FINCS,

8899 East 56th St.

Indianapolis, Indiana 46249; or

U.S. Navy Finance Center,

Accounts Receivable and Claims Division,

Code FR.

Washington, D.C.; or

Finance Officer,

Air Force Accounting and Finance Center,

Symbol CF,

Denver, Colorado; or as required by the department or office that placed the

contract.

6-204 Time-and-Materials Contracts **

6-204.1 General Policy **

a. Time-and-materials (T&M) contracts (including subcontracts) provide for the

procurement of supplies or services on the basis of:

(1) direct labor hours at specified fixed hourly rates (which rates include direct

labor, indirect costs, and profit) and

(2) material at cost. Material handling costs may be included in the charge for

"material at cost," when it can be demonstrated that they were not included in the

overhead factor of the hourly rate to be applied to direct labor.

b. The basic auditing procedures in Chapter 6 will be applied, as appropriate, to

audit of time-and-materials contracts. The guidelines of Chapter 9 should be used in

the evaluation of proposals for time-and-materials contracts. In addition to the

foregoing, the audit program should include the considerations discussed below.

6-204.2 Audit of T&M Labor Costs **

a. General. An important prerequisite to the audit of labor (salaries and wages)

is a good understanding of the contract clauses relating to the classes of labor and

types of operations to which the contractual rates apply. Labor rates are normally

negotiated during the award of a contract (or subcontract) or exercise of an option,

however auditors should be aware that in some instances labor rates subject to the Fair

Page 29 of 227

Labor Standards Act or the Service Contract Act may have been adjusted from the

initial contractual rates to comply with the Acts [see FAR 22.1006(c)(1) & (2), FAR

52.222-43, and FAR 52.222-44]. Also, since the contract labor rates include indirect

labor, indirect costs, and profit, only the hours of workers performing labor directly

related to the item produced or service rendered will be considered to be direct labor.

The basis upon which the direct labor hours are computed and charged must be

acceptable and subject to audit verification. Arbitrary or unsupported allocations of

direct labor will not be acceptable.

b. Classes of Labor. Unless otherwise specified in the contract, the direct labor

charged by the contractor should include only that which is consistently classified as

direct labor with its regularly established practice and is consistent with the labor so

classified in the proposal upon which the contract was negotiated.

(1) Wages of personnel such as clerks, material handlers, receiving or

shipping personnel, stockroom employees, tool-crib attendants, janitors, maintenance

men, packers, contact men, and expediters, as generally defined within the trade, are

not acceptable as direct labor unless specifically authorized in the contract.

(2) The time of partners, officers, or supervisors is not acceptable as direct

labor unless specifically authorized in the contract. In such event, the time of the

individual must be properly recorded and subject to audit verification.

(3) Where separate rates are not established for the various skill levels, the

time of apprentices and learners as a direct charge normally should be limited to the

ratio of such time considered in the development of the hourly rate included in the

contract. Disproportionate use of lower paid employees will be promptly brought to the

attention of the contracting officer.

c. Overtime. Only the hours actually worked are acceptable whether regular or

overtime. Overtime hours will not be converted to a larger number of regular hours to

compensate for any overtime premium payments, nor will the rates charged for overtime

hours be increased unless the contract so provides.

d. Floorchecks. Floorchecks will be made to determine that employees are

actually present and working on the job and that their time is being properly charged.

The contractor's system of internal control should provide for such checks. Therefore,

the frequency and scope of floorchecks performed by the auditor will be determined, in

large measure, by the frequency and effectiveness of similar checks performed by the

contractor (see 6-400).

6-204.3 Material Costs **

The material costs should be audited by the terms of the contract and the

procedures in 6-300. While all such procedures are applicable, care should be taken to

ascertain, when appropriate:

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(1) that the method(s) of determining material costs is consistent with the

factors included in the determination of labor rates,

(2) that all applicable discounts or expense credits have been included,

(3) that subcontract billings do not exceed rates for such work regularly

agreed upon between the contractor and subcontractor unless specifically authorized by

the contracting officer or terms of the contract.

6-205 Technical Service Contracts **

6-205.1 Introduction **

Technical service contracts provide for the contractor to furnish personnel and

other services for the performance of the work specified in the contract, with

reimbursement for such services usually on the basis of:

a. A fixed rate per hour, day, or month for the services of the assigned

technician, which sum may vary depending on whether the technician is on domestic or

foreign duty. Such fixed rate should normally provide for treatment of nonworking time

(i.e., vacations, illnesses, etc.).

b. An allowance for subsistence and housing at either actual costs, if reasonable,

or at specified fixed per diem rates, subject to modification when subsistence or

quarters are furnished by the Government.

c. The cost of transportation to and return from the duty station as well as

transportation while at the duty station incident to the performance of the contract. Cost

of employee dependents will not be at any additional cost to Government.

d. The allowable cost of such other items is expressly provided for in the

contract.

6-205.2 Audit Responsibility – Technical Service Contracts **

a. Audits will be performed on those contracts that specifically provide for audit

determinations or in response to specific requests made by the procuring activity. In

some cases, the provisions for audit, or the submission of reimbursement claims for

audit, will be limited to certain items as designated under the contract.

b. When audits are required, arrangements for assist audits required to

determine the propriety and reasonableness of cost will be the responsibility of the

auditor at the prime contract location.

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c. When technical service contracts represent substantial values, normal auditing

procedures should provide for a determination that the contractors' procedures for

costing the performance of the technical services are consistent with the cost objectives

considered in negotiating the billing rate. For example, if a staff-month billing rate

provides for inclusion of vacation or other leave as properly billable time, amounts for

these leave allowances for other direct employees should not be included in the

overhead used for determining the staff-month rate and all such leave should be

included in the labor base. Further, the overhead expense factor included in the staff-

month rate should represent a reasonable offsite rate which will include only those

expenses applicable to the offsite operation.

6-205.3 Audit Reports **

Reports will be issued in accordance with the applicable section of Chapter 10

and will be fully responsive to the specific requests. In addition, reports should be

issued without a request whenever the auditor encounters information which would be

of value in the administration of the contract or in the negotiating of contract prices.

6-206 Underuns, etc. on Incentive Contracts **

a. In those instances where the actual costs vary widely from the estimated costs

which were considered in setting the target cost, the report should contain specific

coverage as to the cost element and reasons, if discernible, for the variance. The

following are some of the areas which may cause major deviations between actual and

estimated costs.

(1) Changes in the "Make-or-Buy" pattern of major components.

(2) Changes in the cost accounting system including basis for allocation of

indirect expenses. If the contractor is required to comply with the Cost Accounting

Standards Board rules, regulations, and standards, the auditor should refer to Chapter

(3) Provision for contingencies which did not materialize such as forecasted

increases in the cost of raw materials; anticipated union demands; or anticipated

increases in costs of major components and royalties.

(4) Engineering changes which resulted in extraordinary and unanticipated

reductions in costs.

(5) Overstatements of important elements of cost during the initial price

negotiations due to subsequent developments which were not foreseen by either the

contractor or the Government.

(6) Overstatements of important elements of cost due to defective pricing (see

14-100).

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b. It is not intended that the auditor make a detailed analysis of the entire amount of

the underrun or an evaluation of the adequacy of the initial price negotiations. Audit

programs should, however, be designed to bring any items of significance mentioned in

the preceding paragraph to light at the earliest practicable time. If the items disclosed

have a material effect on the relationship of actual costs to target costs, they should be

brought to the attention of the contracting officer. Items which involve apparent

defective pricing or indicate a need for voluntary price adjustments will be reported

separately as provided in 14-100 and 4-802, respectively. A reference to such reporting

will be included in the report on the finalization of price of the incentive type contract; all

other matters will be reported in detail as provided in 6-205.3.

6-207 – Limitation on Pass-Through Charges **

6-207.1 General **

FAR 15.408(n) requires the Contracting Officer to include FAR 52.215-22

(Limitation on Pass-Through Charges - Identification of Subcontract Effort) and FAR

52.215-23 (Limitations on Pass-Through Charges) in solicitations and contracts as

follows:

• For DoD when the total estimated contract or order value exceeds the

threshold for obtaining certified cost or pricing data and the expected contract

type is any contract type except-

o Fixed-price with economic price adjustment, Firm-fixed-price or fixed-

price incentive contract awarded on the basis of adequate price

competition

o Fixed-price with economic price adjustment, Firm-fixed-price or fixed-

price incentive contract for the acquisition of a commercial item

• For civilian agencies when the estimated contract or order value exceeds the

simplified acquisition threshold and the contemplated contract type is

expected to be cost-reimbursement type.

FAR 52.215-22 (Limitation on Pass-Through Charges—Identification of

Subcontract Effort) requires contractors to identify in its proposals the total cost of work

to be performed by the offeror, and by each subcontractor. When more than 70 percent

of the total cost of the work to be performed is subcontracted, this clause requires the

contractor to (1) identify its indirect costs and profit/fee applicable to the work to be

performed by the subcontractor, and (2) provide a description of the “added value” it will

provide related to the work performed by the subcontractor(s).

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FAR 52.215-23 (Limitation on Pass-Through Charges) defines “added value” to

be subcontract management functions (either direct or indirect) that are a benefit to the

Government (e.g., processing orders of part or services, maintaining inventory, reducing

delivery lead times, managing multiple sources for contract requirements, coordinating

deliveries, performing quality assurance functions, etc.). An “excessive pass-through

charge” includes only indirect costs and profit applicable to the subcontracted work.

The clause also stipulates that the Government will not pay indirect costs or profit/fee to

a higher tier contractor on work performed by a lower-tier subcontractor unless the

higher tier contractor provides sufficient evidence that it “adds value”.

These FAR provisions create an allowability issue on excessive pass-through

costs, not an allocability issue. The excessive pass-through costs are still allocable to a

contract, but will not be paid by the Government (i.e., unallowable) if the contracting

officer determines the contractor does not provide “added value” to the subcontracted

portion of the work. FAR 31.203(i) specifically makes the indirect costs that meet the

definition of “excessive pass-through charges” in FAR 52.215-23, unallowable. The

intent of the clauses is to minimize excessive pass-through charges by contractors (or

lower-tier subcontractors) that add “no” or “negligible” value to the subcontracted work.

6-207.2 Evaluation of Regulatory Requirements **

Auditors should use Schedule H (Schedule of Direct Costs by

Contract/Subcontract and Indirect Expense Applied at Claimed Rates) of the

contractor’s incurred cost submission to identify indicators of contracts with potential

excessive pass-through charges (i.e. those with subcontract costs exceeding 70 percent

of work performed). Based on these indicators, auditors should perform procedures to

test compliance with the subject FAR provisions. For example, for contracts identified

where subcontract costs represent over 70 percent of the costs of work performed, the

auditor should review contract briefings to identify contracts containing FAR 52.215-23,

Alternate I. For those contracts containing Alternate I, auditors should perform

procedures to determine if the contractor is performing its “added value” functions as

asserted during the initial proposal evaluation. For all other contracts, auditors should

obtain information from the contractor to ascertain whether subcontract costs expect to

exceed 70 percent of the total costs of work performed. If so, the auditor should notify

the contracting officer and request the contractor to provide a description and

demonstration of the “added value” by the contractor related to the subcontracted work.

The auditor should evaluate the functions to determine if the “added value” functions are

consistent with the definition in the contract clause and perform testing to determine if

the contractor is performing the “added value” functions and ascertain if the costs are

reasonable. If not, the pass-through charges applicable to the subcontracted effort

should be questioned based on FAR 31.203(i).

6-300 Section 3 - Audit of Incurred Material Costs and Purchased

Services **

6-301 Introduction **

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This section presents audit guidance and procedures for the audit of direct and

indirect material costs and purchased services. Incurred material costs and purchased

services can be audited in real-time and/or as part of the post year end incurred cost

audit. The guidelines relate to the audit of the following areas: material costs

accounting; physical inventories and adjustments; scrap, spoilage, excess, and

obsolescence; determination of contract requirements; make or buy decisions;

purchasing and subcontracting; receiving and inspection; storing and issuing; and inter-

organizational transfers.

6-302 Audit Objectives and Scope of Audit **

a. The auditor's examination of transactions and procedures in the functional areas

discussed in 6-301 must be sufficient to support an opinion on whether proposed

amounts on unsettled flexibly priced contracts comply, in all material respects, with

contract terms pertaining to accumulating and billing incurred amounts. Compliance

with contract terms includes the allowability, allocability, and reasonableness of costs

charged to the contract. In performing this overall test, determine whether the material

was:

(1) needed for the contract

(2) charged and billed in a reasonable relationship to its use in the manufacturing

process

(3) considered properly for make or buy

(4) purchased in reasonable quantity

(5) purchased at a prudent price

(6) used on the contract

(7) in compliance with contract terms and CAS (particularly CAS 402 and 411)

(8) accounted for properly as to initial charge, transfer in or out, and residual

value.

b. Also be alert for restraints on competition attributable to a contractor's director(s)

having an interest in a supplier or subcontractor. Any suspicion of preferential treatment

(such as indications of conflicts of interest, unwarranted sole-source purchases, or

kickbacks) should be evaluated for possible reporting under 4-700.

c. Many different functional areas comprise contractor Material Management and

Accounting Systems (MMAS). Audit objectives and guidelines for each of the major

MMAS functional areas are discussed throughout the remainder of this section.

Generally, the audit scope will address:

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(1) gaining an understanding of the contractor’s internal controls that are relevant

to the audit (when an Accounting System and/or MMAS audit(s) have been performed,

the auditor should consider the use of prior audit efforts, when applicable), and

(2) whether material and related costs comply with contract terms and are

allowable, allocable, and reasonable.

The scope of audit in any of these areas will consider the work of others (4-1000).

Particular consideration should be given to adjust, when appropriate, audit scope to give

consideration for adequate contractor walk-throughs audits performed under DFARS

242.72 or DFARS 244.

d. The Government expects all contractors to have sufficient internal controls to

ensure system and data integrity. The auditor's understanding of the key internal

controls will influence the design and nature of testing and verification necessary to

express an opinion on whether the material costs charged to Government contracts

complied with contract terms.

e. Major considerations affecting the extent of the testing and verification of material

costs include:

(1) the significance of the dollar amount of material costs

(2) the extent of prior audit experience with the contractor involving the same or

similar items

(3) the reliability and acceptability of the contractor's management policies,

procedures, and system of internal controls

(4) the contractor's use of information technology

(5) the nature, extent, and results of any reviews accomplished by other

Government activities, and

(6) the existence of Non-DoD contracts. Contractors may have non-DoD

contracts which may affect the scope of audit. Identify any Non-DoD contracts subject

to audit and verify the audit effort is reimbursable. Some non-DoD agencies request

and reimburse DCAA for audit services. The requirement for our services on non-DoD

contracts should be confirmed by discussion with the appropriate agency Office of the

Inspector General (1-300 and 15-100 for guidance on audit services for non-DoD

agencies and DMIS User Guide). If the Non-DoD agency is not willing to participate,

discuss this with the audit supervisor and adjust the scope of the audit appropriately.

f. When material costs are significant, consider the following when designing

substantive tests:

(1) Audit of large purchases in which control risk is assessed as high.

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(2) Audit of sensitive purchases, such as scarce materials, sole-source items, or

purchases from vendors suspected of improper practices.

(3) Audit of other items on a selective basis, using the most practical selection

methods available in the circumstances.

(4) Stratify or group the purchases to be audited in some meaningful and efficient

way, such as by dollar amounts, buyers, contracts, types of material, products,

departments, vendors, or a combination of these and other factors.

6-303 Reserved **

6-304 Gaining an Understanding of Internal

Controls Relevant to the Audit and Walk-

Through **

The auditor must obtain a sufficient understanding of the contractor's policies,

procedures, and internal controls relevant to the subject matter of the audit. A

walkthrough includes questioning the entity's personnel about their understanding of

what is required by the entity's prescribed procedures and controls at the points at

which important processing procedures occur. These probing questions, combined with

the other walkthrough procedures, allow the auditor to gain a sufficient understanding of

the process and to be able to identify important points at which a necessary control is

missing or not designed effectively. In most incurred cost audits, the auditor expresses

an opinion on compliance with contract terms, including the allowability, allocability, and

reasonableness of material costs. Understanding the internal controls will directly

influence the design and nature, timing and extent of testing necessary to express an

opinion. The auditor should verify his or her understanding of the risks and business

processes to address the risk of material noncompliance.

6-305 Accounting for Material Cost **

a. The accounting department is generally the focal point for material cost control,

because it correlates the cost data applicable to requisitioning, purchasing, receiving,

storing, issuing, and finally paying for the material. The auditor should consider the

following when evaluating material costs:

(1) gaining an understanding of the internal accounting controls, including the

type of accounting system in use and the methods used to control the level of material

costs; and

(2) determining the propriety, consistency, and logic of the costing procedures;

the composition and allocation of material charges; and the manner in which payments

are made.

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b. The distribution of material charges to contracts, accounts, projects, or work

orders offers various opportunities for misrepresentation of material costs. Fraud cases

have included the following examples: altered vendor invoices, duplicate claims for

material on public vouchers and progress payments, fraudulent billings from dummy

companies, related party transactions, kickback arrangements, claims for materials not

received, claims for materials not required by the contract, and claiming material cost

applicable to other contracts because of funding limitations. Suspicions of these or

similar practices should be considered for possible reporting under 4-700.

6-305.1 Audit Objectives **

The basic audit objectives for accounting for material costs are to gain an

understanding of the contractor's policies, procedures, and internal controls and

determine if the proposed costs comply with contract terms, including the allowability,

allocability, and reasonableness of material and purchased service related costs.

These objectives include satisfying applicable portions of real-time audit of purchase

existence/consumption.

6-305.2 Internal Control **

The auditor’s understanding of the contractor's material management and

accounting system’s compliance with DFARS 252.242-7004, CAS 411, and FAR

31.205-26 will influence the nature, timing, and extent of testing to be performed. For

example, when standard costs are used, we should gain an understanding and have the

contractor perform a walk-though to determine whether there is consistency in

establishing the standards and in applying the variances. The contractor may be

experiencing a high loss factor and significant material price fluctuations in processing

materials for commercial production, while losses and fluctuations for the Government

operation are negligible. In this situation, the contractor should be adjusting the

standard material variance for the high losses and price fluctuations before the

variances are applied to the Government production. As an alternative, a separate

material variance factor could be established for application to Government production.

6-305.3 Audit Guidelines **

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Auditors should consider the guidelines below during annual program planning or

while formulating an audit program for evaluating the accounting for material costs.

a. Real-time Testing of Purchase Existence and Consumption: For major and

non-major contractors, auditors should consider whether real-time testing of purchase

existence and consumption is appropriate based on the assessed level of risk. In

effectively planning the audit, auditors may consider the following risk factors to assist in

their determination:

• materiality,

• significant findings from previous years,

• Department (e.g., DCMA, DCAA, or PCO) concerns,

• determined to have an unacceptable accounting system,

• significant business system deficiencies,

• significant accounting system changes, and

• significant organizational changes.

Additionally, auditors should also consider planned or scheduled audits from the

Agency Risk-Based Sampling of Incurred Cost Proposals when developing a plan (see

6-104). For example, incurred cost proposals with sampling ADV of $100 million to

$250 million must be audited every 5th year. Based on this requirement, the audit team

may consider conducting a real-time testing of purchase existence and consumption

audit during the same year of a scheduled incurred costs audit.

(1) The auditor should assess the risk that certain significant direct material

costs recorded to a particular contract did not benefit that contract. The risk of

inappropriate direct material charging is greater when a contract receives direct material

costs under unusual circumstances (e.g., transfer from a commercial contract; recording

occurs well after assembly, etc.). Contractors often summarize and report unusual

transactions through adjusting journal entries and/or exception reports. Therefore, the

auditor should evaluate adjusting journal entries and exception reports related to

material purchases to identify adjustments and/or exceptions that require further audit

analysis and/or explanation . Direct material transfers from one contract to another are

sometimes necessary to satisfy unplanned changes to contract material requirements.

However, audit attention to transfers and other unusual transactions permit the auditor

to apply efficient testing based on increased risk.

(2) After risk determination is made, if the auditor determines that real-time

testing is necessary, the testing should be performed on the fiscal year the costs were

incurred to test that the materials were in fact received and, if applicable, used on the

contract charged. If purchased services are significant, or of a sensitive nature, the

audit should also consider an evaluation of these services to ensure they were

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performed or are being performed. The extent of testing is based on audit risk and

auditor’s judgement (e.g., whether testing should be performed periodically over the

contractor’s fiscal year or at a single point in time). Auditors should ensure the nature,

extent and timing of testing addresses the documented risk. Ascertain whether the

material was:

• needed for the contract;

• purchased in reasonable quantity;

• purchased at a prudent price;

• used on the contract; and

• properly accounted for as to initial charge, transfer in or out, and

residual value.

If during the performance of the real-time testing, the auditor finds that

selected material parts are not located at the contractor’s facilities (e.g., the parts were

shipped to an off-site location or directly to a subcontractor), the auditor needs to

perform sufficient follow-up effort to verify the existence of the material parts and not

automatically substitute other parts for them. Similarly, if selected purchased services

are not being performed at the primary contractor’s location, sufficient follow-up effort is

required to verify the services are being performed. Follow-up effort could include:

• Requesting confirmation of the existence of selected material parts

and/or the performance of purchased services from the cognizant

offsite auditors;

• Reviewing shipping/receiving documents; and/or

• Making inquiries to contractor and/or Government representatives.

(3) Physical observations and other steps needed to gain evidence of proper

usage of material and services purchased may be done as part of an audit covered in

6-306 or 6-313 below.

(4) Appraise the adequacy and usefulness of the stock records used to

provide information on the location, nomenclature, and quantities of items in inventory.

Also, determine whether any inventory algorithms used are based on valid and current

data.

(5) Miscellaneous costs associated with material purchases charged directly

or as items of indirect costs, such as transportation and material handling charges

should be evaluated. In verifying these costs, determine whether the accounting

treatment is reasonable and consistent. Circumstances requiring special attention are:

(a) The contractor may charge transportation on material purchased for

Government contracts as direct contract cost, and the transportation on material

purchased for commercial work to overhead. In this case, the Government will absorb

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excessive costs if the commercial transportation costs are not eliminated from

overhead.

(b) Contractors may add material handling charges to the cost of materials

by applying a percentage factor to the invoice cost. When the factor is arbitrarily

determined without specific identification of the costs in the records or without

eliminating such costs from the overhead, question the costs for the appropriate reason,

(e.g., for lack of records or for duplication of costs). When handling costs are computed

on a recognized and acceptable accounting basis (such as when a separate pool is

maintained for expenses of this nature and the allocation is made on an appropriate

basis), then the additional charge for material handling may be accepted by the auditor

subject to the test of reasonableness. The auditor's evaluation of material handling

costs should determine the reasonableness of the costs and whether they represent

specifically identifiable items which are not included in any allocable indirect cost pool.

(6) Materials fraud is often perpetrated by charging inflated material prices to

the Government based on fictitious or dummy company invoices. A common method

used to make improper charges to flexibly priced contracts is to change the account

number to which a vendor invoice is charged. Accordingly, be alert for accounting

miscommunication intended to conceal the true purpose of an expenditure. Also,

consider applying data analytics techniques to reveal these types of inconsistencies.

(7) MEMORANDUM FOR RECORD should be issued to close a real-time

testing of purchase existence and consumption assignment that supports the incurred

cost audit for a contractor's fiscal year. The results of real-time testing will be

incorporated to the final incurred cost report. However, if significant business system

deficiencies are found, auditors should prepare a DFARS business system deficiency

report (see 5-110 and 10-200). Auditors may also become aware of conditions which

may indicate fraudulent or other suspected irregular activities as defined in 4-702.1b.

Promptly report these as described in 4-702.4.

b. Procedures when real-time testing was performed: Real-time testing can be

accomplished only during the contractor fiscal year to which they apply. The audit team

should review and incorporate the results as part of their post year-end audit

procedures. The audit team should appropriately design and perform sufficient testing

to address any significant deficiencies noted during performance of the real-time audit.

Auditor’s judgment should be used to determine if the combination of evidence gathered

is sufficient and appropriate to support an opinion or if additional procedures are

required.

c. Procedures when testing of purchase existence and consumption were not

completed in a real-time basis: The audit team should, as part of their post year-end

audit procedures:

(1) Ensure alternate procedures are performed to satisfy the overall audit

objectives. For example, auditors can satisfy testing of purchase existence and

consumption, by performing transaction testing on purchased materials and services;

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i.e., tracing a sample of material transactions from the contractor’s cost ledger to the

source documentation to verify the materials were used and costs charged to the

correct contract.

(2) Consider such things as audit risk, significance of claimed material costs,

contract mix, and the sufficiency and appropriateness of evidence gathered in

determining the overall opinion.

(3) Use professional judgment to determine what procedures are needed to

express an opinion and document the sufficiency of the evidence.

(4) If the alternate procedures do not provide sufficient appropriate evidential

matter, the audit team may not be able to opine on the direct purchased materials and

services cost element resulting in a qualified or overall disclaimed opinion.

(5) If the audit team determines that they have to disclaim an opinion, they

should report only significant noncompliances that can be supported by sufficient

appropriate audit evidence in the appendix (i.e., Other Matters to be Reported).

d. Payment for Materials:

Testing to payments for material costs should include gaining an understanding of

the internal control activities and the testing and verification of the invoice processing

and payment functions, which may be accomplished during a walk-through. An

evaluation of material payments should also verify that the distribution of costs to cost

objectives is consistent with payments. In some automated systems, the distribution of

costs may be separate from payment allowing the possibility of billing material to

Government contracts before the contractor actually makes payment for the materials.

The auditor may consider evaluating the aging of the payables when performing real

time auditing to determine whether there is a large amount of materials or services not

paid for but billed on contracts. Conversely, ensure that the contractor is not paying for

material (e.g., to take advantage of discounts) unless it has proper proof of receipt (see

6-312). In the event the contractor pays the vendor, but does not make the payment in

a timely manner, the contractor is still entitled to reimbursement of the costs.

e. Material Transfers Between Contracts:

(1) Material may be transferred at actual cost or standard cost or according to

some other generally accepted inventory costing method as long as it is consistently

applied, is equitable, and is based on unbiased logic (see FAR 31.205-26 and DFARS

252.242-7004(d)(7) if applicable). As to indirect costs allocable to the prime costs, CAS

410.50(i) provides the proper accounting for allocating G&A costs and for transfers. In

general, material transfers should be priced using the G&A (or overhead) rate derived

when the material was purchased/manufactured. The auditor should ascertain

compliance with these standards.

(2) Normally a transfer of parts will also mean that the related cost is transferred

within the same billing period. However, in some limited circumstances it may not be

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appropriate to transfer parts and associated costs within the same billing period. In

these cases, use of a "loan/pay back" technique must be approved by the ACO (DFARS

252.242-7004(d)(7)(iii)). The loan/payback technique is the movement of materials from

one contract to another contract that has a more pressing production requirement

without a transfer of cost because the contractor plans to pay back the materials once

additional parts are received. When the technique is used, there must be controls to

ensure that:

(a) parts are paid back expeditiously,

(b) procedures and controls are in place to correct any overbilling that might

occur,

are identified monthly, and

(d) the cost of the replacement part is charged to the borrowing contract.

(3) When a loan/pay back transfer is made, the audit concerns are that:

(a) borrowed parts are not paid back on a timely basis or never paid back,

(b) progress and/or final payments are received by the contractor for the

same part on more than one cost objective resulting in double billings,

borrowing contract, or when the parts were borrowed and/or paid back, and

(d) the borrowing contract was not charged for the cost of the replacement

parts. Perform appropriate tests to ensure loan/pay backs have been treated properly.

6-306 Physical Inventories and Adjustments **

a. Fundamental to the viability of any inventory control system is a requirement that

recorded inventory accurately reflects actual, physical inventory. The contractor,

therefore, must establish and maintain adequate controls to ensure acceptable levels of

record accuracy if applicable (DFARS 252.242-7004(d)(5)). Contractors' procedures to

verify the quantities and dollar value of physical inventories may include test counts of

inventories on hand, comparison of the actual count with the quantity reflected in the

inventory control records, appropriate adjustments for differences between book

inventory and the physical count, and verification that inventory pricing factors are

determined on an acceptable basis.

b. The Government has an interest in contractors' effective utilization of inventories.

Effective utilization of inventories requires that the investment be kept to a minimum and

that management knows the quantities, quality, and location of goods on hand.

c. The Government is also interested in whether the contractor makes an adequate

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investigation of inventory adjustments and whether losses are acceptable as reasonable

costs on Government contracts. Adjustments of losses and overages and deterioration

of inventory items may indicate inadequate inventory control and storage procedures.

Adjustments of items that are surplus or obsolete may indicate the contractor is

purchasing excessive quantities.

d. Some contractors' policies, procedures, and practices result in a lack of perpetual

inventory records once materials have been physically issued to work-in-process. In

these cases, the shop control function must maintain adequate records to manage and

account for issued inventory. Specific attention should therefore be given to the

procedures governing perpetual inventory records (see 6-313).

6-306.1 Audit Objectives **

The audit objectives relating to physical inventories are primarily performed

during a business system audit to determine compliance with DFARS 252.242-7004,

which include:

(1) gaining an understanding and walk-through of the contractor's policies,

procedures, and internal controls relating to physical inventories,

(2) determining whether differences between the physical count and book

inventories are accounted for and adequately explained,

(3) determining if total inventory value represents correct quantities

appropriately priced, and

(4) determining if inventory levels indicate a balanced stockage position.

6-306.2 Internal Control **

The auditor should gain an understanding of the internal controls related to the

dollar value and physical quantities of the inventory in order to properly design the

testing and verification to be performed. Insufficient internal controls may result in

excessive charges to Government contracts and the use of erroneous cost data by

management.

6-306.3 Audit Guidelines **

a. When it is anticipated that the dollar value of the physical inventory

adjustments will have a significant effect on Government contract prices, the auditor

may consider arranging to observe the taking of the inventory. This should include an

evaluation of the planning and the adjustment phase which follows and an evaluation of

the journal entries adjusting the book inventory to physical inventory. If applicable, the

auditor should consider relying on the work performed by external auditors (see 4-

1000).

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b. In developing the audit procedures, consider the following steps:

(1) Evaluate and test the contractor's procedures for establishing an inventory

cut-off for inventory in transit during the inventory-taking period to preclude improper

treatment of items in transit.

(2) Evaluate the manner in which the physical inventory is reconciled with the

book inventory. This audit should include an evaluation of the inventory adjustments

and the contractor's investigation of the reasons for the adjustments. It also should

determine whether necessary adjustments are acceptable as reasonable costs on

Government contracts and whether they result from insufficient internal controls.

Adjustments of losses and overages, and deterioration of inventory, may indicate

insufficient control and storage procedures. Adjustments of items that are surplus or

obsolete may indicate:

(a) the purchase of excessive quantities,

(b) insufficient control of change orders,

(d) another significant cost management problem.

Such matters may need to be checked further in another audit.

(3) Test and evaluate the contractor's records supporting the physical

inventory and test areas such as the pricing and the arithmetical accuracy of the

computations. A large number of material expediters, substantial excess inventory, and

frequent shortages of material to satisfy production needs may indicate that the formal

system is not providing accurate information regarding what materials are needed,

when materials are needed, and/or what materials are already available in inventory.

(4) Determine whether the contractor segregated any inventory adjustments

resulting from price fluctuations due to market conditions.

(5) Determine whether inventory adjustments relate to the performance period

of the contracts under audit.

(6) Ensure that the contractor has sufficient controls over physically

commingled inventories to allow proper charging to contracts.

c. Additional guidance on material handling can be found in 6-313.

6-307 Spoilage, Excess Scrap, and Obsolete

Material **

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This paragraph presents audit guidance applicable to scrap, and to spoiled, excess,

and obsolete materials.

6-307.1 Audit Objectives **

The audit objectives are to determine whether:

(1) the scrap, spoiled, excess, and obsolete material generated is reasonable

in amount;

(2) the physical property is adequately safeguarded;

(3) the price received through sale or other disposal is equitable; and

(4) the receipts from the sale or other disposal are reasonable and properly

credited.

6-307.2 Audit Guidelines-Scrap and Spoilage **

There are various methods for accounting for costs of scrap and spoilage. The

auditor should review the contractor’s disclosure statement, if applicable, to determine

the method used to account for scrap and spoilage. The method which should be used

depends in part on the type of plant operation. Costs may be charged as overhead, as

a variance to be applied to the material costs, as loading factors to material costs, or

direct to a specific contract. When scrap and spoilage costs are associated with

material costs, they may be commingled with the regular material costs or may be

identified separately. The audit considerations listed below should be included in the

audit program for audit of this area:

a. When practicable, scrap and spoiled items resulting from the performance of

Government contracts should be segregated physically from scrap and spoiled items

resulting from commercial contracts and should be accounted for separately. The

auditor should observe the contractor's stock of scrap and determine the cause for any

large quantities of scrapped or spoiled items. Particularly be alert to the possibility that

the cause of such scrap may be capital equipment that is faulty or inadequate for its

current use.

b. When scrap and spoilage costs have been charged direct to contracts,

proceeds from the sale of the material as scrap should be credited to the appropriate

Government contract.

c. The contractor may maintain statistical records to accumulate scrap and

spoilage cost data when these costs are not separately identified in the accounting

records. These statistical records should be evaluated for completeness and reliability.

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d. When scrap and spoilage costs are not separately identified, or are not

separately accounted for in the records, the total proceeds from sales should be

allocated in an equitable manner.

e. When the auditor's evaluation indicates that the contractor has incurred

excessive scrap or spoilage costs or there is an apparent misuse of Government

material, the auditor should consider requesting the services of a qualified Government

representative to assist in determining the reasonableness of cost. Also be alert to

instances of scrap caused by failure of the production unit to promptly receive and

implement engineering changes in the product or failure to suspend production of

deficient items pending resolution of the problems involved.

6-307.3 Audit Guidelines-Excess and Obsolete Materials **

a. Excess or obsolete items may be from purchased material or parts, or

manufactured parts. Gain an understanding of the contractor's policy for recording and

recovering obsolescence costs and evaluate the causes that generated the obsolete

items. In addition, be alert to those situations in which the contractor:

(1) is reimbursed for the cost of obsolete items but subsequently sells them to

a subsidiary or affiliate at significantly reduced prices,

(2) uses the items as a no-cost component on the contractor's commercial

work or in performing a firm-fixed-price or incentive contract for the Government, or

(3) scraps items and then buys similar items from surplus or salvage dealers.

Practices of this nature should be reported to the contracting officer and should also be

considered for possible reporting under 4-700 or 4-800.

b. Gain an understanding of the contractor's procedures and practices for using

or disposing of excess or obsolete items, including:

(1) Screening procedures adopted in order to determine whether parts

produced under, but no longer needed for, a particular contract can be used on other

contracts. These items should be transferred for use without charge to the

Government.

(2) Procedures for obtaining the highest possible prices on items sold or

scrapped.

(3) Procedures for ensuring that the Government receives proper credit for

proceeds of items sold or scrapped. Related adjusting entries should be evaluated for

appropriateness (6-305.3).

6-308 Determination of Material Requirements **

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The decision to purchase a standard item, the quantity required, and the timing of

the delivery usually are the responsibility of such departments or functions as planning

and production control, engineering, storeroom, and office services. Deciding to buy

nonstandard items is frequently delegated to a make or buy committee or a similar

group.

6-308.1 Audit Objectives **

a. The audit objectives of this area are to gain an understanding of the extent of

coordination between the purchasing function and the departments responsible for

determining requirements. Effective coordination may have a significant impact on

purchasing economies and production efficiencies and in turn may affect the ultimate

cost to the Government. The quality, quantity, and delivery date of materials to be

purchased may be based on information generated by:

(1) stock level requirements established for standard items,

(2) bills of material coordinated with production schedules, and

(3) individual purchase requests from departments authorized to requisition

material.

b. The need for special tooling or special test equipment is generally established

at the proposal or negotiation stage (9-605.2). These special items, which are not part

of the deliverable end product under the contract, must comply with the definitions in

FAR 2.101b, and the FAR requirements for approval, control, accountability, use, and

disposition (see Selected Areas of Cost Guidebooks, Chapter 9 and 14-400).

6-308.2 Internal Control **

The material purchases by the contractor's buyers should be based on requests

received from departments responsible for material requirements. Gain an

understanding of the internal control system should be made to determine whether all

purchase actions are in response to need, supported by properly initiated and approved

requisitions, and accomplished in a timely and effective manner

6-308.3 Audit Guidelines **

Of particular concern here are:

• claimed costs not properly traceable to source documents;

• excess material costs being charged to Government contracts;

• no audit trail supporting "no cost" transfers of material;

• loans of materials to other contracts outstanding for an excessive time

period; and

• inaccurate material records (see 6-306).

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Accordingly, gain an understanding of the purchasing and requisitioning functions

to include, but not be limited to:

(1) Buying practices to determine whether a pattern of rush, emergency, or

premature buying exists which may have resulted in;

(a) increased purchase prices,

(b) excessive use of uneconomical transportation,

(d) excessive obsolescence as a result of subsequent changes, or

(e) premature billing of material costs.

(2) The follow-up procedures used by the purchasing department to ensure

timely deliveries.

(3) Modifications to purchase orders to determine if changes in specifications

and quantities have resulted in obsolescence or increased costs and to determine

whether changes were due to poor planning and lack of coordination, the untimely

processing of purchase orders, or other causes that could have been avoided by better

management practices.

(4) Significant increases in material costs charged to Government contracts to

determine if increases were due to year-end inventory write-downs and whether write-

downs resulted from inefficient requisition procedures and purchasing operations.

(5) Coordination procedures when there are indications of repeated

requisitioning of small quantities of the same item with substantial increase in costs to

Government contracts.

(6) Controls that prevent requisitioning materials in excessive quantities or

premature charging to Government contracts, resulting in unnecessary material costs

and in increased storage and material handling charges to the Government.

(7) Trends in transfers from one type of contract to another or significant

increases in cost transfers from one month to another that might indicate system control

problems.

6-309 Make or Buy Decisions – Incurred Material

Costs and Purchased Services **

The contractor's make or buy decisions determine which components, assemblies,

subassemblies, or parts are to be manufactured and which are to be purchased. These

determinations affect contract prices, contract performance, and adherence to

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Government procurement policies. When make-or-buy programs are required, the

Government may reserve the right to review and agree on the contractor’s make-or-buy

program when necessary to ensure negotiation of reasonable contract prices,

satisfactory performance, or implementation of socioeconomic policies.

DCMA is the agency responsible for evaluating the contractor’s purchasing system

and determining if the contractor complied with the DFARS purchasing system criteria.

DFARS 252.244-7001(c)(6) requires the contractor to, “Apply a consistent make-or-buy

policy that is in the best interest of the Government.” The auditor should contact DCMA

to determine if a Contractor Purchasing System Report (CPSR) has been performed.

6-309.1 Audit Objectives **

The objectives when auditing this area are to determine whether make or buy

decisions:

(1) are reasonable in concept,

(2) are applied effectively,

(3) are in compliance with FAR 15.407-2, and

(4) generally result in the lowest cost to the Government.

6-309.2 Internal Control **

The contractor is responsible for its make or buy program. The decisions made

by the contractor should generally result in the lowest cost to the Government. The

guidance in 14-600 on economy and efficiency audits of capital investments is

applicable in the audit of make or buy determinations.

6-309.3 Audit Guidelines **

a. FAR 15.407-2 generally requires contractors to submit make or buy programs

for negotiated acquisitions requiring certified cost or pricing data with an estimated

value of $13.5 million or more (see exception at FAR 15.407-2(c)). It also allows, for

monitoring purposes, the incorporation of the program in negotiated cost-reimbursable

contracts, some cost sharing contracts and major systems contracts and subcontracts

for monitoring purposes. The contract clause at FAR 52.215-9 requires notification of

any changes in the program as incorporated in the contract. Alternates 1 and 2 require

adjustment of incentive fees if during performance the contractor reverses a make or

buy categorization which initially was economically detrimental to the Government.

Determine the effect of and compliance with any agreements resulting from these

requirements.

b. The contractor has the basic responsibility for make-or-buy decisions.

Therefore, its recommendations should be accepted unless they are inconsistent with

Government interests or policy. Evaluate the contractor's decisions in the make or buy

area which may have been motivated by considerations other than economies or

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efficiencies for the Government operation. For example, the contractor may desire to

gain experience in a particular manufacturing or fabricating process. Another

consideration which may influence a contractor's make or buy decisions involves the

extent of available idle facilities. The contractor's decision to manufacture in lieu of

purchase may be in the best interests of the company, but not in the best interests of

the Government. When a contractor decides to manufacture a part or component not

normally within its experience or production capabilities or which had been purchased in

the past, determine whether the decision results in additional costs to the Government.

6-310 Purchasing and Subcontracting **

a. The purchasing and subcontracting function includes make or buy decisions

(6-309), the selection of vendors, analysis of quoted prices, negotiation of prices with

vendors, placing and administration of orders, and expediting delivery of materials.

b. When DCAA business system audits are performed at a contractor location, the

auditor will make maximum use of the work performed and the conclusions reached

during these audits in establishing the extent of any separate coverage and audit tests

to be undertaken in this area. In addition, the auditor and the cognizant Government

procurement office have related responsibilities regarding purchasing and

subcontracting. DCMA is the responsible agency for performing Contractor Purchasing

System Reviews (CPSR). Refer to Appendix B for using the work of a specialist.

6-310.1 Audit Objectives **

The audit objectives of this area are to determine whether the proposed

subcontract amounts on unsettled flexibly priced contracts comply, in all material

respects, with contract terms pertaining to accumulating and billing incurred amounts.

Compliance with contract terms includes the allowability, allocability, and

reasonableness of costs charged to the contract. This includes determining whether the

contractor: made reasonable make or buy decisions (see 6-309); ensures the purchase

of only properly determined requirements (see 6-306); obtained maximum competition;

made a proper analysis of quoted prices; made a reasonable attempt to negotiate with

the vendors; had a reasonable basis for vendor selection; has internal controls over

placement and administration of orders; and is expediting delivery of materials where

appropriate

6-310.2 Internal Control **

The contractor should have a sufficient internal control system for purchasing

and subcontracting activities. At as a minimum, the contractor should have effective

management policies, implemented by written procedures which will allow the

contractor to ensure compliance with contract terms and control the level of costs. The

prime contractor should have controls in place to ensure all costs billed to the

Government under flexibly priced contracts are compliant with FAR 31.2 since this is a

requirement under the contract clause FAR 52.216-7, Allowable Cost and Payment.

Therefore, the prime contractor is responsible for ensuring the subcontract costs billed

to the Government are allowable, allocable, reasonable and compliant with contract

terms. This clause also requires the prime contractor to settle its subcontractors’

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indirect rates and costs before submitting the final voucher to the Government. When

the subcontractor has not submitted an incurred cost proposal, the prime contractor is

still responsible for ensuring the costs billed by the subcontractor are compliant with

FAR 31.2. Effective internal controls require that the most recent policies and

procedures related to the purchasing and subcontracting function be made available to

all personnel concerned. All purchasing department personnel should understand their

assigned responsibilities, authority, and limitations.

6-310.3 Audit Guidelines-Basic Procedures **

In formulating audit procedures for evaluating purchasing and subcontracting,

consider the contractor’s internal control structure. The auditor should gain a thorough

understanding of the contractor’s subcontract award and management practices that

were in place during the contractor’s fiscal year under audit. The understanding of the

contractor’s internal controls over purchasing and subcontracting will be useful to design

appropriate audit procedures. The nature, timing and extent of the testing is a matter of

auditor judgment. When material costs are significant, the auditor should consider the

following when designing the substantive testing:

a. Testing Methods. The auditor should consider testing:

(1) large purchases;

(2) sensitive purchases, such as scarce materials, sole-source items, or

purchases from vendors suspected of improper selection;

(3) related party transactions; and

(4) other items on a selective basis, using the most practical selection

methods available in the circumstances. For example, stratify or group the purchases

to be audited in some meaningful way, such as dollar amounts, buyers, contracts, types

of material, products, departments, vendors, or a combination of these factors.

b. Administration of Subcontracts. The prime contractor is responsible for

managing contract performance, including planning, placing, and administering

subcontracts as necessary to ensure the lowest overall cost and technical risk to the

Government. The auditor should gain a thorough understanding of the prime

contractor’s subcontract management process and determine whether the contractor

ensured subcontractor capability and contract compliance by reviewing their policies

concerning on-going monitoring and well documented subcontract files. This can be

accomplished by, but not limited to the following practices:

(1) request the contractor to provide a written description of the organizational

structure identifying the duties and responsibilities of the employees involved in

subcontract administration;

(2) review policies and procedures related to managing subcontracts;

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(3) review contract clauses for any relevant prime and subcontract

requirements. Determine if there are flow-down clauses that require: Government or

contractor access to the subcontractor's books and records; billings only include

allowable costs; and the subcontractor entity to submit an annual incurred cost

proposal; and

(4) review relevant subcontractor data obtained by the upper-tier contractor

(i.e., accounting system information, provisional rates, incurred cost proposal if

available).

c. Testing of subcontract costs. Based on the risk assessment and the auditor’s

understanding of the contractor's subcontract management process, the auditor should

consider testing selected subcontract costs to determine if the costs are allowable,

allocable, reasonable and compliant with contract terms.

(1) Allowability: FAR 31.201-2(d) makes it clear the prime contractor must

maintain records that adequately demonstrate the proposed costs are allowable. This

requirement also applies to subcontract costs. The prime auditor should request

documentation of any reviews performed by the prime contractor for compliance with

FAR 31.2, and should determine which contract terms to test for compliance based on

the risk assessment. The prime auditor should also ensure the subcontract terms are

consistent with the prime contract terms. Compliance with the terms of the contract is a

requirement for allowability (FAR 31.201-2(a)(4)). For significant subcontract costs that

are high risk for noncompliance with FAR 31.205 cost principles, the auditor should

consider requesting an assist audit.

(2) Allocability: The prime contractor must adequately demonstrate with

documentation that the proposed costs are allocable to the contract. FAR 31.201-2(d)

states, “A contractor is responsible for accounting for costs appropriately and for

maintaining records, including supporting documentation, adequate to demonstrate that

costs claimed have been incurred, are allocable to the contract, and comply with

applicable cost principles in this subpart and agency supplements.” Some possible audit

steps the prime auditor could perform to test for allocability could include:

• Compare product/service with subcontract statement of work (SOW)

• Compare subcontract SOW with prime contract SOW

• Examine engineering drawings

• Obtain technical assistance

• Perform physical examination of the product

• Review the subcontract invoice, purchase order, and receiving

documents for contract number, quantity, etc.

(3) Reasonableness: The prime auditor may begin the evaluation of

reasonableness by requesting how the prime contractor determined price

reasonableness and obtain the related supporting documentation. Under

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FAR 31.201-3, Reasonableness, the prime contractor is ultimately responsible for

demonstrating the costs are reasonable. Also, FAR 31.201-3(a) makes it clear that

there is no presumption of reasonableness only because the costs were incurred. The

contractor must demonstrate the proposed subcontract costs are reasonable. When

subcontracts are awarded on a competitive basis, in most cases the subcontract costs

would be considered reasonable. However, modifications to the subcontract above the

original subcontract amount would not be considered competitive, and therefore, should

be further evaluated for reasonableness. Some steps the auditor could perform to test

reasonableness include:

• Examining any files supporting the contractor’s assertion of

reasonableness;

• Evaluating the upper-tier contractor's subcontract files to ensure that all

required certified subcontract cost or pricing data was obtained;

• Evaluating the adequacy of the contractor’s cost/price analysis;

• Reviewing the contractor’s make-buy documentation;

• Examining files documenting competitively awarded subcontracts,

including the rationale for selecting the subcontractor;

• Performing market research; or

• Comparing subcontract items to the price of similar items.

Although it is the prime contractor’s responsibility to manage its subcontracts,

we should not question all the proposed subcontract costs due to the prime contractor’s

ineffective subcontract management process. If the contractor does not have sufficient

controls over its significant subcontracts, the auditor should consider whether a

business system deficiency report should be issued after considering the size and

complexity of the contractor. The auditor should also consider performing alternate

procedures to examine the proposed subcontract costs and test for compliance with

FAR based on the disclosed risks.

d. Sufficient Competition. Consider the elements of FAR 15.403-1(c)(1) and

review the procurement files that support adequate price competition when evaluating

whether there were bid solicitations from a sufficient number of prospective sources to

promote effective competition commensurate with the nature and dollar value of the

purchase action. When the lowest cost subcontractor is not selected, the prime

contractor should have adequate documentation to support the selection decision. The

auditor should also be alert to competition involving related parties. Related party

transactions minimize the effect of competition and inherently involve higher levels of

risk to the Government.

e. Basis for Selection. Factors to be considered when evaluating purchases

involving noncompetitive items are whether:

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(1) the vendor was designated by the contracting officer who awarded the

prime contract and

(2) the purchase, if made from a sole source supplier, was approved by a

responsible company official.

f. Negotiation. The auditor should consider performing the following based on

the risk assessment:

(1) identify those awards made to other than the low bidder and determine

whether the purchase files reflect the justification for the rejection of the low bidder and

the basis for the selection,

(2) ascertain if the contract files contain sufficient evidence of negotiation

when it is necessary to establish a reasonable price because the item is nonstandard or

an insufficient number of bids have been received,

(3) determine the extent of the audit given the supporting data submitted by

the prospective vendor,

(4) ascertain if the type of subcontract issued meets the requirements of

FAR Part 16 and includes all clauses required by the prime contract,

(5) determine if awards have been made to other than the low bidder on the

basis of delivery, the purchase order should provide for a downward price adjustment if

delivery schedules are not met, and

(6) determine if there is sufficient justification for awarding inter-organizational

transfers (see 6-314).

g. Unallowable Procurement. Determine whether the contractor issued any cost-

plus-a-percentage-of-cost subcontracts (FAR 44.203(b)(2)). Under this type of

procurement, the subcontractor would receive payment for, and the prime contractor

would pass on to the Government as cost of its contract, the costs incurred in

performing the contract, plus a specified percentage of such costs as a profit or fee.

Thus, the fee would increase in direct proportion to any increase in cost.

h. Subcontract Changes. The Contractor shall notify the contracting officer

reasonably in advance of placing any subcontract modification for which consent is

required under FAR 52.244-2(e)(1). The auditor should determine whether the upper-

tier contractor expedites delivery where appropriate, and meets the FAR requirements

for change orders, modification notices, and overall costs.

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In evaluating subcontract changes which affect cost or price, consider:

(1) reasons for the change,

(2) reasonableness of the adjustments to the subcontract price or cost,

(3) complexity or risk involved, and

(4) reasonableness of profit or fee adjustment compared to the estimated cost

of the change.

When the cost of the subcontract before the change exceeded or is expected to

exceed original estimates, be alert to changes which have been overpriced to avoid an

overall loss or to provide total profit or fee in accordance with original contract

estimates.

i. Repricing. The auditor should determine whether:

(1) the contractor’s policies and procedures require documentation justifying

reasons for subcontract changes which affect cost or price;

(2) revised contract prices are negotiated or arrived at as provided by

contractual requirements;

(3) certified cost or pricing data which was used as the basis for repricing is

accurate, complete, and current; and

(4) results of the repricing action are in the best interests of the Government.

j. Purchases from Debarred Companies. Debarred or suspended contractors are

excluded from receiving contracts; and agencies shall not solicit offers from, award

contracts to, or consent to subcontract with these contractors, unless the acquiring

agency's head or a designee determines that there is a compelling reason for such

action, as explained in FAR 9.405-2, 9.406-1(c) and 9.407-1(d). An important criterion

in determining the propriety and allowability of payments for material purchases or

subcontracts is the "consent" requirement of specific contracts. FAR 52.244-2 through

52.244-5 are the pertinent solicitation provisions and contract clauses which, if included

in a contract, delineate the "consent" requirements by types and categories of contracts.

If by the terms of the contract, prior consent is required of the ACO in

subcontracting/purchasing, the ACO is prohibited from consenting to award to a

debarred contractor. "Consent" here means to consent to contract with a particular

entity or person; not consent to make a purchase. If prior consent is not required or if it

is required for approval to make purchases only, a prime contractor is free to solicit from

any sources available, including debarred, suspended, or ineligible contractors.

When the prime contractor has failed to comply with the "consent" requirements

of a contract, consult with the contractor to determine if any additional data exists to

preclude the suspension of costs. If the contractor cannot provide an adequate

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explanation or documentary support for audit approval of payments on public vouchers,

the situation should be brought to the attention of the contracting officer and the auditor

should consider whether costs should be suspended.

6-311 Excessive Pass-Through Charges **

6-311.1 General **

a. FAR 15.408(n) requires the Contracting Officer to include FAR 52.215-22

(Limitation on Pass-Through Charges - Identification of Subcontract Effort) and FAR

52.215-23 (Limitations on Pass-Through Charges) in solicitations and contracts as

follows:

(1) For DoD when the total estimated contract or order value exceeds the

threshold for obtaining certified cost or pricing data and the expected contract type is

any contract type except-

(a). Fixed-price with economic price adjustment, Firm-fixed-price or fixed-

price incentive contract awarded on the basis of adequate price competition;

(b). Fixed-price with economic price adjustment, Firm-fixed-price or fixed-

price incentive contract for the acquisition of a commercial item.

(2) For civilian agencies when the estimated contract or order value exceeds

the simplified acquisition threshold and the contemplated contract type is expected to be

cost-reimbursement type.

b. FAR 52.215-22 (Limitation on Pass-Through Charges—Identification of

Subcontract Effort) requires contractors to identify in its proposals the total cost of work

to be performed by the offeror, and by each subcontractor. When more than 70 percent

of the total cost of the work to be performed is subcontracted, this clause requires the

contractor to (1) identify its indirect costs and profit/fee applicable to the work to be

performed by the subcontractor, and (2) provide a description of the “added value” it will

provide related to the work performed by the subcontractor(s).

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c. FAR 52.215-23 (Limitation on Pass-Through Charges) defines “added value”

to be subcontract management functions (either direct or indirect) that are a benefit to

the Government (e.g. processing orders of part or services, maintaining inventory,

reducing delivery lead times, managing multiple sources for contract requirements,

coordinating deliveries, performing quality assurance functions, etc.). An “excessive

pass-through charge” includes only indirect costs and profit applicable to the

subcontracted work where the upper tier contractor does not provide added value. The

clause also stipulates that the Government will not pay indirect costs or profit/fee to a

higher tier contractor on work performed by a lower-tier subcontractor unless the higher

tier contractor provides sufficient evidence that it “adds value”.

d. If the amount of subcontract or lower-tier effort is changed after contract award

such that it exceeds 70 percent of the total cost of work under a covered contract or

subcontract, FAR 52.215-23(c) requires reporting of performance of work by the

contractor or a subcontractor. The contractor shall notify the contracting officer in

writing if it changes the amount of subcontract or the subcontract changes the amount

of the lower-tier subcontract and this exceeds 70 percent of the total cost of work to be

performed under the contract, task order, or delivery order. The Contractor should also

include support to demonstrate that the contractor or subcontractor (in the case of

lower-tier subcontract) will provide added value to the contract.

e. The audit team should notify the contracting officer if they find through the

audit procedures that the contractor failed to comply with the requirements of FAR

52.215-23(c) and consider an accounting and/or purchasing system deficiency.

f. These FAR provisions create an allowability issue on excessive pass-through

costs, not an allocability issue. The excessive pass-through costs are still allocable to a

contract, but will not be paid by the Government (i.e., unallowable) if the contracting

officer determines the contractor does not provide “added value” to the subcontracted

portion of the work. FAR 31.203(i) states indirect costs that meet the definition of

“excessive pass-through charges” in FAR 52.215-23, are unallowable. The intent of the

clause is to minimize excessive pass-through charges by contractors (or lower-tier

subcontractors) that add no or negligible value to the subcontracted work.

g. FAR 52.215-23 is a mandatory flow down clause to all subcontract tiers.

However, in the evaluation the auditor need only review the subcontract value at its first

lower-tier level. The auditor should coordinate with the lower tier auditor if the auditor

believes there is risk of excessive pass through costs at the lower tier contractor.

6-311.2 Evaluation of Regulatory Requirements **

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a. Auditors should use the information in the contractor’s incurred cost

submission (e.g., Schedule H and Schedule J) to identify indicators of contracts with

potential excessive pass-through charges (i.e., those with subcontract costs exceeding

70 percent of work performed). For those contracts identified, the auditor should then

inquire with the contractor and ascertain whether total subcontract costs expect to

exceed 70 percent of the total costs of work performed. The auditor should also

confirm the identified contracts are subject to the applicable FAR provisions. If risk

necessitates, auditors should perform procedures to test compliance with the subject

FAR provisions for the contracts identified.

b. For those contracts containing FAR 52.215-23(b) Alternate I, auditors should

perform procedures to determine if the contractor is performing its “added value”

functions as asserted during the initial proposal evaluation. If the value-added functions

are not being performed, the excessive pass-through costs should be questioned per

FAR 31.203(i).

c. For all other contracts, the auditor should perform the following:

(1) Ascertain whether or not the contractor complied with FAR 52.215-23(c) by

notifying the contracting officer of the changes in expected subcontract effort after

award exceeding 70 percent of the contract value.

(2) Request the contractor to provide a description and demonstration of the

“added value” by the contractor related to the subcontracted work. The auditor should

evaluate the functions to determine if the “added value” functions are consistent with the

definition in the contract clause. The auditor should also perform testing to determine if

the contractor is performing the “added value” functions and ascertain if the costs are

reasonable. If not, the excessive pass-through charges applicable to the subcontracted

effort should be questioned based on FAR 31.203(i).

6-312 Receiving and Inspection **

The receiving activity is responsible for the receipt and inspection of incoming

materials and the movement of these materials to the areas where the storage and

usage functions are carried out. Common responsibilities include:

(1) unloading, unpacking, identifying, sorting and verifying that the quantity and

quality of materials received agree with purchase order requirements;

(2) noting shortages, damage, and defects;

(3) reporting receipts and discrepancies;

(4) moving materials to storage or other appropriate activities; and

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(5) providing appropriate transaction inputs to the inventory requirements and

accounting systems.

6-312.1 Audit Objectives **

The primary audit objectives are to gain an understanding of the contractor's

receiving and inspection function and identify any risks of noncompliance with contract

terms, including whether allowable, allocable, and reasonable costs are charged to

Government contracts.

6-312.2 Internal Control **

If an MMAS audit has been performed, the auditor should refer to the MMAS

working papers to determine if the key controls in this area were documented. If an

MMAS audit has not been performed, the auditor will need to gain an understanding of

the receiving and inspection internal controls. In any case, the auditor's understanding

of the key internal controls should be noted in the working papers and reflected in the

design of the audit procedures, including the nature, timing and extent of the

procedures.

6-312.3 Audit Guidelines **

In developing audit procedures for confirming the auditor’s understanding of the

key internal controls of the receiving and inspection function, consider the following

guidelines.

a. The auditor should physically observe the receiving and inspection functions

and examine selected transactions to test whether key internal accounting control

requirements are being carried out in accordance with the auditor’s understanding. Also

be alert to any inefficiencies caused by poor work layout or poorly planned and

executed movement of materials. Attention should be given to signs of bottlenecks, idle

personnel, excess or slow-moving materials, poor material handling practices, and

inadequate protection of material from theft and the elements.

6-313 Storing and Issuing **

The storing and issuing function is responsible for:

(1) the protection and preservation of material in storage, including appropriate

safeguards for items of a sensitive nature and items subject to deterioration by the

elements;

(2) accessibility of fast-moving items;

(3) the examination of material requisitions for the appropriate stock number,

nomenclature, and authorized usage;

(4) a knowledge of items, to permit substitution if appropriate when a

requisitioned item is not available;

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(5) the timely issuance of material when presented with an authorized requisition;

(6) initiating purchase requisitions when stock levels reach the reorder point or

when authorized requisitions cannot be filled, duly noting due-ins and due-outs;

(7) reviewing stock or slow-moving items and items in long supply and initiating

appropriate action for consumption or disposal; and

(8) providing appropriate transaction inputs to the inventory requirements and

accounting systems.

6-313.1 Audit Objectives **

The primary audit objectives are to gain an understanding of the contractor's

storing and issuing function and identify any risks of noncompliance with contract terms,

including whether allowable, allocable, and reasonable costs are charged to

Government contracts. Additional audit objectives in evaluating storage and issuing

may include determining:

a. If accounting documentation is properly prepared/controlled and the material is

properly stored and protected from pilferage, the weather, and other hazards. Material

should be issued from stores as required, with proper documentation, and support the

production schedule.

b. Storerooms are arranged to promote economy and efficiency in storing,

locating, and issuing material.

c. If the movement of material from receiving and inspection to storage and then

to production is reported for proper entries in the accounting records. When material

flows directly from receiving and inspection to production (bypassing storage),

equivalent accounting control is likewise maintained.

6-313.2 Internal Control **

If an MMAS audit has been performed, the auditor should refer to the MMAS

working papers to determine if the storage and issuance internal controls were

documented. If an MMAS audit has not been performed, the auditor will need to gain

an understanding of the internal controls relating to the storage and issuance function.

In any case, the auditor's understanding of the key internal controls should be noted in

the working papers and be used to determine the nature, timing and extent of testing to

be performed.

6-313.3 Audit Guidelines **

The auditor should consider the performing some of the following to confirm the

auditor’s understanding of the storage and issuance internal controls.

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a. Determine by observing, evaluating, and testing the practices and

documentation in the warehouses, storerooms, and factory whether the amount of

merchandise withdrawn from stores is adequate but not in excess of current needs.

b. Determine the accuracy of the records of materials in transit from the

warehouse or storeroom area to the production area.

c. Make physical observations and tests of documentation in production areas to

determine whether material is being used in a timely manner and for the purposes for

which it was issued.

d. Test the application of procedures for (1) returning material to the storeroom,

(2) replacing material in stock, and (3) correcting the inventory and cost records to

reflect the return. Change orders and cutback in production schedules usually require

the return of material issued to production.

e. Verify the delivery of requisitioned items and evaluate the procedures for

handling replacement orders for material lost in delivery.

f. Test effectiveness of inventory controls and management by examining a

representative number of contractor-acquired Government-owned (excluding

Government furnished material) and contractor-owned items in order to audit the:

(1) basis for establishing stock levels and reorder points,

(2) causes for any items in short supply, and

(3) actions taken in response to data shown in inventory and stock status

reports prepared by the contractor.

6-314 Inter-Organizational Transfers (IOT)s **

a. Auditors should review the contractor's inter-organizational transfer (IOT)

policies and procedures, and gain an understanding of where the costs are proposed in

the incurred cost proposal.

b. Careful consideration should be given to items or services transferred at

amounts other than cost. Of particular importance is whether the price charged for the

item has been established by a competitive market place. If the item is:

(1) proprietary,

(2) sole source, or

(3) produced solely or substantially for Government end use, it may be

concluded that it does not meet the requirement for acceptance at price.

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Under these conditions, amounts in excess of actual or estimated cost should be

questioned.

c. For a contractor to obtain reimbursement on a basis other than cost, for items

or services sold or transferred between divisions, subsidiaries, or organizations under

common control, certain requirements of FAR 31.205-26(e) must be met. The initial

requirement is that the transferring organization has an established practice of pricing

IOTs of materials, supplies and services at other than cost for commercial work of any

division, subsidiary, or affiliate of the contractor under a common control. This means

the receiving organization should be recording and carrying the cost of the

items/services at the price charged by the related organization. The existence of an

established practice should be readily determinable from evidence such as contractor

policies and procedures and supporting records (e.g., job cost summary reports,

purchase orders, receiving/acceptance records, and invoices).

d. Once the auditor is satisfied that the transferring organization has such a

practice, a determination should be made as to whether reimbursement for the item

under consideration is being requested based upon an exception from certified cost or

pricing data at FAR 15.403-1(b). These exceptions include:

(1) adequate price competition,

(2) prices set by law or regulation,

(3) commercial item exception,

(4) modification to a commercial contract or subcontract, or

(5) a waiver has been granted.

This information should be determinable from the contract file. (See 14-907 for a

detailed discussion of these exceptions)

e. The final requirement for the inter-organizational transfer to be allowed at price

is that the contracting officer must not have determined the price to be unreasonable.

There could be a situation where the auditor has evidence that the price of the item

being transferred is unreasonable. In this case, amounts in excess of actual or

estimated cost should be questioned.

6-315 Special Considerations for Auditing

Purchased Services Acquired from Service

Organizations **

Contractors may use using service organizations to process certain accounting

transactions. Service organizations may provide services ranging from performing

certain tasks under the direction of the user organization to replacing entire functions

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within the user organizations. The services provided range from checking accounts and

payroll processing to providing complete information technology services. Because

many of the functions performed by the service organizations affect the user

organization's financial data, FAO auditors performing audits at the user organization

may need to obtain information about the services being provided, the related service

organization's controls, and their effect on the financial data being audited (see 3-

204.20).

The cost of obtaining services from a service organization is usually accounted for in

an indirect cost pool. If significant, the costs of obtaining these services need to be

evaluated during the incurred cost audit (see 6-608 for indirect cost transaction testing

plan). All claimed costs must be supported by adequate evidence of the nature and

scope of the services furnished. The auditor should review the service agreement to

determine the nature of the services to be provided. Purchased services should be

reviewed for reasonableness and allocability per FAR 31.201-3 and 31.201-4.

6-400 Section 4 - Audit of Incurred Labor Costs **

6-401 Introduction **

This section presents audit guidance and procedures for the audit of direct and

indirect labor costs. Incurred labor can be audited in real-time and/or as part of the post

year end incurred cost audit. Real-time audits provide for the verification of the

existence (floorchecks) and allocation (employee interviews) of prime costs (e.g., direct

and indirect labor) as they are incurred. Therefore, they can be accomplished only

during the contractor fiscal year to which they apply. The timing and extent of testing

will be based on the assessed level of risk and auditor’s judgement. The guidelines

relate to the audit of the following areas:

(1) evaluation of labor cost charging and allocation (employee interviews),

(2) observations of work areas (floorchecks) procedures,

(3) evaluation of payroll preparation and payment,

(4) evaluation of personnel policies and procedures,

(5) evaluation of recruitment costs and practices,

(6) evaluation of overtime, extra shifts pay, and multi-shift work,

(7) evaluation of uncompensated overtime,

(8) evaluation of other labor systems (standard costs and proprietor/partners

salaries), and

(9) evaluation of quantitative and qualitative utilization of labor.

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6-402 Audit Objective and Scope of Audit **

a. The results of a business system and related internal controls audit can be a basis

for determining specific risk area and control risk. The extent and frequency of testing is

based on assessed level of risk and auditor’s judgement (e.g., whether testing should

be performed periodically over the contractor’s fiscal year or at a single point in time).

Auditors should ensure the nature, extent and timing of testing addresses the specific

risk area, control risk, and materiality of relevant labor cost. Substantive testing may be

greatly reduced when the contractor effectively maintains an adequate and compliant

system of internal controls, including monitoring and testing of the system. Substantive

testing should be focused on the high risk areas.

b. In carrying out the primary audit objectives, the auditor should be alert to any

condition which raises reasonable suspicion of unlawful or fraudulent activities.

c. The audit objective of a real-time testing of labor is to ensure employees are

actually at work, that they are performing in their assigned job classification, and their

time is charged to the proper cost objective. Auditors should consider the guidelines

below during annual program planning or while formulating an audit program for

evaluating direct and indirect labor costs. For major and non-major contractors,

auditors should consider whether real-time testing of labor is appropriate. Auditors may

consider the following risk factors to assist in their determination:

• materiality,

• significant findings from previous years,

• Department (e.g., DCMA, DCAA, or PCO) concerns,

• determined to have an unacceptable accounting system,

• significant business system deficiencies,

• significant accounting system changes, and

• significant organizational changes.

Additionally, auditors should also consider planned or scheduled audits from the

Agency Risk-Based Sampling of Incurred Cost Proposals when developing a plan (see

6-104). For example, incurred cost proposals with sampling ADV of $100 million to

$250 million must be audited every 5th year. Based on this requirement, the audit team

may consider conducting a real-time testing of labor during the same year of the

scheduled incurred costs audit.

Real-time testing may be accomplished by conducting a labor cost charging and

allocation evaluation (interviews) and/or observations of work areas (floorchecks).

These evaluations may appear similar but vary in the overall objective and the

techniques and procedures used. The decision as to whether to perform interviews or

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floorchecks or a combination of both approaches depends on the level of risk

associated with the recording and accumulation of labor costs.

The audit objectives of a labor cost charging and allocation evaluation (interviews)

(6-404) are to evaluate the contractor's:

• compliance with labor charging policies, procedures, and internal controls;

• reliability of the contractor's labor cost accounting system, and;

• accuracy of contractor employee (salaried and/or hourly) labor hour charges

to contracts, indirect accounts, or other cost objectives.

Interviews are designed to evaluate employee labor charging over a recent period of

time and are most often appropriate in auditing high risk areas. See assessment of

conditions influencing labor charging practices (6-404.6) to identify any high risk areas

requiring a more detailed labor interviews.

The audit objectives of an observations of work areas evaluation (floorchecks) (6-

405) are to verify the existence of employees, evaluate compliance with timekeeping

internal control procedures, and evaluate employee labor charging at the time of the

floorcheck. Perform a floorcheck when no high risk areas have been identified.

d. If labor is a significant cost element and the real-time testing of labor was not

performed for the year of a scheduled incurred costs audit, the audit team should make

every effort to apply alternate procedures to test employee existence and allocability as

part of their post year-end audit procedures. Alternative procedures are described in

(employee interviews) (6-404) and (floorchecks) (6-405).

e. If the audit team determines that labor is a significant element and they are unable

to develop alternate procedures to test for employee existence and allocability, the audit

team should change the scope of the engagement by documenting there are no

reasonable alternate procedures that can be performed. The audit report will also need

to be modified to address only the cost elements/accounts examined in the subject, and

results of audit sections and report exhibits (e.g., direct material, non-labor expense

accounts, etc.).

f. The auditor should also be concerned with the contractor’s compliance with its

policies and procedures relating to payroll and personnel, recruitment, overtime, and

labor standards. The extent of audit effort in testing and verifying labor costs will be

influenced by:

(1) the adequacy and reliability of the contractor's system and related internal

controls,

(2) the nature and significance of labor and related expenses,

(3) prior audit experience with the contractor,

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(4) the reliability and acceptability of the contractor's labor policies and

procedures,

(5) the audit objectives,

(6) the contractor's mix of contracts and nature of contract provisions, and

(7) the nature of the contractor's organization and operations.

6-403 Coordination and Reporting Results **

a. Conduct an exit conference in accordance with 4-304 only after approval of the

supervisory auditor. Include the contractor's reactions in the working papers and the

report.

b. A MEMORANDUM FOR RECORD should be issued to close a real-time testing of

labor assignment that supports the incurred cost audit for a contractor's fiscal year. The

results of real-time testing will be incorporated to the final incurred cost report.

However, if significant business system deficiencies are found, auditors should prepare

a DFARS business system deficiency report (see 5-110 and 10-200). Auditors may

also become aware of conditions which may indicate fraudulent or other suspected

irregular activities as defined in 4-702.1b. Promptly report these as described in 4-

702.4.

c. If employee interviews and floorchecks were not completed in a real-time basis,

as part of their post year-end audit procedures, the audit team:

(1) Should consider such things as audit risk, significance of claimed labor costs,

contract mix, and the sufficiency and appropriateness of evidence gathered in

determining the overall opinion.

(2) Should use professional judgment to determine what procedures are needed

to express an opinion and document the sufficiency of the evidence.

(3) May not be able to opine on the labor cost element resulting in a qualified or

overall disclaimed opinion if the alternate procedures do not provide sufficient

appropriate evidential matter.

(4) If the audit team determines that they have to disclaim an opinion, they

should only report significant noncompliances that can be supported by sufficient

appropriate audit evidence in the appendix (i.e., Other Matters to be Reported).

6-404 Evaluation of Labor Cost Charging and

Allocation (Employee Interviews) **

6-404.1 Audit Objectives **

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a. The primary objective of a labor cost charging and allocation evaluation is to

determine the accuracy of contractor employee (salaried and hourly) labor hour charges

to contracts, indirect accounts, or other cost objectives. The auditor should determine if

the recorded labor hour charges are a fair representation of the actual work performed.

Hours recorded on an employee's timecard or electronic record must be adequately

supported/ documented if they are to be accepted as the basis for reimbursable labor

costs on Government contracts.

b. An underlying principle of an effective labor charging and allocation evaluation

is that it must be performed on a current basis. Experience has shown that long lapses

of time between when labor effort is expended and when it is audited tend to diminish

the effectiveness and productivity of the audit. Ideally, labor allocation evaluations

should be performed on a real time basis, i.e., labor effort is assessed at the time of

occurrence. From a practical standpoint, however, labor should be assessed as close

as possible to the date of occurrence. This approach has many benefits. The

employee should be better able to remember recent events, and sufficient, competent

evidential matter to support audit conclusions should be more readily available.

c. If employee interviews were not completed in a real-time basis, the audit team

should apply alternate procedures to test employee allocability as part of their post year-

end audit procedures. Alternate procedures to test for allocability may include:

(1) Review contract requirements (e.g., key employee, job title, or labor

category).

(2) Review statement of work and work orders/authorizations to ensure labor

type (e.g., scientist) is required to perform the work.

(3) Determine if the Contracting Officer has other evidence corroborating

employee’s labor is allocable to the contract.

d. Because audit resources are limited, it is impractical to audit an entire labor

system at the same time. Efforts must be concentrated on those areas requiring

immediate attention. To do this, it is necessary to perform an analysis on the

contractor's current labor system. The analysis should help the auditor identify those

problem areas most likely to result in a significant adverse cost impact to the

Government (risk) and the extent of Government exposure to suspected irregular

conduct (vulnerability). The analysis consists of preliminary audit effort, an evaluation of

the adequacy of and compliance with internal controls, and consideration of other

conditions which may influence the contractor's labor charging practices.

6-404.2 Analysis of Labor Charging and Allocation Procedures **

The objective of the analysis of the contractor's labor charging and allocation

procedures is to identify specific areas or situations where there is high risk of labor

mischarging. This will usually result in the identification of specific cost or profit centers,

departments, contracts or cost objectives, or employees or groups of employees where

the potential for mischarging is high.

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6-404.3 Preliminary Audit Effort **

a. Because the effectiveness of the audit depends on the auditor's knowledge of

the contractor's labor charging and allocation procedures, the auditor should become

familiar with available background information on the contractor's organization,

budgetary controls, direct/indirect labor charging policies and procedures, and results of

the labor internal controls audit. Obtain pertinent information from up-to-date

permanent files, coordination with procurement officials, and discussions with the

contractor.

b. Contractor organization charts, listings of current Government contracts, and

listings of contractor employees by locations are very useful sources of information and

should be examined and referenced often during the audit. In addition, the auditor

should update the labor portion of the permanent file to facilitate the performance of

real-time testing of labor (see 6-405.3(a)).

c. Coordinate the planned audit with the ACO and other contracting officer

representatives to:

(1) Ensure that adequate, but not duplicate, coverage of time-and-materials

contracts is provided by the auditor and the contracting officer's technical representative

(COTR).

(2) Solicit any input that may affect the audit.

(3) Establish procedures for requesting needed technical assistance (see

Appendix B).

(4) Determine if the audit is to be conducted as a joint ACO/DCAA review.

(5) Establish target dates for status meetings to keep the ACO informed of the

audit progress. Bring any difficulties to the ACO's attention for prompt resolution.

(6) Invite the ACO to attend the entrance conference and to suggest

conference agenda items.

d. The auditor should hold an entrance conference in accordance with 4-302 to

exchange preliminary information about the audit and to enable the contractor to

provide a briefing about its direct/indirect labor charging and allocation policies. During

the entrance conference the auditor should:

(1) Discuss the general area(s) to be covered and the general period of audit

performance.

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(2) Advise the contractor that the audit will include a series of employee

floorchecks/interviews. The contractor should designate a representative to accompany

the audit team during the floorchecks/interviews. A primary and alternate representative

should be designated for each of the contractor's locations.

(3) Set the ground rules for the interviews; e.g., the interviews will be on an

unannounced basis, scheduled, or a combination of the two. The interviews will be

conducted in-person, over telephone, or video conferencing, attended by one auditor (or

two auditors for in-person floorchecks/interviews) and a contractor representative (see

6-404.9). The representative will not be allowed to interpret the employee's responses

nor be allowed to "coach" the employees in their responses.

(4) Request a contractor representative to act as coordinator for discussing

audit progress and findings.

6-404.4 Evaluation of the Adequacy of Internal Controls **

a. Consideration of the contractor's internal control structure is an important part

of the labor audit. An adequate internal control structure is essential if the labor system

is to be relied upon for cost reimbursement and as a basis for future estimates. The

evaluation of the internal control structure must encompass both IT and manual

processes that are used in the accumulation and recording of labor costs. The result of

the internal controls audit will enable the auditor to determine the effectiveness of labor

functions and the reliability of labor records. When combined with appropriate tests of

amounts included in cost representations, internal control evaluations will provide a

basis on which the auditor can render an opinion as to whether the contractor's labor

cost representations are acceptable.

b. Start and Stop Time Recording

Recording of start and stop times is necessary only when the lack of such a

control results in a risk of a material labor cost misallocation. Determining the need to

record start/stop time is made on a case-by-case basis. The factors that should be

considered in assessing the appropriateness of recording start/stop times include:

(1) nature and variety of tasks worked on each day,

(2) significance of employees working on multiple tasks compared to total

work force, and

(3) mix of contracts.

After considering these factors, the DCAA auditor must exercise professional

judgment as to whether there is sufficient risk to warrant recommending recording

start/stop time. Inherent in determining risk is the concept that the benefit of the control

- in this case recording start/stop time-must exceed the cost of implementation.

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c. Carefully consider the possible consequences when internal control

inadequacies are significant. Document corrective action taken by the contractor and

consider when planning the extent of testing required.

6-404.5 Evaluation of Compliance with Internal Controls **

Inadequate internal controls or noncompliance with those controls greatly

increase the risk that labor mischarging could be occurring. The scope of the audit

should be adjusted in accordance with the risk determined in the audit of the labor

system of internal controls. When an accounting system audit has been performed, the

auditor should determine if audit effort can be used from prior audits to accomplish

current audit objectives.

6-404.6 Evaluation of Conditions Influencing Contractor Labor Charging

Practices **

a. Proper analysis requires a working knowledge of not only the contractor's

operations, policies, and procedures, but also many conditions that may influence

management decisions. Normally no one factor should become the sole determinant of

whether an audit should be continued, expanded, or terminated. High risk and

vulnerability are usually the effect of the relationships among several conditions.

b. Several conditions and appropriate evaluation procedures are presented in

this section. The evaluation of these conditions may identify areas (e.g., cost/profit

centers, departments, groups of employees, employee labor classifications, or contracts

or cost objectives) where the potential for labor mischarging is high. When high risk

exists, the auditor must also be alert to the possibility of fraud, and should conduct

transaction tests which include a determination that records examined are not falsified.

Give special consideration to unusual transactions. Journal entries and other special

adjustments may provide leads for discovering improper transactions. Many fraud

cases involve deliberately falsified labor distribution, payroll, and other records.

Examples include fraudulent charges to cost-type contracts of costs applicable to firm-

fixed-price work and fraudulent charges to direct and indirect activities of unrelated labor

costs when projects, budgets, contract ceilings, or advance agreement limitations are

about to be exceeded. Although no list can be all-inclusive, the following factors are

examples of conditions which may influence labor charging practices. The auditor

should identify the specific risk area(s) associated with such conditions by designating

them as high, medium, or low risk.

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(1) Mix of Contracts

Determine the Government contract mix (cost vs. fixed-price/commercial). A

contractor whose contracts are all fixed-price or all cost-type would have relatively little

incentive to mischarge between contracts. On the other hand, a contractor with a mix of

cost-type and fixed-price/commercial work would generally have a much greater

motivation to charge effort allocable to fixed-price or commercial work to a cost-

reimbursable contract.

(2) Overrun Contracts

When contract costs have exceeded or are projected to exceed contract

value, contractors may divert these excess costs to other cost objectives such as

indirect labor, overhead accounts, other contracts, etc. Request the contractor to

provide a listing of all contracts that are currently in an overrun position or projected to

be in an overrun position. The ACO can also often provide information on "trouble

contracts”.

(3) Restructuring Costs

Evaluate the contractor’s labor charging practices for its restructuring

activities. Determine if the contractor is properly classifying restructuring activities in

accordance with established agreements and DFARS 231.205-70. As actual

restructuring expenditures near the negotiated restructuring cost ceiling, there is a risk

that restructuring costs may be mischarged to other accounts. Determine if the incurred

and projected restructuring costs are near or in excess of the negotiated ceiling.

(4) Significant Increases in Direct/Indirect Labor Accounts

(a) Trend analyses may disclose instances where charges to direct or

indirect labor accounts have increased significantly. Sufficient analysis should be

performed to determine the nature of the increase. The auditor should evaluate

changes in procedures and practices for charging direct/indirect cost for consistency

with generally accepted accounting principles, the applicable contract cost principles,

and any applicable Cost Accounting Standards requirements.

(b) The auditor can also perform comparative analysis of sensitive labor

accounts. When the comparative analysis indicates a possible misclassification of

direct labor cost or some other condition that cannot be adequately explained, the

auditor should pursue the matter further, (e.g. the contractor may be misclassifying

direct contract costs to selling and marketing or IR&D/B&P costs.) An example of a

sensitive labor account is standby labor. Standby labor is generally defined as the

unproductive time caused by and limited to idle time, capability retention, and waiting for

special customer security clearance (Additional examples of sensitive labor accounts

are presented in other sections of 6-400).

(5) Reorganization/Reclassification of Employees

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The organizational structure of the contractor should be analyzed to

determine if it permits inconsistent treatment of similar labor. In some instances,

reorganizations and reclassifications are implemented to achieve an accounting

objective that was not possible under the previous structure. Sufficient review should

be performed to determine if the changes will have an impact on Government contract

costs.

(6) Adjusting Journal Entries/Exception Reports (Labor Transfers)

Determine if there are any unusual labor transfers made via adjusting journal

entries. Adequate rationale and supporting documentation should be available for all

significant labor transfers. Evaluations in this area require the auditor to be

knowledgeable about how adjusting entries are put into the system, either manually

and/or by computer. If some significant entries appear to be more than just normal

corrections, the Government risk and vulnerability is high and the area should be

reviewed.

(7) Budgetary Controls

Many contractors operate management systems that require strict adherence

to budgetary controls. If the system is inflexible, labor charges may have a tendency to

follow the identical route of the budgeted amounts, especially if managers' bonuses or

incentives are determined based on performance against some predetermined budget.

Rigid budgetary control systems can result in predetermined labor charges. Refer to

the audit of the contractor budgets as described in 5-500.

(8) Contract Definition Contracts

Contract Definition (CD) contracts are generally fixed-price contracts for a

short duration. They are usually awarded to several contractors who will compete for a

major follow-on prime contract. The procurement activity will use the results delivered

under the CD contracts to help define exactly what it wants in the prime contract and

then issue an informative RFP. Since the contractor's performance on the CD contract

will have a direct bearing on its chance of winning the prime, there may be a tendency

to spend more than the established contract value. Therefore CD contracts are highly

susceptible to labor mischarging and the auditor should evaluate to make sure all

allocable effort is being charged.

(9) Contract Provisions

Any contract or contract modification may contain certain provisions which

increase the incentive for labor mischarging. A common example of such a provision is

one which puts ceilings on certain cost elements or rates. Similarly, Time-and-

Materials/Engineering and Technical Services contracts may include task order funding

ceilings which are enforceable when contract language so provides. These ceilings

prohibit the contractor from recovering any costs incurred above these pre-established

limits. The existence of costs incurred in excess of ceiling limitations should alert the

auditor to possible improper cost transfers. Another example of a contract provision

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which increases the risk of labor mischarging is a "Cost Sharing Clause". Such clauses

may require the contractor to deliver goods and/or services at no fee to the

Government.

(10) Labor Accounting by Funding

Labor accounting by funding is the controlled management and charging of

labor costs to cost objectives on the basis of available funding rather than where the

labor efforts are actually performed. Time-and-Materials/Engineering and Technical

Services contracts possess a risk of labor accounting by funding. The availability of

contract funds often controls where labor costs are charged. To the extent that this

practice is employed, the procedures utilized in risk and vulnerability analysis will have

to be adjusted because extensive labor accounting by funding often results in no "red

flag" conditions since all cost objectives will show labor costs at or below funded levels.

The auditor must be alert to this type of situation and consider factors other than cost in

determining the existence or extent of this practice. For example, a review of recent

deliveries made on Government contracts could reveal that no labor costs were charged

to a contract during the period when deliveries occurred. Auditor initiative and

imagination are important ingredients during an assessment of possible labor

accounting by funding problems.

(11) Related/Similar Cost-Type and Fixed-Price Procurements

This situation is fairly common and occurs when procuring agencies award

contracts for the same or similar items using different contract types. It represents a

high risk condition and should be closely monitored. This situation can often result in

some form of "labor accounting by funding," i.e., labor cost to the contracts involved are

charged based on contract funding and ceilings regardless of where they are incurred.

(12) Offsite/Secure/Restricted Locations

(a) Offsite Locations. Significant amounts of labor costs may be incurred

at contractor offsite locations where little or no audit effort has been expended. The

auditor should determine if an assist audit is required based on the level of risk at the

offsite location, (risk assessment factors to consider are included in 6-405.3(a)). The

assessment of risk and vulnerability will require coordination between the primary and

offsite auditors. In some complex, sensitive, or high risk situations, it may be more

timely, efficient, and effective for the primary site auditors to perform the offsite labor

floorchecks/interviews. In these situations, teaming among the primary site and offsite

auditors should be considered. Requests for assist audits should be prepared and

tracked in accordance with 6-805.

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(b) Secure/Restricted Locations. Contractors may have employees

located in a secure or restricted area that requires a security clearance (i.e., Sensitive

Compartmented Information Facility (SCIF) or Special Access Program Facility (SAP-F).

A secure or restricted area usually requires badge access and may have a safe lock on

the door and have a listing of electronic device restrictions posted outside the door. If

the auditor does not have the proper security clearances to enter the secure area,

coordinate with the cognizant Field Detachment office to request assistance. Do not

request the selected employee to leave the secure area. If auditor does have the

proper security clearances to enter the secure area, the auditor should enter area,

locate the employee and perform the floorcheck at the employee’s work location. See

section 6-405.4.

(13) Contractors may have both DoD and non-DoD contracts which may

affect the scope of audit. Identify any Non-DoD contracts subject to audit and verify the

audit effort is reimbursable. Some non-DoD agencies request and reimburse DCAA for

audit services. The requirement for our services on non-DoD contracts should be

confirmed by discussion with the appropriate agency Office of the Inspector General

(see 1-300 and 15 for guidance on audit services for non-DoD agencies and DMIS User

Guide). If the Non-DoD agency is not willing to participate, discuss this with the audit

supervisor and adjust the scope of the audit appropriately.

(14) Labor Charging versus Estimating

An evaluation in this area may reveal that the contractor is charging certain

categories of labor directly to Government contracts contrary to the manner in which the

cost was reflected in the bid proposal or the treatment accorded commercial contracts.

The auditor should ascertain the reason for any divergence in policy. Such practices

should be further analyzed.

(15) Fixed-Price Sole-Source Follow-On Contracts

Contractors may be motivated to charge effort allocable to commercial work

to their sole-source contracts in order to increase the cost of these contracts, which are

then used as a basis for projecting the cost of follow-on work.

6-404.7 Determining Additional Audit Effort **

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a. Use the results of the audit of the contractor's labor charging and allocation

practices and related internal controls, including the contractor's own monitoring and

testing efforts, to determine the nature and extent of further audit effort.

b. The analysis of the conditions in 6-404.6, together with the results of the audit

of internal controls, may identify areas with a high risk of labor mischarging. To best

utilize available audit resources, focus audit effort on those areas in which the

Government's vulnerability and risk are high. For high-risk areas, sufficient analysis

should be performed to assure that the Government's interest is protected. Discuss the

results of the analysis with the audit supervisor and adjust the scope of the audit

appropriately. As an example, the analysis may reveal the following conditions

indicating high risk areas.

(1) The contractor has an overrun/behind-schedule fixed-price contract that is

being worked on by a department that also has responsibility for a cost-type contract.

The cost-type contract is currently under budget. The effort expended under the two

contracts is similar. The ACO and PCO have expressed their concerns and

dissatisfaction with the contract performance to the contractor. In addition, the

department manager's bonus is dependent upon adherence to contract budgets. In this

case, the risk area is all employees assigned to the department.

(2) The contractor has an offsite facility that has two fixed-price contracts and

one cost-type contract. One program manager is responsible for the three contracts.

The program manager's labor effort on the cost-type contract is charged direct to the

contract, while the effort on the two fixed-price contracts is charged indirect to overhead.

There is reason to believe that this practice is prevalent throughout the company. In

this case, the area of risk is all program manager labor effort regardless of department

or cost/profit center.

c. If high risk areas warranting further audit are identified, perform pre-interview

analysis and employee interviews in accordance with the procedures in 6-404.8.

d. If the analysis does not revealed any high-risk areas, the auditor should

consider a performance of real-time testing of floorcheck as discussed in 6-405.3.

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6-404.8 Pre-interview Analysis **

Once high risk areas have been identified for audit, perform a pre-interview

analysis to identify the population of employees associated with the high risk areas,

e.g., a cost/profit center, department, contract or cost objective, class of employees,

etc., and to select employees to be interviewed. The employee population is usually all

employees charging and/or assigned to the risk area. From this population, specific

employees will be selected for interviews. Sufficient data must be gathered so that an

informed decision can be made on the selection of employees. The employees with the

most questionable labor charges are normally interviewed. Just as the risk and

vulnerability analysis started with the contractor's entire labor system and narrowed the

audit scope to selected areas of risk, pre-interview analysis starts with all the employees

charging/assigned to the risk area and narrows selected employees with the most

questionable time charges within that risk area.

a. To determine the high risk population, the following steps should be performed

for each high risk area identified:

(1) Review labor distribution documents and payroll runs to identify all

employees charging labor effort or assigned to the risk area. Consider using data

retrieval program for this. (See 4-504 for additional guidance.) Prepare a schedule of

employees charging a major portion of their time to the risk area.

(2) Obtain additional evidential matter by reviewing other relevant available

documentation related to the risk area, e.g., organization charts, travel reports, contract

files, work authorizations, Material Inspection and Receiving Reports (DD Form 250),

contract status reports, etc. Gather as much information regarding the risk area as

possible before performing any interviews. For example, if the identified risk area is a

certain contract, evaluate enough available documentation to gain an understanding of

the scope of contract work, contract delivery schedules, special contract provisions, etc.

This evaluation may also identify employees who have worked on the contract but have

not charged labor effort to it.

(3) For employees identified in (1) and (2) review labor time charges for an

appropriate recent period of time. The appropriate time period will vary with each audit.

Determine if any significant trends exist. Identify all employees with irregular or

inconsistent charging patterns. Focus attention on those employees with the most

questionable time charging patterns.

(4) For employees identified in (3), physically inspect timecards (or other

source document) starting with the most current time period. Review each timecard for:

(a) consistent time splitting (be especially alert to employees working

multiple jobs in a day),

(b) changes in charging patterns, and

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completing the timecard.

(5) For employees identified above, review travel expense reports and

compare travel charges to labor distribution charges. Look for inconsistencies.

(6) Gather additional pertinent information on each employee's time charges

by reviewing other available documentation. Obtain an understanding of the nature of

the work for each contract/cost objective charged during the review period, the time

spent on each job including accurate time charging when multiple jobs are worked on a

daily basis, and any other relevant information.

b. Selection of employees for interview should be made as a result of the above

evaluation. Select employees whose time charges and review of other documentation

indicate a high probability of mischarging. There should be a strong indication that the

selected employees have mischarged their labor effort.

c. If no employees in the risk area appear to have questionable time charges,

discuss terminating the audit procedures for the risk area with the audit supervisor.

d. An important phase of pre-interview analysis techniques is the preparation of

adequate working papers. Careful preparation of working papers is critical to the

establishment of a basis for effective interviews. Consistency in working paper

preparation should be maintained throughout the evaluation. The working papers

should include the employee name and ID number, date of interview, the attendees, the

reason for employee selection, an interview summary, and audit conclusion.

e. Data gathered during the pre-interview analysis forms the basis for questions

asked during the interview. Formulate the questions to be asked each employee and

anticipate the responses. The questions should be designed to confirm the employee's

suspected mischarging. Keep questions factual in nature; avoid questions which solicit

the employee's opinion. Develop a "game plan" for each interview.

6-404.9 Detailed Employee Interviews **

a. Effective interviews and an evaluation of the labor system of internal controls

can provide sufficient information to form an opinion on the adequacy of, and

compliance with internal controls and the propriety of the recorded labor charge. To

express an opinion in an examination, the auditor obtains reasonable assurance about

whether the subject matter is free from material misstatement. To obtain reasonable

assurance, the auditor must obtain sufficient appropriate evidence by designing and

performing appropriate procedures. Examination procedures may involve inspection,

observation, analysis, inquiry, reperformance, recalculation, or confirmation with outside

parties.

b. The conduct of employee interviews will vary according to the amount and

quality of pre-interview data gathered.

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c. Determine if the interviews will be conducted either on an unannounced basis

or scheduled. Interviews should be in-person, to the greatest extent possible, and

alternative interview procedures, such as, by telephone or by video conferencing, will be

determined and designed by the audit team as needed. In making the determination,

reference 6-404.2 through 6-404.8 to assess the following risk factors:

(1) Size and complexity of the company.

(2) Contractual requirements.

(3) Company policies (e.g., telework policy and/or Work at Home (WAH)

Program (see 6-405.5)).

(4) Security and contractor concerns (e.g., employee working in secure

locations).

(5) Access to contractor’s information system (e.g., ability to download

timesheets ahead of time to ensure employees are not changing/inputting timesheets

before the interview).

(6) Access to contractor’s communication system (e.g., utilizing contractor’s

equipment to facilitate interviews by video conferencing).

(7) Readily available documentation.

(8) Whether final audit objectives can be met.

d. Auditors should consider benefits of in-person interviews such as the

opportunities for the auditor to build a rapport with the interviewee, allow for more fluid

questions and answers, and allow for the auditor to read body language The auditor

should consider whether the benefits from in-person interviews will outweigh the

efficiencies gained through utilizing telephone or video conferencing. Ideally, there

should be a combination of in-person, telephone, and video-conference interviews.

e. A benefit of real-time interviews is that recent events are fresh in the

employee's mind and responses to questions on current time charges will usually

produce the most reliable audit evidence. However, the auditor is not precluded from

asking questions about general time charging patterns that may have occurred over an

extended period of time.

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f. When conducting in-person interviews, auditors may be required to have the

proper security clearances to enter a secure area. If the auditor does not have the

proper security clearances to enter the secure area, coordinate with the cognizant Field

Detachment office to request assistance. Do not request the selected employee to

leave the secure area. If auditor does have the proper security clearances to enter the

secure area, the auditor should enter area, locate the employee and perform the

interviews at the employee’s work location.

g. The interview team should generally be comprised of one auditor (or two

auditors for in-person interviews or in more sensitive situations). When there are two

(one shall be the interviewer and one shall be the recorder). The recorder is expected

to ask pertinent questions overlooked by the interviewer. In addition, a contractor

representative should accompany each team (see 6-404.3c(3)).

h. In some circumstances, the contractor should not be advised ahead of time

about the specific department or individuals to be interviewed. In these circumstances,

advance notice of time of the interviews or the employees to be interviewed will not be

given.

i. The length and complexity of the interview will vary with the number and types

of discrepancies disclosed during pre-interview analysis. Questions should be tailored

to specific risk area. In addition, below is a list of certain general information that will be

elicited from each employee interviewed and documented on a labor interview

worksheet to facilitate recording of the employee responses:

(1) Employee's name and identification number.

(2) Employee's current job title, position description, and nature of his or her

work.

(3) Employee's current projects and the period of performance.

(4) Description of the nature of work performed during the period being

evaluated.

(5) Percentage of time worked on each project.

(6) The charge numbers/accounts used to record their effort on each job.

(7) How and from whom work authorizations and charge numbers are

obtained.

(8) Employee's timekeeping procedures, including maintenance of informal

logs.

(9) Any other relevant information resulting from employee responses or

observations at the employee's workstation.

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j. Listen and record the employee's complete response and be alert to any

comments or reactions that seem inconsistent. Ask appropriate follow-up questions.

k. Obtain any available documentation from the employee substantiating the

labor effort. Documentation may include final reports, trip reports, drawings, working

papers, inventory tags, etc.

6-404.10 Development of Findings **

a. Data gathered during the interview, compared with information obtained in the

pre-interview analysis will either confirm the employee labor mischarge or establish the

propriety of the charge. Labor mischarges confirmed during interviews should be

discussed with the audit supervisor and, if an assist audit, with the requesting FAO.

Sufficient analysis should be performed to determine if the mischarge represents an

isolated instance or is indicative of a more widespread condition. Determine if more

audit effort (interviews) is needed to support the audit conclusion. All conclusions must

be fully documented.

b. Each risk area should be treated independently. This approach results in a

more effective evaluation and diminishes the chance of wasting time during the

evaluation.

c. Determine any costs questioned related to labor mischarges. Costs

questioned should be specifically identified (contract, department, cost center, etc.) to

each risk area.

6-405 Observations of Work Areas (Floorchecks)

Procedures **

6-405.1 Audit Objectives **

a. The audit objectives include: (1) an evaluation of the contractor's compliance

with its internal controls and procedures to insure the reliability of employee time

records and (2) the physical observations (floorchecks) of work areas to determine that

employees are actually at work, that they are performing in the assigned job

classification, and that the time is charged to the appropriate job.

b. Floorcheck procedures are appropriate when there is limited Government risk

or vulnerability. If conditions indicating a high probability of mischarging exist, a

comprehensive analysis of labor charging and allocation, including employee interviews,

as described in 6-404 is appropriate.

c. If performance of floorchecks were not performed for the current year (real-

time), the audit team should apply alternate procedures to test employee existence as

part of their post year-end audit procedures. Alternate procedures to test for existence

may include:

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(1) For employees still employed, physically observe employee and inquire as

to start date with contractor to ensure the employee worked for the contractor in the

year under audit.

(2) For employees no longer employed, review employee personnel records

(e.g., copies of driver license, passport, contractor badge, etc).

(3) Validate payment of sampled employees to contractor bank statement,

electronic funds transfer, or third party payroll processor records.

(4) Review other documents the employee may have created, processed, or

approved during the period under audit (e.g., travel records/employee expense reports,

W-4s, leave requests).

(5) Determine if Contracting Officer has other evidence corroborating

employee existence.

d. The extent and frequency of additional floorchecks should depend upon the

adequacy and reliability of the contractor's system for controlling the accuracy of time

charges, materiality, internal controls, the frequency and effectiveness of floorchecks by

contractor personnel, and the results of previous floorchecks. (See 6-405.3(a) for audit

coverage at off-site locations).

e. Floorcheck procedures include evaluating the contractor's timekeeping

procedures, selecting employees to be floorchecked, gathering background data,

performing the floorchecks, and summarizing the results.

6-405.2 Procedures for Evaluating Timekeeping Controls **

a. Obtain an understanding of the contractor's timekeeping procedures prior to

performing floorchecks. When an accounting system audit has been performed, the

auditor should determine if audit effort can be used. The evaluation of timekeeping

procedures should include the following procedures:

b. Establish the validity of the time records by observing the contractor's

timekeeping system in operation. This includes an observation and evaluation of the

method for recording time and periodic physical observations of the work areas.

c. Determine whether employee attendance is controlled by clock cards,

timecards, or other suitable time and attendance records and review contractor's

procedure for checking employee early leave and late arrival.

d. Review and evaluate the system by which employee time records are

controlled at each timekeeping station, including assignment of job numbers for tasks

performed. If job cards are completed by employee, evaluate procedures for notifying

the worker of the assigned job number. Determine whether procedures provide that all

changes are properly initialed by the employee who initially prepared the time ticket or

job card and the approving supervisor.

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e. Determine whether hours shown on time tickets or job cards are reconciled

periodically with the hours recorded on attendance records and the total hours recorded

on the payroll.

f. Determine whether there is a division of responsibility between personnel

responsible for the preparation of time and attendance records and those responsible

for the preparation and distribution of the payroll.

g. Determine whether there is a division of responsibility between personnel

having a part in the preparation of time and attendance records and those responsible

for operating within budgets.

h. Determine whether procedures have been established for coding and

recording idle time. The auditor should review or prepare an analysis of idle time

according to the reasons for idle time such as waiting for inspection, lack of materials on

hand, etc., and ascertain whether the contractor has taken corrective action to reduce

the idle time.

i. Determine whether records of piecework and work performed under wage

incentive plans are checked and controlled independently as to production counts,

approvals for allowances, and other operations.

j. Perform independent floorchecks and test employee attendance and the

accuracy in recording the work performed for all shifts.

k. When appropriate, request representatives of the contracting officer to

accompany the auditor on floorchecks.

l. Scan batches of labor distribution documents for obvious errors or arbitrary

allocations of time to contracts.

m. Determine if the contractor has an employee work at home program and

assess the materiality of the costs incurred by employees in the program.

6-405.3 Procedures for Performing Observations (Floorchecks) **

a. Floorchecks should be conducted in a manner which will least disturb the

normal operations of the contractor. When appropriate, other Government personnel or

contractor representatives may accompany the auditor during the floorchecks. The

extent and frequency of floorchecks should depend upon the adequacy and reliability of

the contractor's system for controlling time, internal controls, and prior findings.

Consider the procedures described below in conducting a floorcheck (note, the auditor

should adjust the procedures to accomplish the audit objectives when performing

unannounced or scheduled floorchecks by telephone or by video conferencing).

b. As part of the planning process, auditors should identify the population of

employees by obtaining a control list of persons assigned to the department or area to

be checked. A listing of employees by location should be obtained far enough in

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advance to allow sufficient time for the audit team to perform the floorcheck and

determine any necessary assist audits (see 6-805). Assist audits may not be necessary

if telephone or video conferencing floorchecks can be used to meet the audit objective.

Auditors should update the labor portion of the perm file with the listing of employees by

location. Auditors should also consider the risk at off-site locations as part of the

planning process. If only minimal risk is indicated, the audit team does not need to

select the location to perform a floorcheck at this time. To the extent possible, the

assist audit requests should be made at the beginning of the risk assessment to allow

sufficient time for the FAO(s) cognizant of the off-site location(s) to plan and perform the

audit(s). Some risk assessment factors to use for selection of the off-site locations are:

• Results of recent audits;

• Headcount at each site;

• Pattern of direct vs. indirect charging;

• Number and mix of contracts at the site;

• Contract overruns;

• Contract values at the respective sites;

• Facility dedicated to a specific contract/program vs. a facility that supports

multiple contracts/programs; and

• Audit leads and discussions with the contracting officer cognizant of the off-

site locations.

When a common area is used to perform Government and other production, a

floorcheck of the Government work alone is not sufficient. To establish overall control,

check the entire department, work area, or specific labor category, but when

circumstances warrant, emphasize the Government portion of the operation.

c. Select employees to be floor checked. Employees may be selected either

randomly or judgmentally, depending upon the audit circumstances and objectives. If

chosen randomly, procedures described in the Attribute Sampling Guidebook should be

followed.

d. Gather background data relating to the selected employees. Appropriate data

may include:

(1) Employee identification numbers.

(2) Employee job classifications.

(3) Nature of the work usually performed by the employee and by the

department or cost center to which he or she is assigned.

(4) Employee shift schedule and telework schedule.

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e. Determine if the floorchecks will be conducted on an unannounced basis or

scheduled. Floorchecks should be in-person, to the greatest extent possible, and

alternative floorcheck procedures, such as, by telephone or by video conferencing,

should be determined and designed by the audit team as needed. In making the

determination, reference 6-404.2 through 6-404.8 to assess the following risk factors:

(1) Size and complexity of the company.

(2) Contractual requirements.

(3) Company policies (e.g., telework policy and Work at Home (WAH) Program

(see 6-405.5)).

(4) Security and contractor concerns (e.g., employee working in secure

locations).

(5) Access to contractor’s information system (e.g., ability to download

timesheets ahead of time to ensure employees are not changing/inputting timesheets

before the interview).

(6) Access to contractor’s communication system (e.g., utilizing contractor’s

equipment to facilitate interviews by video conferencing).

(7) Readily available documentation.

(8) Whether audit objectives can be met.

f. Auditors should consider benefits of in-person floorchecks such as

opportunities for the auditor to build a rapport with the floorcheck selected employee,

allow for more fluid questions and answers, and allow for the auditor to read body

language. In addition, in-person floorchecks can allow the auditor to identify other risk

areas (e.g., idle facilities). The auditor should consider whether the benefits from in-

person floorcheck or interview will outweigh the efficiencies gained through utilizing

telephone or video conferencing. Ideally, there should be a combination of in-person,

telephone, and video-conference floorchecks.

g. Offer the contractor an opportunity to designate a representative to

accompany each audit team during the floorchecks. A primary and alternate

representative should be designated for each of the contractor's locations.

h. Determine the make-up of the floorcheck team. The auditor should use

judgment in determining the makeup of the team; however, the team generally should

include two people. Possible other team members include an ACO representative such

as a technical specialist or contract specialist, or a contractor representative such as an

internal auditor. For in-person floorchecks or sensitive situations (e.g. contractor

frequently challenges floorcheck findings), consider having two auditors: one interviewer

and one recorder.

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i. Ensure that all team members are thoroughly briefed on the overall audit

objectives and that they have the necessary background knowledge to contribute to the

floorcheck.

j. If performing in-person floorchecks, obtain a plant layout and note the location

of employees selected for questioning. Identify each selected employee at work in the

department or area being observed and check to the control list, showing the time

observed. The employee's manager should not be present unless it will facilitate

accomplishment of the objectives. Try to question all selected employees in a given

work area before moving to another. If a particular employee cannot be located, obtain

contractor assistance. Note, for unannounced visits, seeking such assistance has the

effect of providing advance notice of the floorcheck.

k. Floorcheck the selected employees either in-person, by telephone, or by video

conferencing.

l. If performing an in-person floorcheck, identify each selected employee at work

in the department or area being observed and check to the control list, showing the time

observed.

m. Determine whether the employee is performing in the proper capacity as

direct or indirect labor and whether time is being charged correctly by discussing the

nature of the work being performed with the employee and observing the actual work

performance. If an employee's time for the prior period was charged to a cost code or

work project other than the one he or she is working on during the floorcheck and the

nature of his or her work is not such that it obviously entails frequent job changes, the

employee should be queried regarding his or her work assignment in the prior period.

This procedure may disclose errors, adjustments, or alterations to the prior period labor

distribution records which require further analysis.

n. Discuss the employee's timekeeping procedures to determine compliance with

established internal controls and to determine if the employee has received adequate

orientation and training. Question the employee to ascertain the following:

(1) Procedures for receiving the timecard.

(2) Procedures for receiving work assignment charge numbers and

descriptions.

(3) Procedures for completing and submitting the timecard.

o. Listen patiently and attentively to the employee's complete responses to

questions. Do not interrupt or answer for the employee nor allow the contractor's

representative to do so.

p. Record the employee's complete response and be alert to any comments or

reactions that seem inconsistent with question responses.

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q. Compare responses with previous data gathered. If inconsistencies arise or

further clarification is required, ask appropriate follow-up questions.

r. Obtain explanations promptly (before the close of the shift whenever possible)

concerning all questionable procedures or practices observed during the floorcheck.

Determine the reasons for any timekeeping discrepancies noted on the control list, such

as: employees at work who are not on the control list, employees on the control list who

could not be located, reasons for time being charged to work which is not being

performed, reasons for working at other than assigned labor classifications, and

reasons for idleness. When employees selected for interviews are unavailable, follow-

up effort is required to verify the existence of the employee. Auditors should attempt to

interview the employee at a later date. It is acceptable to limit the follow-up interview to

satisfy this single objective, i.e. employee existence, if sufficient steps were already

accomplished to satisfy the other audit objectives of the labor floorcheck. If a follow-up

interview is impractical, other audit steps should be conducted to verify employee

existence. These steps could include, but are not limited to a review of personnel

/security files; observations of the employee’s work area; follow-up telephone

interviews; and/or video teleconferencing. The extent of the additional audit steps to be

accomplished should be based on auditor judgment.

s. Determine whether the observations made during the floorcheck are properly

reflected on the payroll and labor distribution records. Advance planning may be

required to assure that the records are available in sufficient detail to make this check

possible. When the contractor's timekeeping system is automated, special print-outs

may be required. For assist audits conducted at off-site locations, the auditors at the

primary location are responsible for reconciling the time charges collected at the time of

the employees’ interviews to the labor distribution records when the official books and

records are maintained at the primary location. Prime and off-site auditors should

effectively communicate to assure adequate supporting documentation is provided for

the prime auditors to perform this reconciliation.

t. With automated timekeeping procedures, additional care must be taken in the

design of the floorcheck and the subsequent comparison to labor distribution records.

An automated system uses remote data entry terminals to record labor charging data

directly to the computer for processing. Supporting documentation normally consists of

machine printouts showing data that, in a manual system, appears on source

documents. A computerized system can be programmed to alter the labor cost

distribution and prepare printouts to support it. The effect is the same as a manual

alternation of records. The computer, however, can do the job more efficiently and

without involving large numbers of people. If internal controls over the automated

system are weak, consideration should be given to expanding the floorcheck into an

audit of labor cost charging and allocation (6-404).

u. Be alert to unusual situations such as employee idleness, extensive use of

labor for rework or remake operations, excessive number of workers or inefficient use of

workers assigned to Government work, lack of appropriate protection of property from

theft or the elements, use of maintenance supplies to construct capital assets, unused

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floor space or equipment, or assignment of the more efficient workers to commercial

work while similar Government work is being performed by less efficient workers

receiving substantially the same rate of pay. Information to substantiate the use of less

experienced workers on Government contracts may be developed from an examination

of personnel records (length of service and background experience), labor tickets, and

payroll. When a situation as described above exists, ascertain the reasons for the

condition, whether it is permanent or temporary, and whether corrective action is

necessary.

v. Discuss the results of the floorchecks with the audit supervisor and summarize

the results of audit.

6-405.4 Access to Restricted Areas (Floorchecks) **

Occasionally during the course of a floorcheck an auditor is denied access to an

employee, documentation regarding the employee's work, or an area of the contractor's

facility due to security reasons. The floorcheck audit team should not automatically omit

selected employees because of these security restrictions. When access is denied, the

auditor should coordinate with the cognizant Field Detachment office to make

arrangements for the employee to be floorchecked by an auditor with the appropriate

security clearances/briefings. If it is determined that another audit organization has

cognizance of the area, an assist audit request to that organization should be

considered.

a. At contractors where both the regular and Field Detachment DCAA FAOs have

audit workload, annual coordination meetings are held between the two FAOs to

determine the cognizant FAO and discuss the responsibilities of each FAO. During this

meeting, the FAOs should discuss suggested procedures to follow where access is

denied during a floorcheck because of security clearance reasons.

b. If there is reason to believe that the denial of access to the restricted area is

not based on a Government-imposed security restriction and the auditor has the

appropriate clearance to obtain access, carefully consider the guidance in 4-803 and

4-708 to determine whether this condition should be reported as an unsatisfactory

condition or an obstruction of audit. If the auditor is denied access to documents or

records required in the audit, carefully consider the guidance in 1-504 to determine

whether the procedures cited in DCAA Instruction No. 7640.17 are applicable.

6-405.5 Contractor Employee Work at Home (WAH) Programs **

With the advancement of information technology, defense contractors are

establishing employee work at home programs. The auditor should be able to perform

floorcheck of the employee by telephone or video conferencing as described in 6-405.3.

In addition, the following are the minimum internal controls necessary for a contractor’s

work at home policies to be considered acceptable for Government contract costing.

a. Materiality

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(1) When a WAH program is identified, auditors should first assess the

materiality of the costs associated with the contractor’s employees who work at home.

The determination of materiality should consider factors such as the total number of

contractor employees, the number of employees under the WAH program, the dollar

amount of WAH labor, and the mix of contracts.

(2) If costs associated with the WAH program are determined to be material,

the contractor’s policies and procedures covering the program should be evaluated to

determine if adequate internal controls over the WAH program are in place. If the

contractor does not have adequate written policies and procedures, the contractor

should be cited for a labor accounting system deficiency, usually under the Labor

Authorization/Approval or Timekeeping control objectives.

(3) If the costs of the WAH program are not material and the contractor does

not have written policies and procedures, the auditor should notify the contractor in

writing that if WAH costs become material, the Government will require a demonstration

of the adequacy of the internal controls over the WAH program. In addition, the auditor

should establish acceptability of the employees’ labor costs by other means.

b. Internal Controls

Good internal controls over the WAH program should address at a minimum:

(1) Eligibility and status. These programs are usually offered to employees

on an exception basis for situations where attendance at the company facility is a

hardship such as when an employee is injured. However, adequate policies should

include a description of the type of work that may be performed at home. The auditor

should evaluate the reasonableness of performing this work at home. For example,

work that must be closely supervised, requires access to non-portable equipment or

depends on the frequent interaction with others, cannot be performed at home. The

contractor’s policies should also include the status of employees working at home (e.g.,

full time, part-time, temporary, etc.) and the employee’s eligibility for benefits such as

insurance and leave.

(2) Approval policy, employee performance, work schedule and attendance.

Contractor policies and procedures should require:

• proper advance approval by appropriate management officials;

• continuing evaluation of the participating employee’s performance in

completing assigned tasks;

• written documentation of the specific tasks to be performed along with

expected completion dates;

• that WAH employees attend periodic meetings at the contractor’s work

site to allow the employee and supervisor to discuss work progress,

assign new tasks, and evaluate work performed; and

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• that WAH employees work a mutually agreeable set of core hours to

allow management to have access to the WAH employee at

designated times.

(3) Timekeeping Requirements. WAH employees should be required to

submit timecards in accordance with the company-wide timekeeping system. If

applicable, copies of the timecards should be kept at the company facility.

c. Floorcheck Procedures for WAH Programs

Auditor’s judgment based on materiality and audit risk should be used to

determine the need for additional procedures related to WAH program. If necessary,

floorcheck procedures for WAH programs may include:

(1) Discuss with the employee’s supervisor to obtain evidence of the

employee’s work, and documented evidence of supervisory control over the employee’s

WAH schedule.

(2) The auditor should also communicate with the employee by telephone or

video to determine if the employee has knowledge of WAH procedures, and discuss

specific type of work being performed along with the related labor charge numbers.

(3) If the employee has a regularly scheduled meeting with the supervisor in

the near future, any questionable procedures or practices identified in steps (1) and (2)

can be discussed and verified with the supervisor and employee at that time. In

addition, the individual’s employment should be verified to the payroll/personnel

records.

6-406 Evaluation of Payroll Preparation and

Payment **

6-406.1 Audit Objectives **

a. The basic audit objectives are to determine whether:

(1) the contractor's compliance with its policies, procedures, and internal

controls for the preparation of payroll,

(2) the payroll payment procedures afford adequate protection to payroll

checks and cash,

(3) distribution is made to employees named as payee on payroll check or

pay envelope,

(4) there is adequate control over undelivered payroll checks or cash,

(5) these activities are accomplished in an economical manner, and

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(6) the integrity of payroll and labor cost records by reconciling payroll

accruals and disbursements to cost distribution records.

6-406.2 Audit Procedures **

a. Payroll Preparation. Ascertain whether the payrolls are prepared by personnel

independent of persons responsible for the timekeeping operation and for the actual

payroll payment. If an accounting system audit have currently been completed,

determine if information could be used l to facilitate the completion of these procedures.

The auditor should consider the work performed, the sufficiency of audit evidence and

additional audit procedures required. In evaluating compliance with the internal controls

for payroll preparation, the auditor should be guided by the following procedures:

(1) Ascertain the accuracy of the basic payroll records (clock cards, job

tickets, assignment records) and evaluate the method for processing the data.

(2) Evaluate the methods used to reconcile the totals of clock cards and job

tickets and note changes made in time recorded on clock cards.

(3) Ascertain whether all time adjustments, other than apparent and obvious

arithmetical errors, indicate evidence of supervisory review and control.

(4) Ascertain whether pay rates in effect are supported by written

authorization from the personnel department or other authorized source.

(5) Determine whether suitable cross checks are maintained within the payroll

department for verifying the accuracy of names, rates, hours, extensions, deductions,

footing, and accounting distribution.

(6) Determine the adequacy of procedures to assure that payroll advances

are not charged as a direct or indirect expense.

(7) Test pay rates by reference to labor union or other employment

agreements, applicable contract provisions, and contracting officer approvals.

(8) Evaluate the methods used for reconciling over-all payments to labor cost

distribution records.

(9) Evaluate the periodic reconciliations performed by the personnel

department from the information submitted by the payroll department.

b. Payroll Payments. If the auditor determines this step is necessary based on

audit risk and materiality, the auditor should observe, and in selected areas on a test-

check basis, the actual distribution of checks or cash to employees, including the

method used to identify employees. The auditor should determine the methods for

safeguarding pay checks or cash for persons absent on the regular pay date and the

procedures for subsequent payment to employees. The auditor should determine the

method of observation (i.e., unannounced basis or scheduled) based on audit risk, size

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and complexity of the company, contractual requirements, company policies, security

considerations, and when audit objectives can be met. The auditor should be guided by

the following procedures in examining payroll disbursements:

(1) Determine whether all employees are paid by pre-numbered checks and

whether the contractor accounts for all numbers.

(2) Ascertain whether checks prepared in error are voided by permanent

notation and are filed in numerical sequence with the canceled checks. The contractor's

procedures should provide for obsolete or surplus checks to be destroyed in the

presence of authorized personnel and the destruction evidenced by their signature.

(3) Ascertain the disposition made of unclaimed payroll checks. Where the

Government has been charged for the cost represented by unclaimed checks, the

auditor should determine that costs to the Government are properly adjusted, either by

payment to the Government, by a credit to the accounts originally charged to an

overhead account, or in some other equitable manner.

(4) Compare selected names on the payroll with personnel records to

establish authenticity of employment and pay rates.

(5) Determine whether the contractor's internal audit staff observes the

distribution of payroll checks at unannounced intervals.

(6) Evaluate the manner in which the reconciliation of the payroll bank

account is performed, and determine whether it includes:

(a) examination of endorsements on paid checks,

(b) accounting for the numerical sequence of checks,

(d) appropriate action to cancel long-outstanding checks.

The reviews and reports of this function by the contractor's public accountant

and internal auditors should be considered.

6-407 Evaluation of Personnel Policies and

Procedures **

Evaluation of the contractor's personnel policies and procedures should assist the

auditor in determining the extent of verification and testing required.

6-407.1 Evaluation of Management Policies **

a. The evaluation of the contractor's policies and internal controls for:

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(1) hiring, assigning, dismissing, and controlling the labor force,

(2) establishing pay rates, rate changes and any additional compensation,

(3) establishing attendance and time keeping controls,

(4) authorizing and monitoring overtime and multi-shift work by hourly paid

personnel,

(5) authorizing, controlling, and disposing of compensatory time worked by

salaried personnel, establishing vacation, sick leave, and holiday allowances.

b. The auditor should obtain an understanding of the internal control for

personnel records. Effective controls should include as a minimum, the following

practices and procedures:

(1) Hiring and dismissal of employees should be approved by responsible

company officials.

(2) The personnel department should exercise control over all absences.

(3) Reasonable ranges of compensation should be established for each

salary and wage grade.

(4) Payroll increases or decreases should be approved by a responsible

official of the personnel department.

(5) Procedures should be established in the personnel department for the

prompt reporting to the payroll department of all changes affecting payroll, such as new

hires, rate changes, dismissals, and other employee separations.

(6) Personnel records should be maintained for each employee. The records

should be independent of the payroll department and should include information such

as the date of employment, pay rate, classification, terms of employment, personal

history, and approval for hire.

(7) The payroll department should compile a listing of all employees by class,

department assigned, and pay rate. This information should be forwarded periodically

to the personnel department for reconciliation with its records.

6-407.2 Evaluation of Advance Planning Procedures **

The auditor should evaluate the contractor's plan for establishing the proposed

level of operations and should review all significant contemplated increases or

decreases in labor costs. When marked increases in production are planned, the

auditor should review the contractor's plans for lead time in hiring, training, and utilizing

additional personnel. When necessary, the auditor should seek the opinion of qualified

Government technical personnel. Improper lead time may generate unwarranted costs

either by hiring personnel in advance of need (considering the training period) or by not

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hiring soon enough and thereby disrupting the production line. When the contractor

contemplates a cut-back in production, and a consequent decrease in personnel, the

auditor should evaluate the contractor's plan for decreasing personnel and determine

whether the contractor is retaining the higher salaried technical and supervisory

personnel beyond the required period at an increased cost to the Government. The

auditor should ascertain that direct labor personnel who should be terminated are not

transferred to duties of an indirect nature without justification. This is particularly

important when the Government is sharing substantially in the contractor's indirect

expenses.

6-407.3 Evaluation Guidance **

In evaluating the contractor's personnel practices, the auditor should include, but

not limit his or her evaluation to the following:

a. An analysis of the corporate minutes generally record top-management

decisions which affect personnel policies. (In multi-plant operations, this analysis is

usually made by the Contract Audit Coordinator or the auditor of the corporation home

office.)

b. An evaluation of the current written operating procedures which apply to

personnel activities.

c. An analysis of the actual practices followed at the operating levels and a

comparison of these practices with the written procedures.

6-407.4 Evaluating Procedures for Determining Personnel Requirements **

The auditor should evaluate the procedures by which the contractor determines

the required number and classification of personnel. When contractors have been

producing under Government contracts over an extended period of time at

approximately the same level of operations, requirements are usually based on

personnel turnover experience. When a program is undergoing expansion or when the

contractor has been awarded a contract for the first time, determination of the number,

type, and quality of personnel required is usually based on the contractor's estimates.

The auditor's evaluation of the contractor's basis for determining personnel

requirements should include, as a minimum, ascertaining:

(1) that the policies are sound, clearly stated, and generally applicable to a

prudently operated business,

(2) that the request for personnel is approved by a responsible executive, and

(3) that when a request for additional personnel is submitted it is supported by

valid reasons and management has considered all other alternatives before granting the

request.

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6-408 Evaluation of Recruitment Costs and

Practices **

6-408.1 Area of Coverage **

The recruitment of most employees is a function of the personnel department.

Costs incurred typically include:

(1) help wanted advertising,

(2) salaries and travel expenses of company personnel engaged in recruiting

efforts,

(3) travel and living expenses of applicants and new employees,

(4) expense of moving household effects of new employees, and

(5) fees paid to employment agencies.

6-408.2 Audit Objectives **

The audit objectives are to establish whether:

(1) the contractor's recruiting policies, procedures, and practices are

acceptable,

(2) the program is effectively administered, and

(3) the total cost is reasonable in comparison with the results achieved and

appropriately allocated.

6-408.3 Audit Procedures **

In accomplishing the audit objective, the auditor should be guided by the

procedures described below:

a. Evaluate the prescribed duties and responsibilities assigned to the

organizational unit responsible for recruitment activities and ascertain that they are

clearly established to accomplish the assigned mission.

b. Evaluate recruitment activities for the most recent operating period and obtain,

among other information, data on:

(1) Employment changes during the period under evaluation (new hirings,

transfers, separations) to determine the rate of turnover by classes of employees.

(2) Recruitment efforts (applicants interviewed and employment offers made,

accepted, and rejected).

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(3) Sources of new hires (advertising, referrals, and employment agencies).

(4) Total costs of recruitment (advertising, salaries, travel expense of

contractor personnel and recruits, relocation expense, and employment fees). The

auditor should review or develop data on the cost per hire, and by type of hire, such as

engineers or executives.

c. Evaluate the various types of payroll allowances or fringe benefits to

employees. Determine whether allowances are in accordance with established

company policy and whether they are reasonable in view of standard industry practices

and criteria for determining reasonableness contained in procurement directives.

d. Ascertain the nature and extent of budgetary controls exercised over the cost

of different types of recruiting methods used and allowances paid employees.

e. Compare employee turnover rates being experienced for various categories of

personnel with prior years' rates and with rates anticipated by management. Consider

the effect of the turnover rates on the continued need for large scale recruitment

activities; or conversely, the need to reduce these activities significantly. Ascertain if

measures are being taken to identify and eliminate the causes of the turnover.

f. Determine the extent to which recruitment is controlled by manpower forecasts,

specific job requisitions, and by management approval.

g. Evaluate procedures used to recruit qualified technical personnel to meet work

requirements.

6-409 Evaluating Overtime, Extra-Shift Pay, and

Multi-Shift Work **

The auditor should evaluate the contractor's policies, procedures, and internal

controls on overtime, extra-pay shifts, and multi-shift work, and the accounting and

distribution of the premium costs. The auditor should be familiar with the provisions of

FAR 22.103, which includes definitions and conditions under which overtime costs may

be approved under Government contracts. When overtime work is required, the

contractor's policies and procedures should comply with FAR 22.103 and insure that the

operations will be limited to the actual need for the accomplishment of specific work.

The auditor should ascertain that the amount of work performed at premium rates is

equitably divided between Government and commercial operations.

6-409.1 Audit Objectives **

The audit objectives are to determine whether:

(1) management is properly authorizing, scheduling, and controlling overtime,

extra-shift, and multi-shift work,

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(2) contracting officer's written approval is obtained when required by contract

provisions,

(3) premium costs are reasonable and properly allocable to the Government

contracts,

(4) adequate control is exercised over productivity in the extra-pay periods,

and

(5) compensatory overtime work by salaried personnel is properly authorized,

and application against subsequent working hours is properly monitored.

6-409.2 Audit Procedures **

Audit procedures should include the following:

a. A determination as to whether the contractor's practices are consistent with the

Government's interests. Effective procedures should include:

(1) acceptable standards to determine the need for overtime and premium

shift work,

(2) the establishment of categories of employees eligible to receive premium

pay,

(3) the proper levels of management authorization, approval, and continuing

control over these operations,

(4) the establishment of adequate procedures for authorizing compensatory

overtime and effective monitoring of compensatory overtime credits against subsequent

working time not actually worked, and

(5) the continual review of overtime and shift data by management to control

overtime and shift premium costs.

b. An evaluation of contracts, when overtime and shift work is applicable, and an

examination of the bid proposal and negotiating memorandum to ascertain the extent to

which the contract price provided for overtime premium and shift premium expenses. If

overtime and shift premiums were not considered in the contract price, the auditor

should ascertain and evaluate the reasons for the overtime and shift premiums.

c. A determination that premium labor costs charged to the contract have been

approved by the contracting officer, when required, and have been incurred in

accordance with the contractor's normal policy.

d. A periodic review of the continuing need for the exception types of overtime

operations cited in FAR 22.103-4 and DFARS 222.103-4.

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e. An evaluation of the accounting treatment accorded overtime premium pay

and the method of cost distribution. Overtime premium pay may be treated as indirect

expense or as a direct charge when it is the contractor's regularly established policy and

when appropriate tests clearly demonstrate that this policy results in equitable cost

allocations. Irrespective of the practices disclosed by a contractor, the question of

whether or not, or the extent to which, overtime premium pay is allowable, allocable,

and reasonable under a contract remains for consideration in each specific instance

considering contractual requirements and applicable Government regulations.

f. An evaluation of the accounting and distribution treatment accorded shift

premium pay.

g. An evaluation of the contractor's procedures for compensatory overtime work

to determine that this type of work is properly authorized and performed according to an

acceptable company policy and that proper monitoring is exercised by management in

applying an employee's compensatory overtime to subsequent scheduled working time

in which the employee does not work.

6-410 Evaluating Uncompensated Overtime **

6-410.1 Introduction **

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a. The Fair Labor Standards Act (FLSA) requires employers to compensate

hourly workers (i.e., non-exempt employees) for hours worked in excess of a “normal

workweek”. FAR 22.103 defines a “normal workweek” as generally a workweek of 40

hours per week. Employers may also have alternative work schedules that are

considered the normal work period, for example, an employee may work 80 hours in a

two week period, with varying hours in each week. The FLSA does not require

employers to pay overtime to salaried employees (i.e., exempt employees). Salaried

or exempt employees receive a salary to provide a service in whatever time is

required. Therefore, the salary of an exempt employee provides full compensation for

all hours worked including those worked beyond the normal work period. There are

contractors' whose accounting systems account for labor based on an employee’s

normal work period; the hours worked by an exempt employee in excess of the normal

work period are commonly called uncompensated overtime. In October 1997 the

solicitation provision and contract clause, FAR 52.237-10, Identification of

Uncompensated Overtime, was issued for acquisitions of service contracts that are

based on labor hours rather than tasks performed. The clause defines

uncompensated overtime as “hours worked without additional compensation in excess

of an average of 40 hours per week by direct charge employees who are exempt from

the Fair Labor Standards Act”. See 9-505. Although this provision applies specifically

to certain service contracts, uncompensated overtime also presents a risk for

inequitable allocation of direct labor costs for other contract types in accordance with

FAR 31.201-4, Determining Allocability. Additionally, if an employee works

uncompensated overtime hours directly on a contract and does not account for the

hours as direct hours, an inequitable allocation of labor costs could result in

noncompliance with CAS, such as CAS 403, 410, and 418. The solicitation clause is

provided here to provide context; auditors are reminded that when examining costs

incurred, solicitation clauses are not the appropriate audit criteria.

b. There are those contractors' whose accounting systems do not assign costs to

hours worked by exempt employees in excess of the employee’s normal work schedule

for the work week. In some cases, labor costs are distributed only to cost objectives

worked on during the normally scheduled hours (for example, the first 40 hours of the

week, or the first 80 hours of a work period). In other cases, employees may select

which cost objectives to charge when they work more hours than their normal work

schedule requires. The contractor may also have an informal policy for how employees

should select the objectives to charge when they work beyond their normally scheduled

hours. For example, the policy might be to charge direct hours first and indirect hours

for the remaining hours. Say an employee is on a standard 40 hour work schedule, and

the employee works 30 hours on a contract and 20 hours on a B&P project during the

same week. The actual hours incurred on the contract (30 hours in this case) might be

charged directly to the contract with the balance of the hours for the work schedule (10

hours) charged to the B&P project. This practice means that 10 hours of effort

benefitted, but were not charged to, the B&P project. Not accounting for all hours

worked creates a serious risk of mischarging costs to Government contracts in such

circumstances. For example, let’s say an employee with a normal work schedule do 40

hours per week, is paid a weekly salary of $2,000. The employee works 50 hours

during a given week, 40 hours on Project A and 10 hours on other projects, but charges

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only the normal scheduled 40 hours, all to Project A. A misallocation of labor cost

occurs because Project A was charged for costs that benefited other projects. The

misallocation of labor cost to Project A causes an overstatement of its direct costs which

further results in Project A receiving an over allocation of indirect costs. If the amount of

uncompensated overtime hours worked is significant, the resulting allocation of cost,

both direct and indirect, could result in a material overcharging of cost to a project. An

equitable allocation of the labor costs would result if labor costs are distributed to all

benefiting objectives based on an adjusted hourly rate. In our example, the $2,000

weekly salary would be divided by 50 hours, for an adjusted hourly rate of $40, and

Project A would then be allocated 8 hours ($1,600) rather than the full $2,000.

6-410.2 Audit Objectives **

The basic audit objectives are to determine whether:

(1) the contractor is accounting for all hours worked;

(2) the contractor is allocating an equitable share of salary costs to all

benefitting cost objectives performed in accordance with FAR 31.201-4; and

(3) all work accomplished, including uncompensated overtime hours worked

by exempt employees, is included in the base for distribution of indirect costs and in

accordance with CAS 418.

6-410.3 Basic Audit Procedures **

a. Evaluate the contractor's policies and procedures relative to recording

uncompensated overtime hours worked by exempt employees in excess of the

employee’s normally scheduled hours per pay period. If the contractor has been

awarded a service contract based on the number of labor hours, FAR 52.237-10

requires the offeror to have a policy addressing uncompensated overtime and to have

accounting practices to estimate uncompensated overtime that are consistent with its

cost accounting practices used to accumulate and report uncompensated overtime

hours(see 9-505). If a contractor has not been awarded a service contract based on the

number of labor hours, a formal policy addressing uncompensated overtime may not

exist; the auditor will need to determine the contractor’s actual charging practices

relative to recording uncompensated overtime hours and determine if the contractor

consistently follows its practice. If the contractor does not have a practice for recording

uncompensated overtime, the auditor should consider if unrecorded uncompensated

overtime could result in material mischarging and design audit steps accordingly, to

determine the materiality of the potential risk, such as additional testing during the labor

floorchecks and conducting employee interviews.

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b. Determine whether the contractor is recording all hours worked by exempt

employees. If a review of employee time records discloses that exempt employees

consistently record only their normally scheduled hours per pay period, conduct floor

checks and/or employee interviews to see whether exempt employees work in excess

of their normally scheduled hours. If they do, discuss with the contractor the need to

record all hours worked by exempt employees in order to ensure that salary and

applicable indirect costs are being equitably allocated for all effort performed by the

employees during the period. If the contractor refuses to record all hours worked by

exempt employees, the audit team may need to expand the floor-checks and employee

interviews to determine whether the failure to record all time worked results, or could

result, in a material impact on the allocation of costs to final cost objectives. Request

the contracting officer to require the contractor to record all hours worked when a

material impact on allocation of costs is determined.

c. Determine whether the contractor is allocating salary costs for exempt

employees based on all effort performed in accordance with FAR 31.201-4 and, where

applicable, CAS 418.

d. If it is determined that Government contracts are being materially over-charged

due to an inequitable allocation of labor costs because the contractor does not record all

time worked, the contractor should be cited as being in noncompliance with FAR

31.201-4 and, if applicable, CAS 418. The auditor should question or disapprove, as

applicable, any material excess allocation of costs to Government for FAR

noncompliances (however, if a CAS noncompliance is cited, the costs will need to be

resolved through the CAS Administration procedures in accordance with FAR Part 30).

Materiality is the governing factor when determining whether noncompliances should be

cited and whether a contractor should be required to implement a total-hour accounting

system (see 6-410.6).

6-410.4 Acceptable Accounting Methods **

Accounting for uncompensated overtime hours worked by exempt employees

may be accomplished by a variety of methods, including:

a. Distributing the salary cost using an adjusted hourly rate (computed by dividing

the salary paid by the total hours worked during the period) to all benefitting cost

objectives worked on during the period.

b. Distributing the salary cost using a pro rata allocation. For example, if an

employee worked 20 hours on one cost objective and 30 hours on another 40 percent

(20 divided by 50 total hours) of the weekly salary would be allocated to the first cost

objective and 60 percent (30 divided by 50) would be allocated to the second cost

objective.

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c. Charging a standard adjusted hourly rate to cost objectives for all hours

worked. The standard adjusted rate is computed by dividing the annual salary by the

number of hours the employee is expected to work during the year. Any variance

between actual salary costs and the amount distributed is applied to the corresponding

overhead pool.

6-410.5 Other Possible Accounting Methods **

A contractor may use other methods to account for uncompensated overtime

worked by exempt employees. The audit team should evaluate the acceptability of the

method used and determine the significance of any inequities that may result.

Examples of methods that require further evaluation include:

(1) distributing salary cost pro-rata to all cost objectives based on a normal

work schedule (e.g. 8 hour days/40 hour week, or 80 hours per pay period) and

charging the amounts in excess of the normal work schedule to overhead. Note that

this method can result in cost shifting since the direct costs that are charged as indirect

will be spread to other cost objectives; and

(2) distributing salary costs using a pro rata allocation of hours worked each

day. (Note: daily distribution of cost increases the possibility for "gaming" or abuse.)

6-410.6 Materiality Considerations **

a. The risk that unrecorded uncompensated overtime will materially impact the

allocation of labor and overhead costs on Government contracts is an important

consideration in deciding whether or not to recommend a contractor to be required to

record all hours worked. Auditors should make two basic determinations as part of their

preliminary evaluation of uncompensated overtime to determine whether to expand the

scope of the evaluation (e.g., number of contracts, contract mix, etc.):

(1) Determine whether significant unrecorded uncompensated overtime does,

or may exist.

(2) Assess the risk that a material inequitable distribution of costs may result

from unrecorded uncompensated overtime.

b. If procedures to evaluate uncompensated overtime indicate that:

● uncompensated overtime could materially impact labor cost allocations,

and

● a significant amount of unrecorded uncompensated overtime exists and

has, or could potentially have a material impact on cost allocations.

A determination must be made whether to recommend the contracting officer

require the contractor to account for uncompensated overtime. This determination is

necessary to:

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(1) Pursue recovery of any costs due to the Government as a result of the

unrecorded uncompensated overtime, and

(2) Support a recommendation to require the contractor to modify its labor

system to account for all hours worked.

c. Determining the impact of a contractor’s unrecorded uncompensated overtime

can be difficult and time consuming. In low-risk situations, the effort required to

determine the impact may not be justified. The auditor must make an independent and

timely assessment of the situation, and cannot rely on the contractor’s assertion that

unrecorded uncompensated overtime is not material. If the risk of material impact from

unrecorded uncompensated overtime is determined to be low, the auditor must

document the rationale for this determination in the risk assessment. In situations

where the risk is considered significant that material mischarging of labor costs may

result due to unrecorded uncompensated overtime, the auditor must take appropriate

steps to determine the cost impact. At a minimum, the audit team needs to perform

steps similar to those listed below to determine if accounting for uncompensated

overtime would have a material impact on the contractor’s allocation of costs to

Government contracts:

(1) Identify the contractor’s departments/operations presenting the highest

risk for significant unrecorded uncompensated overtime that could have a material

impact on the allocation of labor and overhead costs to Government contracts. In

assessing risk, consider the factors and conditions noted in 6-404.6, “Evaluation of

Conditions Influencing Contractor Labor Charging Practices.” Examples include

contract mix and overrun contracts.

(2) Focus floorchecks and employee interviews within the high risk

departments and operations. Distinguish between work performed during standard 8

hour day/40 hour week for which time is recorded, and work performed during the

unrecorded hours.

(3) Determine if observations made during the floorchecks and/or interviews

support the conclusion that not recording uncompensated overtime results in a material

impact on allocation of costs. If findings support this conclusion, perform one or more of

the following steps:

(a) Expand the audit scope to include other potentially high risk

departments or operations.

(b) Discuss the observations/findings with the ACO and recommend that

the contractor be required to modify its labor accounting system to record and account

for all labor hours worked.

performed in accordance with 6-404.7.

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(4) If the findings from the evaluation of the highest risk

departments/operations do not support the conclusion that a material impact on the

allocation of costs exists, document the reasons for this conclusion in the working

papers and consider the impact and modify the audit program as necessary.

6-411 Evaluation of Other Labor Systems

(Standard Costs and Proprietor/Partner

Salaries) **

a. Standard Cost System. The use of standard costs (when variances are

appropriately applied) to record direct labor costs for Government contracts is

acceptable, particularly when the operations among several Government contracts or

the operations between Government and commercial production are similar and are so

intermingled as to unduly complicate the actual cost accounting processes. Use of a

standard cost accounting system to cost Government contracts is permitted only when it

meets the criteria in CAS 407 (see 8-407).

(1) In accepting standard labor costs, the auditor should determine the extent to

which collateral labor costs such as overtime, shift premium, sick leave, and vacation

pay are included in the established standard.

(2) The auditor should determine whether standards are based on formal,

scientific and reasonably current studies representative of actual operations performed.

The auditor should trace standard labor charges from distribution sheets to the payroll

records to determine whether recorded standard operations for a given date or period

conform to the actual operations for which payment was made to employees.

(3) The auditor should test related variances to product line to determine whether

standards and variances approximate actual costs.

(4) The auditor should also analyze variances, preferably by examining

contractor's own analyses, to find the causes of variances (for example, rate, efficiency,

down time, or setup). This may disclose improper charges to direct labor through the

variance accounts.

b. Sole Proprietors' and Partners' Salaries. Sole proprietors' and partners' salaries

usually are included in overhead. However, when owners or partners are personally

engaged in performing under Government contracts, particularly in research and

development contracts, their compensation may be charged as direct labor. The

evaluation of time charged directly should be coordinated with the screening of other

direct and indirect labor to prevent duplication of charges in direct and indirect labor. It

may be more appropriate in some instances to treat the compensation of proprietors

and partners as Other Direct Costs without overhead. The auditor should evaluate the

reasonableness of the compensation charged on the basis of services rendered.

Proprietors and partners time charged direct will also influence consideration of profit or

management return. In accordance with FAR 31.205-6(a)(6)(ii) compensation costs

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must be reasonable for the personal services rendered and not be a distribution of

profits (which is not an allowable contract cost). When the rate of pay has not been

stipulated in the contract, the auditor should evaluate the reasonableness of the rate.

The auditor should ascertain whether acceptable time records are available to

substantiate the time charged to the contract. When the amount of time spent on the

contract is significant, all of the individual's time should be accounted for and not only

that portion of time charged to the contract. The services of a Government technical

representative should be solicited when the auditor is unable to evaluate the

reasonableness of the charge because of technical considerations.

6-412 Evaluation of Quantitative and Qualitative

Utilization of Labor **

6-412.1 Audit Objectives **

The basic audit objectives are to evaluate the internal controls instituted to

assure prudent utilization of staffing in the performance of Government contracts, to

determine whether the costs are commensurate with the benefits derived, and to

determine the reasonableness and efficiency of the labor utilization.

6-412.2 Audit Procedures **

To accomplish the audit objective, the auditor should be guided by the

procedures described below. The evaluation of the quantitative and qualitative

utilization of labor may require the assistance of qualified Government technical

personnel. The auditor should go as far as he or she can in each audit step pending

technical review and analysis. When the issuance of an audit report would otherwise be

unduly delayed because the technical analysis is not available, a qualified report should

be issued. The auditor should identify manpower utilization reviews performed by the

contractor or others and consider the results in completing the following audit

procedures.

a. Evaluate the contractor's functions and related activities for quantitative and

qualitative utilization of labor. The evaluation should disclose organizational and

functional areas that require audit emphasis.

b. Ascertain whether the work performed by the contractor is required by the

terms of the contract, properly authorized, and directed to the appropriate operational

unit.

c. Determine whether there are unwarranted variations between staffing budgets

allocated by upper management and staffing budgets actually used by operating or

middle management. (See 5-500 for guidance on contractor budgeting procedures.)

d. Determine whether the contractor maintains adequate control over the

expenditure of the technical effort to assure maximum productivity, whether this control

includes the evaluation of actual work assignments and target completion dates, and

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whether comparisons are made with staffing budgets and staffing tables approved by

management.

e. When salaries and wages constitute a significant portion of contract costs,

evaluate, on a selective basis, personnel files of employees assigned to Government

contract work to determine whether qualifications of workers performing the contract are

commensurate with the rates charged and all other requirements of the contract.

f. Evaluate the contractor's personnel practices during start-up and phase out

periods to determine whether the cost of excess personnel is charged to Government

contracts in the build-up period and whether the Government contracts are unduly

burdened with the retention of unnecessary personnel in the phase out period.

g. Evaluate the contractor's basis for assigning and phasing out technical

personnel for both Government production and commercial operations. Audit emphasis

should be accorded the phase out portion of the contract to determine the reasons for

retaining certain classes of technical personnel to complete the contract. The auditor

should also determine whether the contractor is assigning technical personnel in

accordance with their skills. The use of highly trained personnel to perform routine work

which could be performed by lower paid personnel is not economical. The use of less

than qualified personnel to perform difficult work may result in higher costs to the

Government because more time and greater supervision may be required. The type of

contract should be a guide to the auditor in determining the extent of verification in

these areas.

h. Examine the contractor's staffing and labor control practices to determine the

effectiveness of controlling idle time. If unreasonable idle time is perceived or controls

are judged to be inadequate, conduct a preliminary work sampling (probe).

i. Compare labor classifications charged to the contract with those proposed to

ascertain whether the contractor is utilizing the type of personnel for which the

Government has contracted.

j. Determine whether engineering, technical writing, etc. on Government work is

subcontracted rather than performed by the contractor and whether such practice

results in unreasonable costs to the Government. Among the factors to be considered

is whether, under the prevailing conditions, there is any necessity for subcontracting

other than to meet temporary or emergency requirements. (See the Selected Areas of

Cost guidebook for further guidance in this area.)

k. Evaluate manual labor procedures for possible mechanization (capital

investment opportunities, 14-600) which will result in increased efficiencies and

economies of the contractor's operation and less cost to the Government.

6-413 Reasonableness of Compensation Costs **

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The guidance contained in this subsection is designed to assist the auditor in

determining the reasonableness of employee compensation costs in accordance with

the criteria set forth in FAR 31.205-6, Compensation for personal services. The scope

and extent of any testing for reasonableness should be based on the control risk

assessment and results of the audit of internal controls over compensation. For specific

guidance on when the auditor must perform tests of reasonableness of non-bargaining

unit employees, refer to 6-413.2.

6-413.1 Compliance with FAR 31.205-6(b)(1), Compensation Pursuant to

Labor Management Agreements **

a. All costs of compensation established under an "arm's length" labor-

management agreement negotiated under the terms of the Federal Labor Relations Act

or similar state statutes are considered reasonable unless the provisions of the

agreement are either unwarranted or discriminatory against the Government in

accordance with FAR 31.205-6(b)(1). That is, it will not be tested for reasonableness

under FAR 31.205-6(b)(2). But it must, nonetheless, satisfy any specific compensation

element allowability criteria elsewhere in FAR 31.205-6.

b. Unwarranted or discriminatory provisions exist when, under unique

circumstances, the work conditions vary significantly from those contemplated by the

negotiating parties or the collective bargaining agreement contains provisions that are

inequitable to the Government as a class of customer by the character and nature of the

work.

c. Arm's length agreements refer to those agreements between independently

organized labor groups, such as labor unions, and contractor management for the

purpose of establishing wage increases, hours, benefits, and working conditions.

d. Provisions of an agreement designed to set pay rates based on a given set of

circumstances and conditions of employment, such as work involving extremely

hazardous activities, are unwarranted if the work on Government contracts is less

hazardous.

e. Provisions of an agreement are considered discriminatory against the

Government (as a class of customer) when the agreement mandates pay provisions for

work of the same character and nature that exceed those comparable to similar

commercial work. Therefore, an agreement with provisions which require higher pay

levels for contractor employees who work on Government contracts than for those

contractor employees performing under the same conditions on commercial contracts is

discriminatory. For example, a union agreement that provided for higher wage rates for

construction work on a Government installation than for rates applicable to commercial

construction in the same area under similar circumstances would be considered

discriminatory.

6-413.2 Evaluation of the Reasonableness of Non-Bargaining Unit

Compensation in Accordance with FAR 31.205-6(b)(2) **

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a. The auditor should apply the tests of reasonableness, in accordance with FAR

31.205-6(b)(2), in those circumstances where (1) the auditor has performed the audit

procedures and has determined that the contractor’s internal control system cannot be

relied upon to demonstrate reasonable levels of compensation, and (2) the auditor has

identified the potential for unreasonable levels of compensation. Before taking

exception to compensation costs, consider the reasonableness test procedures as

discussed in this subsection.

b. Compensation costs of owners, some executives, and other employees having

a higher risk of unreasonable compensation will not be accepted on the basis of a

compensation system audit without some specific testing to substantiate the

reasonableness of the compensation. Refer to 6-414. These types of employees are

considered to be outside the reach of established control activities.

c. When evaluating wage increases, if the compensation system is adequate and

the contractor's established practice is to provide wage increases to certain non-

bargaining unit employees comparable to those given bargaining unit employees, no

tests of reasonableness need be applied.

d. Compensation for each employee or job class of employees must be

reasonable for the work performed. Compensation is reasonable if the aggregate of

each measurable and allowable element sums to a reasonable total per FAR 31.205-

6(b)(2). In determining the reasonableness of total compensation, consider only

allowable individual elements of compensation.

6-413.3 Determining Reasonableness for Non-bargaining Unit Employees **

To determine the reasonableness of total compensation, consider the provisions

of FAR 31.201-3 and FAR 31.205-6(b)(2) as well as factors determined to be relevant

by the contracting officer. The most likely source for obtaining the compensation data

will be market pay surveys. When market pay survey data are used to make the FAR

comparison tests, identification of the firm participants and their qualifications to meet

the FAR criteria is required and should be documented in the audit working papers.

a. As addressed in FAR 31.205-6(b)(2), factors that may be relevant in

evaluating compensation reasonableness include general conformity with the

compensation practices and data of other firms of the same size, in the same industry,

in the same geographic area, and engaged in similar non-Government work under

comparable circumstances.

(1) Geographic area refers to comparisons made with firms in the same local

or regional area as that of the contractor.

(2) Size pertains to comparisons with firms of relatively the same size in terms

of number of employees or sales volume. Sales volume is also a factor in evaluating

executives' compensation.

Page 108 of 227

(3) Industry means comparisons with firms producing similar products or

providing similar services. For instance, the compensation levels for a contractor whose

principal product is shipbuilding should be compared to other shipbuilders. Other

industries include aerospace, electrical/electronics, office equipment and computers, or

research and development. The contractor's specific industries may be identified by

reference to the Government's North American Industry Classification System (NAICS)

codes, which are used to classify companies by industry. It should be noted that

compensation survey data for several related NAICS codes is often aggregated to

represent a group of industries commonly categorized, for example, as aerospace

industries.

(4) Contractors engaged in similar non-Government work under comparable

circumstances refers to comparable services from sources outside of the contractor.

b. All factors discussed in 6-413.3.a may not be relevant to the same extent. The

extent to which each of the factors must be considered depends on the degree to which

each of the factors is representative of the labor market for the job being evaluated.

Relevance is directly tied to a contractor's circumstances. Rationale for the

determination of the significance of the relevant factors to be applied must be sufficient

to address the considerations of reasonableness, as set forth in FAR 31.201-3.

c. Acceptable compensation surveys to be used for applying the FAR tests

should provide the appropriate relevant factor data, as outlined above, to make the

comparisons, and should be determined reliable. An acceptable survey may include

firms that represent more than one of the relevant factors, such as firms that are of the

same size, geographic area, and industry as the contractor. If the auditor determines

that the contractor’s pay surveys do not represent the relevant market for the jobs to be

benchmarked or the contractor will not provide access to survey data, the auditor should

independently determine availability of reliable surveys and market price compensation.

d. In those circumstances where the auditor has determined that acceptable pay

surveys exist and are available for audit use, the auditor will make comparison tests

with benchmarked jobs within a pay structure job class. However, top executive

positions are unique and must be audited individually. This is true regardless of the

individuals’ assignment to a job class, grade or pay structure (see 6-414). All

comparison tests are to be made by comparing the weighted average (or median) wage

or salary of a job class with those provided in an acceptable survey. Update survey(s)

to a common data point for each year through the use of appropriate escalation factors.

e. More than one survey may be required to consider the significance of the

relevant factors in the circumstance. If determined reliable and applicable, use the

contractor's market comparison studies wherein the contractor has selected jobs to be

benchmarked and has compared them with survey job pay rates.

f. As stated in FAR 31.205−6(b)(2), compensation is reasonable if the aggregate

of each measurable and allowable element sums to a reasonable total. To test the

reasonableness of compensation costs by job class, the auditor should compare

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sufficient individual jobs within the job class to comparable jobs in external pay surveys

to determine compensation reasonableness. As defined in FAR 31.001, a job class is

comprised of a group of employees performing in positions within the same job,

performing work of the same nature at the same skill/responsibility level. The auditor

must exercise judgment when determining the number of jobs to test so that all

significant findings are adequately supported. The auditor should consider the following

before performing extensive benchmarking:

(1) In the audit of the contractor's internal controls, the auditor should have

previously determined whether the contractor has a market comparison process

adequate to demonstrate the reasonableness of compensation. Accordingly, where

possible, the auditor should rely on the contractor's benchmarking effort as a baseline

for determining reasonableness. Additional audit effort will then be directed at

supplementing, where necessary, the contractor’s work.

(2) During the preliminary stage of the audit, the auditor should request the

contractor to provide available evidence of the reasonableness of the aggregate of

compensation elements.

(3) A contractor with a majority of commercial and competitively awarded

Government fixed price work in its business base may be under considerable pressure

from its product market competitors to keep compensation costs low. This may reduce

the risk of unreasonable compensation where compensation for employees working

commercial/fixed priced work and employees working on negotiated Government

flexibly priced work are administered the same.

6-413.4 Determining Reasonableness of Compensation Costs **

a. Compensation is considered unreasonable if the aggregate of each allowable

and measurable element of compensation exceeds the survey data weighted average

(or median) rates by 10 percent. This judgment factor considers that a determination of

unreasonable compensation results from material compensation system deficiencies or

unjustified pay policies. A large difference between the average and median can be the

result of a few atypical cases skewing the average, especially in small sample sizes.

When sample sizes are small and there are material differences between the average

and the median (e.g., executive salaries) the median should be used.

b. Each allowable element of an employee’s compensation for jobs within a job

class is benchmarked to survey data. The benchmarking of jobs to determine

reasonableness for the salary element of compensation is explained in 6-413.3f.

c. A contractor's pay structure may include jobs that cannot be compared to

market survey data because of a low number of incumbents or the jobs are unique to

the organization. Since reliable survey data is not available, the contractor may place

these positions within its compensation structure based on their relative value (skill,

responsibility level, etc.) as compared to benchmarked jobs (commonly referred to as

“slotting”). If the auditor deems this process acceptable, then compensation for the

Page 110 of 227

nonbenchmarked jobs would be considered unreasonable to the same degree as the

benchmarked jobs because they are of the same relative value.

d. Individual elements of compensation (such as wages and salaries, bonuses,

fringe benefits, and deferred compensation) may each be subject to the FAR tests for

allowability. However, the aggregate of allowable elements of compensation should be

considered in assessing reasonableness. See 6-413.7 for guidance.

6-413.5 Fringe Benefits **

FAR 31.205-6(m) states that, except as provided otherwise in Subpart 31.2,

fringe benefits are allowable to the extent that they are reasonable and required by law,

employer-employee agreement, or an established contractor policy. Accordingly, when

evaluating fringe benefit costs, auditors should first evaluate the contractor's compliance

with other applicable FAR 31.2 criteria and then make a determination of

reasonableness (see 6-413.3(a)).

a. Legally Required. Those benefits that are required by statutory law are

workers' compensation, social security, and unemployment compensation. The costs of

these benefits are dependent upon the level of wages and salaries.

b. Pensions, Life and Health Insurance. An evaluation of a contractor's

insurance and pension programs is normally performed as a Contractor

Insurance/Pension Review (CIPR) as set forth in DFARS 242.73). The results of these

reviews should be considered in the scope of the benefits program review. Refer to 4-

1000 for guidance on relying upon the work of others. See Selected Areas of Cost

Guidebook, Chapter 53 for additional guidance regarding the audit of pension costs and

Chapter 34 for additional guidance regarding the audit of insurance costs.

c. Pay for Time Not Worked. Benefits within this category include paid vacations

and payments in lieu of vacation, payments for holidays and for holidays worked, paid

sick leave, and payments for National Guard, Army, other reserve duty, or jury duty.

Policies necessary for the control of these benefits include:

(1) eligibility rules,

(2) the size of the benefit, such as how many holidays the company will pay

for or how much vacation an employee is entitled to receive,

(3) the effect of holidays or sickness that occurs during a vacation,

(4) the degree vacation and unused sick leave time can be banked and

carried over to another pay period or paid at time of termination, and

(5) circumstances for extra pay rather than paid time off.

d. Other. Other benefits include severance pay, thrift savings plans, deferred

compensation plans, stock bonus plans, and employee stock ownership plans (ESOPs).

Page 111 of 227

The contractor's policies and procedures for these benefits should be documented,

include authorization procedures, requirements for monitoring and reporting the results

to management, and control ranges on amounts of benefits to be provided.

e. Allowability of Costs. The cost principles provide specific restrictions on the

allowability of some of these benefits, as follows:

(1) Severance Pay -- FAR 31.205-6(g), refer to Selected Areas of Cost

Guidebook, Chapter 69 for guidance on the evaluation of these costs.

(2) ESOP – FAR 31.205-6(q), refer to Selected Areas of Cost Guidebook,

Chapter 23 for guidance on the evaluation of these costs.

(3) Bonuses, including sign-on, relocation and retention bonuses, and

incentive compensation, including compensation based on changes in the prices of

corporate securities or corporate security ownership - FAR 31.205-6(f), (i), and (k), refer

to Selected Areas of Cost Guidebook, Chapter 7 for guidance on the evaluation of these

costs.

f. Reasonableness of Costs. Since the reasonableness of compensation is

assessed “in the aggregate,” comparisons to market survey data as discussed in 6-

413.3 will include an adjustment for the market-determined reasonable fringe benefits.

6-413.6 Justification **

a. The contractor may provide justification for compensation exceeding market

surveys. Examples include compliance with Federal or state laws, employee relation

concerns, or labor shortages. However, the contractor should provide sufficient

documentation to establish a sound basis for any exceptions.

b. The contractor's justification should address the following considerations for

reasonableness, as provided in FAR 31.201-3:

(1) A cost is reasonable if, in its nature and amount, it does not exceed that

which would be incurred by a prudent person in the conduct of competitive business.

(2) The cost is generally recognized as ordinary and necessary for the

conduct of the contractor's business or the contract performance.

(3) Consideration should be given to generally accepted sound business

practices, arm's length bargaining, and Federal and state laws and regulations.

(4) Consideration should be given to the contractor's responsibilities to the

Government, other customers, the owners of the business, employees, and the public at

large.

(5) Any significant deviations from the contractor's established practices

should be considered in determining the reasonableness of a cost.

Page 112 of 227

6-413.7 Offsets – Compensation Costs **

a. FAR 31.205-6(b)(2) provides that compensation is reasonable if the aggregate

of each measurable and allowable element sums to a reasonable total. Offsets

between individual compensation elements are implied in this concept. By using

offsets, the contractor can provide proof that, in total, the cost of the compensation

package is reasonable.

b. An element of compensation proposed as an offset must be an otherwise

allowable element of compensation, and it must be quantifiable for comparison with the

compensation elements deemed unreasonable. For example, deferred compensation

introduced as an offset must be based upon an allowable deferred compensation plan.

Compensation based on changes in the prices of corporate security ownership, such as

stock options, SARs, phantom stock plans, and junior stock conversions cannot be

introduced as an offset because they produce costs which are unallowable for

Government contracts.

c. Offsets can also be proposed by the employee’s job class as defined in FAR

31.001. Offsets by job class that exceeds the external pay survey weighted average by

more than 10 percent could be offset by any compensation for other jobs in the same

job class. In evaluating the propriety of offset(s), the auditor shall coordinate with the

ACO and with the regional/CAD/Headquarters technical programs division specialist on

compensation costs.

6-414 Reasonableness and Allowability of

Compensation for Owners, Executives, and

Other High Risk Compensation Categories **

6-414.1 Introduction **

a. FAR 31.205-6(a)(6) provides for special consideration of compensation costs

for certain individuals. Principally, the special circumstances pertain to individual

owners of closely held corporations, partners, sole proprietors, or members of their

immediate families. Also included are persons who are contractually committed to

acquire a substantial financial interest in the contractor’s enterprise. In general, the

special circumstances criteria include those employees who can exercise influence over

their own compensation, either directly or indirectly through the authority of a family

member. The ability to influence their own compensation creates a higher risk that such

employees could pay themselves unreasonable compensation.

Page 113 of 227

b. Because of their ownership or family position, such persons are often

company executives. However, in many cases, employees who are executives or

members of a corporate board of directors, but who are not owners, have been

delegated ownership type authority to act without being subject to significant oversight.

Such non-owner employees should also be considered as higher risks for unreasonable

compensation. Such persons would normally include officers of the company.

c. If the compensation costs are considered material, the reasonableness and

allowability of compensation for owners, executives, and other high risk employees

should be evaluated in incurred cost audits (see 6-414.6 through 6-414.11; Selected

Areas of Cost Guidebook, Chapter 7; and FAR 31.205-6(f), (i), (k), (l) and (p)).

6-414.2 Ownership and Substantial Financial Interest **

If an employee owns less than 100 percent of a company, the employee may still

exercise substantial influence over the decision making process. By definition, all

partners in a partnership arrangement have substantial influence. Many authorities

(e.g., the SEC) quantify the ownership necessary to influence a corporation's decisions

as 10 percent of the voting stock. The auditor should consider all sole owners, partners,

and persons meeting the 10 percent standard to have influence over their own

compensation. The auditor should also consider the combination of corporate voting

power held by one family in determining if those family members who are employees

can influence their own compensation.

6-414.3 Risks Considerations for Unreasonable Compensation **

a. In general, the evaluation procedures in 6-413 apply to compensation of

owners, executives, and other employees who pose a higher risk of unreasonable

compensation. However, the reason such employees are considered high risk is that

they are not subject to the contractor's normal internal controls over compensation.

Therefore, the auditor may not rely on those normal internal controls.

b. Such higher risk employees may nominally be part of a class of employees.

(The president's son may be an engineer in the design department, or an owner of 25

percent of the firm may be one of several scientists working in research.) The auditor

should not accept their compensation as reasonable because the class is reasonable as

a whole without checking to assure that the higher risk employees have substantially

equal duties and compensation as the other members of the class. Especially in the

case of family members of owners or executives, such an employee may be overgraded

considering the duties actually performed or simply paid more than others doing the

same work.

c. Executive positions within a company are usually unique positions within that

company. Only the largest of firms have the potential for a class of employees

performing vice-presidential level duties, which can be described as having similar rank,

function, and responsibility. Normally, executives are not part of a class of employees

and must be evaluated individually.

Page 114 of 227

d. Such positions are best evaluated by comparison to positions with comparable

rank, function, and responsibility in other firms of similar size. If the firm changes in size,

prior determinations of reasonable compensation amounts will need to be reevaluated.

e. As provided in FAR 31.205-6(a)(6)(ii), compensation to owners must be

reasonable for the personal services rendered, and not be a distribution of profits (which

is not an allowable contract cost). Auditors must ascertain whether payments made to

owners, such as guaranteed payments to partners or bonuses, that may appear to be a

distribution of profits based on the accounting records of the enterprise, are allowable or

unallowable compensation costs in accordance with FAR 31.205-6. In addition,

auditors must ascertain whether total allowable compensation paid to an individual

exceeds a reasonable amount for the services performed.

f. For closely held corporations, compensation, including bonuses, will not be

recognized in excess of the costs that are deductible as compensation under the

Internal Revenue Code (IRC) (26 U.S.C.) and regulations under it. However, the fact

that an executive’s or owner’s compensation has not been challenged by the Internal

Revenue Service (IRS) does not indicate that the claimed amounts are reasonable

costs on Federal contracts.

(1) To be deductible under the IRC and regulations, the total compensation

paid must meet the test of reasonableness. In general, under the IRC and regulations,

reasonable compensation is the amount that would be paid for like services by like

enterprises under like circumstances. The circumstances to be taken into consideration

are those existing at the date of agreement with the employee for the services, not

those existing at the date when the amount is questioned.

(2) Excess compensation received by a shareholder is considered by the IRS

to be constructive dividends. This is likely to occur in the case of a corporation having

few shareholders, practically all of whom draw salaries. If in such a case the salaries

are in excess of those ordinarily paid for similar services, and the excessive payments

correspond or bear a close relationship to the stock holdings of the officers or

employees, it would seem likely that the salaries are not paid wholly for services

rendered, but that the excessive payments are a distribution of earnings upon the stock.

Page 115 of 227

g. Executive compensation claimed may be well below the compensation ceilings

discussed in 6-414.8 and still be unreasonable. Executive compensation claimed

should be evaluated for reasonableness in accordance with FAR 31, even if contractors

have voluntarily excluded some executive compensation costs to comply with the

appropriate regulatory ceiling amount. Determine if the reasonableness of executive

compensation has been evaluated in prior incurred cost audits, or an accounting system

audit, if applicable. If not, test compensation reasonableness in the current audit. If

compensation was evaluated and determined to be reasonable, determine if claimed

compensation (or in some cases the sales revenue of the company) has changed

significantly. If there have been changes in claimed compensation levels or size of the

company measured in sales, perform an evaluation of the reasonableness of executive

compensation. If the prior year’s audit of claimed compensation found unreasonable

levels of compensation, reasonableness should be evaluated again. Reasonableness

testing can be performed in three ways:

(1) If the contractor used survey data to establish executive pay, review the

survey data and/or the market pricing analysis used to determine reasonableness.

Surveys used by the contractor should be evaluated to determine if they are

representative of the contractor’s relevant labor market or industry and are appropriate

in accordance with FAR 31.205-6(b). This evaluation includes determining if the (i)

appropriate survey positions were used based on job descriptions and other data, (ii)

appropriate industry factors have been considered, (iii) survey is statistically reliable for

the selected survey positions, and (iv) percentile to be used from the survey is based on

performance, or in cases lacking demonstrated performance, that the median was used.

Surveys used by contractors should be validated using a secondary survey source. The

use of only one survey to determine reasonableness of contractor executive

compensation is not adequate in most cases. The preference is to use a secondary

survey source to which the contractor has access, but has not used in its market pricing.

Alternatively, the secondary survey source could be one to which DCAA has access.

Do not use free internet salary surveys to evaluate compensation because there is no

way to check the statistical accuracy of the data and most practicing compensation

specialists regard the free surveys as non-credible sources for determining

reasonableness. Coordinate with the regional compensation technical specialist, as

needed.

(2) If the contractor is part of a consolidated group and executive pay is

established at another location, coordinate with the cognizant DCAA office to determine

if an audit of executive compensation has been performed. If not, request an assist

audit to evaluate the executive pay for reasonableness.

(3) When the compensation expense is significant, request assistance from

the Headquarters Agency Compensation Team (ACT). Determine the positions to be

evaluated and complete the Compensation Reasonableness Request Form, which is

available on the intranet.

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h. The following process was the ASBCA’s interpretation (Techplan, Case No.

41470, 96-2, BCA 28426) of how compensation experts would market price executive

compensation. This process is used by the ACT and should be followed to the extent

practical. The auditor should rely on the contractor’s market pricing when available,

unless the contractor used free internet surveys to develop labor costs as these surveys

are not independent or objective. The auditor should ascertain that the contractor’s

market pricing is compliant with FAR 31.205-6 and consistent with the process cited in

the Techplan Corporation ASBCA Decision. Variations from the process cited in the

Techplan decision should be evaluated for the contractor’s particular circumstances.

(1) Determine the position to be evaluated.

(2) Identify survey(s) of compensation for the position to be evaluated that

match the company in terms of revenues, industry, geographic location and/or other

relevant factors.

(3) Update the surveys to a common data point for each year through the use

of escalation factors.

(4) Array the data from the surveys for the relevant compensation elements at

various levels of compensation, such as the average (mean) or selected percentiles,

and develop a composite number for each. Note: Use of other percentiles is necessary

only if the contractor’s performance (see 6-414.3i below) is quantitatively and

measurably above or below average. The Information Systems & Networks Corporation

ASBCA Decision clarified that for companies with performance that was below average,

below average levels of compensation could be utilized as the reasonable level of

compensation for market pricing.

(5) Determine which of the numbers to use for comparative purposes. In

most cases average or median data will be utilized as an initial position prior to

performing a detailed financial performance analysis.

(6) Apply a range of reasonableness, such as 10 percent, to the number or

numbers selected. It is DCAA policy to use 10 percent as the range of reasonableness.

A 10 percent range of reasonableness (ROR) was also supported by the ASBCA in the

Information Systems & Networks Corporation ASBCA Decision.

(7) Adjust the actual total cash compensation for lower than normal fringe

benefits. (Calculate an offset.)

(8) Compare the adjusted compensation to the range of reasonableness.

Differences should be questioned as unreasonable.

i. Often contractors will propose that their executives should be paid more than

110 percent of the reasonable compensation based on the average compensation paid

by comparable firms for executives with similar duties. Above average levels of

compensation are usually identified by percentiles, such as the 75th percentile. For an

executive with responsibility for overall management of a segment or firm, such a

Page 117 of 227

proposal may be justified by clearly superior performance as documented by financial

performance that significantly exceeds the particular industry's average. The ASBCA

decision on Information Systems & Networks Corporation ASBCA No. 47849, “capped”

executive compensation at the 75th percentile when justified by performance.

(1) Examples of financial performance measures may include the following:

• Revenue Growth

• Net Income

• Return on Shareholder's Equity

• Return on Assets

• Return on Sales

• Earnings per Share Growth

• Return on Capital

• Cost Savings

• Market Share

(2) The contractor must show that the measure chosen is representative of

the executive’s performance. Consideration should be given to the competitive

environment in which the contractor operates. There should be no extra compensation

awarded because of high performance measured by a standard which is not affected by

the executive’s performance, and certainly there should be no extra compensation due

to performance which results primarily from the contractor’s status as a Government

contractor. Performance is typically measured using more than one criterion of

performance. For example, a contractor may have significant sales growth through

acquisitions and mergers while operating at a loss. In this situation, the contractor

would not be considered to have superior performance based on the lone measure of

sales growth.

(3) Use of a particular measure to justify higher than average compensation

should be applied consistently over a period of years, with both increases and

decreases in the performance measures reflected in the changes to compensation

claimed as reasonable.

6-414.4 Reporting on High Risk Employee Compensation **

a. Compensation system audits should exclude positions or individual employees

not effectively covered by the compensation system's controls from any opinion that the

contractor's compensation system is adequate.

b. For incurred costs, opinions on such employees' compensation should be

limited to recommendations on the acceptance of specific compensation amounts

claimed which are found to be allowable and reasonable for the services rendered and

disallowance of amounts found to be unallowable or unreasonable.

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c. For forward pricing, the determination of reasonableness is based on an

evaluation of projections made by the contractor.

d. When compensation of employees becomes unreasonable due to changed

circumstances after some period of time during which the Government considered

compensation paid to be reasonable, the contractor is generally afforded a period of

time to adjust its compensation levels before the costs are questioned. However,

compensation of owners and executives is more flexible and is generally dependent on

circumstances as they occur. Thus, compensation of owners and executives should

generally be questioned for all periods if it is found to be unreasonable. Of course, any

increased compensation should be questioned immediately if it is unreasonable due to

a change in the previously audited compensation system or a failure to follow that

system. Also, compensation determined to be unallowable because it is in excess of

the compensation ceilings discussed at 6-414.7 should be questioned for all applicable

periods.

6-414.5 Termination Payments to Owners and Executives **

a. It would be unreasonable for an owner to terminate himself/herself and claim

compensation for the termination. Allowable severance payments must be for

involuntary termination. All other termination payments must make economic sense to

be allowable. If a payment makes economic sense, then the profit motive should be

sufficient reason for the owner to retire. Owners receive their payment through the

profit from their decisions.

b. The auditor should also be alert to termination agreements made with retiring

owners and executives to pay them for consulting services for some period of time after

retirement. The payments should be commensurate with services expected from the

retiree. Such payments may represent unallowable compensation payments.

6-414.6 Bonuses Resulting From Business Combinations **

a. Costs for bonuses or other payments in excess of the employee's normal

salary that are part of restructuring costs associated with a business combination are

unallowable under DoD contracts per DFARS 231.205-6(f)(1).

b. This DFARS limitation does not apply to severance and early retirement

incentive payments. Reasonable payments for these types of costs are allowable

subject to the provisions in FAR 31.205-6(g), “Severance pay,” and (j)(6), “Early

retirement incentive plans.”

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6-414.7 Compensation Ceilings - General Policy **

Congress has established statutory limitations on annual allowable individual

compensation since 1995. The regulatory limitations and factors to consider when

auditing the allowability of compensation in accordance with FAR 31.205-6(p) are

discussed below. A summary of the compensation ceilings for Contractor Covered

Employees by year follows:

Statutory FY

Costs

Incurred *

Compensation

Ceiling

Defense Agencies

(DoD, NASA, Coast

Guard)

Civilian Agencies Audit

Criteria

2002 $387,783 Top five (5) most

highly compensated

employees in

management

positions at each

home office and at

each segment.

Top five (5) most

highly

compensated

employees in

management

positions at each

home office and

at each segment.

FAR

31.205-

6(p)(2)

2003 $405,273 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2004 $432,851 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2005 $473,318 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2006 $546,689 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2007 $597,912 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2008 $612,196 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

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2009 $684,181 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2010 $693,951 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2011 $763,029 Same as FY 2002

(Top 5)

Same as FY 2002

(Top 5)

FAR

31.205-

6(p)(2)

2012 $952,308 Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 12/31/2011

Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 6/24/2014

FAR

31.205-

6(p)(2)

$952,308 All employees

Applicable to

contracts awarded

on or after

12/31/2011 but

before 6/24/2014

FAR

31.205-

6(p)(3)

2013 $980,796 Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 12/31/2011

Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 6/24/2014

FAR

31.205-

6(p)(2)

$980,796 All employees

Applicable to

contracts awarded

on or after

12/31/2011 but

before 6/24/2014

FAR

31.205-

6(p)(3)

2014** $1,144,888*** Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 12/31/2011

Same as FY 2002

(Top 5)

Applicable to

contracts awarded

before 6/24/2014

FAR

31.205-

6(p)(2)

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$1,144,888*** All employees

Applicable to

contracts awarded

on or after

12/31/2011 but

before 6/24/2014

FAR

31.205-

6(p)(3)

$487,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2015 $487,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2016 $500,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2017 $512,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2018 $525,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2019 $540,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

Page 122 of 227

2020 $555,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2021 $568,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2022 $589,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2023 $619,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

2024 $646,000 All employees

Applicable to

contracts awarded

on or after

6/24/2014

All employees

Applicable to

contracts awarded

on or after

6/24/2014

FAR

31.205-

6(p)(4)

* The fiscal year (FY) for the statutory formula cap amount as determined by the Office of

Federal Procurement Policy (OFPP) is the calendar year. If the contractor’s fiscal year does not

coincide with the FY for the statutory formula cap amount, the benchmark compensation amount

must be adjusted by pro-rating the statutory cap for each of the two calendar years straddled by

the contractor’s fiscal year.

** Due to the multiple compensation limits in FY 2014 and later, contractors may propose

their compensation costs using a blending methodology. In order for a contractor to use this

blending methodology, they must have a written advance agreement with DCMA.

*** OFPP has not changed any statutory (41 USC 1127) compensation ceiling amounts

relating to compensation cost incurred after FY 2014 for contracts awarded prior to June 24,

2014 (FAR 31.205-6(p) (2) and (3)). The compensation ceiling amount for these contracts

remains at $1,144,888 until changed by OFPP.

Page 123 of 227

a. FAR Compensation Ceilings for fiscal years (FY) 2002 through 2011. The

Office of Federal Procurement Policy (OFPP) set the FY 2002 through 2011 cap

amounts as shown in the table above. These caps apply to the five most highly

compensated employees in management positions at each home office and at each

segment. These caps apply to contract costs incurred after January 1 of each year on

all defense and civilian agency contracts covered by the FAR cost principles, including

those contracts awarded prior to the enactment of the cap. The method for applying the

cap is the same for 2002 through 2011.

b. FAR Compensation Ceilings for FY 2012 and 2013. The National Defense

Authorization Act (NDAA) for 2012 (Public Law 112-81) expanded the statutory cap

amounts for defense agency contracts (DoD, NASA, and Coast Guard) to cover all

contractor employees and applies to costs incurred after December 31, 2011.

Therefore, for FY 2012 and 2013, the caps in the table above apply to all employees

performing on defense agency contracts. For civilian agency contracts, the 2012 and

2013 caps continue to apply only to the top five most highly compensated employees in

management positions at each home office and at each segment.

c. FAR Compensation Ceiling for FY 2014 and subsequent years. Section 702 of

the Bipartisan Budget Act (BBA) of 2013 (Public Law 113-67, December 26, 2013)

established a compensation limitation of $487,000 for all employees (both defense and

civilian) performing on contracts awarded on or after June 24, 2014, adjusted annually

to reflect the change in the Employee Cost Index for all workers, as calculated by the

Bureau of Labor Statistics. The BBA cap is codified statue (10 USC 2324(e)(1)(P) and

41 USC 4304(a)(16). The Compensation Caps are reflective in the table above.

• For defense agency contracts awarded on/after December 31, 2011, and

before June 24, 2014, the ceiling established by OFPP in accordance with

41 USC 1127 (now repealed but was in effect prior to this date) continues

to apply to all employees.

• For civilian agency contracts awarded before June 24, 2014, the ceiling

established by OFPP in accordance with 41 USC 1127 (now repealed but

was in effect prior to this date) continues to apply to the top five most highly

compensated employees in management positions at each home office

and at each segment.

• The BBA cap replaces the statutory formula cap established by 41 USC

1127 for contracts awarded as of June 24, 2014 and limits the

reimbursement of compensation costs for all contractor employees on all

contracts awarded by all executive agencies of the Government.

• For each year from 2014 going forward, there could be two ceilings in

effect for a contractor, based on the date of contract award on each flexibly

priced contract. The need for the OFPP to publish a separate cap in

accordance with 41 USC 1127 will expire when there are no longer any

costs being incurred on flexibly priced contracts awarded prior to June 24,

2014.

Page 124 of 227

6-414.8 Compensation Ceilings - General Audit Considerations **

a. If an employee’s compensation exceeds the ceiling amount for the year, the

amount in excess of the ceiling charged (directly or indirectly) to any contract covered

by the FAR or DFARS limitation must be disallowed. If the entire amount of an

employee’s compensation is charged to an indirect cost pool, the disallowance may be

effected by disallowing the amount in excess of ceiling amount. If the employee

charges both direct and indirect and the excess compensation charged direct to

contracts is material, then the auditor should calculate unallowable compensation

applicable to specific contract(s) separately.

b. A contractor may have contracts subject to the FAR and/or DFARS limitations,

and contracts not subject to the limitations. Contractors may, at their option, propose

separate sets of labor and indirect rates for contracts covered and not covered by the

limitations. If the contractor proposes separate rates for contracts not subject to any

limitations, those rates should be evaluated using the cost principle provisions at FAR

31.205-6(a) through (o).

c. Since the FAR and DFARS limitations establish an expressly unallowable

category of cost, any costs in excess of the limitations included in the final indirect cost

settlement proposal are expressly unallowable and subject to penalty provisions at FAR

42.709 (previously at DFARS 231.70). It is the contractor’s responsibility to identify the

contracts subject to any of the compensation limitations.

d. Executive compensation subject to the specific FAR and DFARS limitations is

also subject to the reasonableness provisions of the FAR. Compensation that does not

exceed the specific limitations may still be unreasonable when compared to other

positions with comparable rank, function, and responsibility in other firms of similar size.

The smaller the firm, the more likely this will be the case. Therefore, auditors should

consider tests of reasonableness even when executive compensation is below the

ceiling.

e. Executives subject to the compensation cap sometimes perform unallowable

activities, such as lobbying, advertising, and organization or reorganization activities. In

addition, the executive’s compensation may include unallowable elements of cost under

the FAR, such as stock appreciation rights and bonuses calculated based on changes

in the price of corporate securities. To properly apply the FAR 31.205-6 compensation

cap, auditors should verify that contractors determined the allowable portion of

compensation costs for each executive by identifying the amount of unreasonable

compensation, the amount of unallowable compensation elements, the amount

attributable to unallowable activities, and deducting those amounts from the executive’s

total compensation costs subject to the cap. After verifying that the contractors’

adjustments for unallowable compensation costs are appropriate, the auditor should

then compare the allowable portion of the executive’s compensation cost to the

benchmark compensation limitation imposed by FAR 31.205-6.

Page 125 of 227

Figure 6-4-2 - Application of the FAR 31.205-6(p) Compensation Cap**

The following example demonstrates the proper application of the compensation

cap for two executives based on the assumptions below. All amounts presented in the

example below are for the contractor fiscal year 2007.

Figure 6-4-2 Table 1

Cost Elements Executive A

(Note 1)

Executive B

(Note 1)

Reference

Compensation:

Salary $1,000,000 $500,000

Cash Bonus 200,000 100,000 Note 2

Defined Benefit Pension Plan 50,000 30,000 Note 3

Contributions to 401(k) Plan. 5,000 5,000 Note 4

Stock Appreciation Rights 200,000 100,000 Note 5

Medical Insurance 4,000 4,000 Note 6

Company-Furnished Automobile 11,000 11,000 Note 7

Total $1,470,000 $750,000

FAR Benchmark Compensation Cap

for CFY 2007

$597,912 $597,912

Note 1: The total compensation paid to each executive is considered reasonable

in amount. The contractor agrees that both Executives A and B spent fifty percent of

their effort performing unallowable lobbying activities (see FAR 31.205-22).

Note 2: The cost is allowable per FAR 31.205-6(f)). The cash bonus is paid in

accordance with a plan that makes awards based on the executive’s performance

during the year.

Note 3: Costs for defined benefit pension benefits are not included in the

definition of compensation (FAR 31.205-6(p)(2)(i)) subject to the cap.

Note 4: The cost is considered allowable per FAR 31.205-6(j)(4). The contractor

contributes to the 401(k) retirement plan in accordance with the plan provision.

Note 5: Stock appreciation rights (SAR) represent deferred compensation that is

calculated based on changes in the prices of corporate securities, which is unallowable

per FAR 31.205-6(i).

Note 6: The cost is considered allowable per FAR 31.205-6(m)(1). The

contractor provides group medical insurance to all of its employees.

Page 126 of 227

Note 7: The cost is unallowable per FAR 31.205-6(m)(2). The contractor

provides a company automobile for the executive’s personal use.

Calculate allowable compensation in accordance with FAR 31.205-6(p):

Figure 6-4-2 Table 2

6-500 Section 5 - Audit of Incurred Other Direct Costs and Credits **

6-501 Introduction **

This section presents audit guidance for the evaluation of other direct costs

Other direct costs are costs which are in addition to direct labor and material which

can be readily identified with a specific job. Costs of this nature may be charged direct

to jobs, allocated on some representative basis, or charged partially direct and partially

by allocation. Some examples are listed below; additional information on specific other

direct costs can be found in the Selected Areas of Cost Guidebook.

(1) special tooling, dies, jigs, and fixtures;

(2) plant rearrangement;

Cost Elements FAR Executive A Executive B

1. Subject to Limitation

Salary 31.205-6(p)(2)(i)

$1,000,000 $500,000

Cash Bonus 31.205-6(p)(2)(i)

200,000 100,000

Employer Contributions to 401(k) Plan 31.205-6(p)(2)(i)

5,000 5,000

Stock Appreciation Rights 31.205-6(p)(2)(i)

200,000 100,000

Subtotal $1,405,000 $705,000

2. Subtract Unallowable Costs

a. Stock Appreciation Rights 31.205-6(i) (200,000) (100,000)

Subtotal $1,205,000 $605,000

b. Lobbying Activity (50%) 31.205-22 (602,500) (302,500)

3. Allowable Comp Subject to the

Limitation at FAR 31.205-6(p)

$602,500 $302,500

FAR Benchmark Compensation Cap, CFY

2007

$597,912 $597,912

4. Net Allowable Compensation in

Accordance with FAR 31.205-6(p)

31.205-6(p)(1) $597,912 $302,500

Page 127 of 227

(3) packaging and packing;

(4) consultant's fees;

(5) outbound freight;

(6) expediting;

(7) royalties;

(8) travel; and

(9) Computer center and other service center costs

6-502 Audit Objectives **

a. The objectives in auditing other direct costs are to determine whether:

(1) the contractor's cost representations are reliable and accurate,

(2) the amounts charged to Government contracts are allowable, allocable, and

reasonable in accordance with FAR 31.2 (6-505),

(3) costs have been accumulated in accordance with generally accepted

accounting principles appropriate in the circumstances, and

(4) the contractor has been consistent in allocating such costs to commercial and

Government work.

b. Of special concern in the other direct cost area is the differentiation between

direct and indirect cost. The audit should provide assurance that when items ordinarily

chargeable as indirect costs are charged to Government work as direct costs, the costs

of like items applicable to other work of the contractor are treated in the same manner.

CAS 402 evaluations, relevant to the period under audit, may provide sufficient

documentation to reduce scope.

6-503 Audit Approach **

The auditor should determine how the audit will be efficiently performed on auditor

judgment considering the relevant factors in 3-204 and documented in the working

papers and permanent file, if applicable.

6-504 Scope of Audit **

The auditor should exercise professional judgment and consider risk in determining

the audit scope. Factors which may influence the audit scope are discussed in 3-204

with additional considerations are discussed below in 6-504.1 through 6-504.4.

Page 128 of 227

6-504.1 Interrelated Reviews **

a. Other direct costs may be incurred on the basis of management decisions in a

manner similar to the incurrence of indirect costs. Whenever practicable, apply the

scope of audit described in 6-603 to other direct costs and perform the audit in

conjunction with the audit of indirect costs. For example, the contractor's policies and

procedures regarding the segregation of unallowable travel costs should be the same

for both direct and indirect travel.

b. Similarly, when an item is purchased, documents such as the purchase

requisition, purchase order, receiving report, and inspection report should identify the

contract for which the cost was incurred. When the contractor manufactures

components or parts, the work orders and all documents serving as a basis for charges

to the work order, such as requisitions and job tickets, should be identified with the

contract. Internal controls over accounting, purchasing, subcontracting or make/buy

decisions may impact the audit of other direct cost.

6-504.2 Evaluation of Bid Proposals and Contract Provisions **

a. When the contractor's accounting procedures provide for the accumulation of

other direct costs, or the cost representations include other direct costs, the auditor

should review negotiation memorandums and the contract provisions to ascertain

whether it was the intent of the contracting parties to treat certain costs as direct rather

than as indirect costs. Contracts awarded on a firm-fixed-price basis generally do not

contain provisions concerning costs to be charged to the contract. However, if there is

information that a category of cost was considered as a direct charge during the

negotiation of a firm-fixed-price contract, the auditor should determine that other

Government contracts do not share the same cost through an indirect cost allocation.

b. When auditing costs of special tooling or special equipment, review the terms

of the contract to determine whether the costs are to be treated as other direct costs. If

so, evaluate the contractor's controls to determine whether they ensure the appropriate

disposition of specialized items upon completion of the contract. When a contract is

silent concerning these types of costs, seek the assistance of the contracting officer and

ascertain the necessity for the acquisition of the equipment and the propriety of treating

the costs as a direct charge to the contract. (See 3-300, 14-402, and Selected Areas of

Cost Guidebook).

6-504.3 Disclosure Statement **

Page 129 of 227

The auditor should be alert to inconsistencies in the treatment of other direct

costs which may result in inequitable charges to Government contracts. Part 3 of the

disclosure statement delineates the contractor's policy regarding differentiation between

direct and indirect costs, identifies contractor's other direct costs, and explains

deviations from the contractor's normal direct charging policy. Because a primary

concern regarding other direct costs relates to consistency of treatment, an evaluation

of disclosed practices may indicate areas for audit. When such inconsistencies are

noted, advise the contracting officer to take corrective action. When the amounts are

significant and consistent treatment cannot be attained, it may be necessary to establish

special indirect cost rates for the contracts affected to avoid inequitable charges to

those contracts.

6-504.4 Selected Areas of Cost **

The auditor should evaluate the contractor's submission for new, unusual, or

miscellaneous types of ODC. General audit guidance and audit considerations for

selected areas of costs are provided in the Selected Areas of Cost Guidebook.

6-505 Audit Procedures **

The auditor should determine that all items of other direct costs are readily

identifiable with the contract to which they have been charged. The audit of other direct

costs should include an evaluation of:

a. The reasonableness of the amount incurred in relation to the benefits to be

derived;

b. The allocability of the cost to the product, service, activity, or contract to which it

was charged, and the consistency of application; and

c. The allowability of the cost in accordance with FAR/DFARS and the provisions of

the contract.

6-505.1 Reasonableness of Allocation of Cost **

Apply the guidelines in FAR Part 31 to determine whether other direct costs are

reasonable in amount in relation to the contractual benefits to be derived. When the

amount is not significant in comparison to the total costs, determine whether the cost of

additional time expended by cost clerks, voucher examiners, payroll analysts, and

others to accomplish the refinements commensurate with the benefits the Government

may expect to derive from maintaining such precise accounting.

6-505.2 Allocation Methods and Consistency of Application **

a. Evaluate the contractor's methods for identifying other direct costs and

determine whether the methods result in an equitable distribution of costs to both

Government and other work. When items are charged to a Government contract as

other direct costs, the contractor's procedures should provide for like or comparable

items to be similarly charged to other work. When the contractor has not been

Page 130 of 227

consistent, eliminate the comparable or similar cost items applicable to all other work

from the indirect expense pool prior to allocation. Make sufficient tests to determine

consistency of accounting treatment.

b. Under certain circumstances, it is appropriate to treat certain types of costs as

direct charges and as overhead. For example, all travel directly applicable to

Government contracts or other work may be charged direct, while travel, such as for

recruitment and general administration, may be treated as overhead.

c. When a contractor manufactures special tools, evaluate the propriety of

allocating overhead to the in-house manufacturing process. When special tools are

manufactured in a separate department which is considered a production department,

the indirect costs of the department and any proration’s from other service departments

constitute tooling overhead allocable to tooling labor costs. However, when the

contractor considers the special tooling department as an indirect department, overhead

would not be allocable because the overhead generated remains in the expense pool

and is subsequently prorated to production. Consider the equity of this method as part

of the evaluation of the contractor's procedures for accounting for indirect costs.

6-505.3 Allowability of Costs **

Certain categories of cost in FAR Part 31.2 are not allowable in pricing

Government contracts whether charged direct or through allocation. Further, the terms

of a contract may specifically preclude the contractor from classifying certain classes of

costs as "direct," and conversely, the contract may permit the contractor to reflect

certain classes of costs as direct costs. However, in all instances, the allowability of

costs under Government contracts is subject to the tests of allocability and

reasonableness.

6-506 Coordination with Government Technical

Personnel **

The auditor should request technical assistance to determine the need as well as the

reasonableness of the costs in areas outside his or her technical competence and for

which the auditor cannot make an independent assessment. For example, technical

advice may be required when the contractor manufactures special tools or incurs plant

rearrangement costs which are charged to other direct costs, or, when packaging costs

represent a significant amount of other direct costs, in which event the auditor should

seek the services of Government packaging experts to determine the need as well as

the reasonableness of the costs for packaging. Guidance on requesting and using the

work of technical specialists is in Appendix B. See 4-104 for incorporating the request

for technical assistance into the acknowledgment/notification letter.

Page 131 of 227

6-600 Section 6 - Audit of Incurred Indirect Costs **

6-601 Introduction **

This section presents audit guidance and procedures for the audit of indirect costs

used in establishing final indirect cost rates for other than firm-fixed-price type contracts.

Refer to Section 5-1000, Indirect/Other Direct Cost Systems, for guidance and

procedures on the evaluation of the contractor's policies, procedures, and internal

controls which affect indirect costs. The guidance is also to be used for the

determination of allowable indirect costs under other circumstances such as audits of

terminated contracts (12-304.15), audits of progress payment requests (14-200), and for

interim evaluations of incurred costs.

a. An indirect cost is any cost that is not directly identified with a single final cost

objective, but is identified with two or more final cost objectives or an intermediate cost

objective (FAR 31.203(b)). Indirect costs are to be accumulated by logical groups and

distributed on the basis of benefits accruing to the several cost objectives. The

numbers and composition of cost groupings should be governed by practical

considerations.

b. Procedures for settling final indirect cost rates are presented in 6-700. Guidance

for audits of the base costs to which the rates apply is provided in this section.

6-602 Audit Objectives **

a. The audit objectives are to evaluate and determine:

(1) the allowability, allocability, and reasonableness of the costs charged to

Government contracts;

(2) the propriety of the methods used to allocate indirect costs to Government

contracts;

(3) the correctness of the bases used to apportion indirect costs;

(4) the appropriateness of the indirect cost period;

(5) the consistency of the application of policies and procedures to the

Government and to other operations; and

(6) the mathematical accuracy of the computed final indirect cost rates.

Page 132 of 227

b. The discovery of fraud or other unlawful/improper activity is not the primary audit

objective, but the auditor must be attentive to any condition which suggests that such a

situation may exist. If such activity is suspected, the circumstances should be reported

in accordance with 4-700.

6-603 Scope of Audit **

a. The audit should include:

(1) evaluation of the contractor's system of internal control, including the means

by which all echelons of management control the level of indirect costs (see 5-1000);

(2) evaluation of the composition and suitability of the allocation bases;

(3) evaluation of the composition of the various indirect cost pools to ascertain

whether they are logical and bear a reasonable relationship to the bases used for

apportioning expenses to operations;

(4) evaluation of selected indirect cost accounts;

(5) verification to the financial records; and

(6) verification of the mathematical accuracy of the rate computation.

b. The extent of audit effort should be influenced by:

(1) adequacy of the contractor's policies, procedures, and internal controls,

including the contractor's monitoring and testing efforts (see 5-1000);

(2) types of Government contracts and the percentage of Government

participation (the total dollar value of the indirect costs allocated to Government

contracts);

(3) adequacy of the contractor’s records based on past experience and the

impact of changed conditions; and

(4) the contract terms.

6-603.1 Types of Contracts and Government Participation **

Page 133 of 227

a. For discussion, contracts other than firm-fixed-price, time-and-materials, or

labor-hour are referred to as cost-reimbursable. The various types of contracts are

more fully defined in FAR Part 16. Audits of incurred indirect costs are performed only

at contractors with cost-reimbursable contracts. The higher the value and percentage of

reimbursable costs the greater the need to analyze management decisions and internal

controls over costs, and a greater depth of evaluation of selected accounts. The higher

the percentage of firm-fixed-price or commercial work the greater the need to evaluate

the allocation of costs between Government and other contracts. An analysis of

participation may result in reduced scope for the whole audit or only certain pools. For

instance, pools with high Government participation may require detailed account

analysis, whereas pools with no Government participation may require only a

determination that the allocation base is appropriate to assure absorption of all allocable

costs.

b. The scope of audit may also be affected by the percentage and amount of

subcontract or interdivisional work performed. Prime contractors have a responsibility

to audit their subcontractors. The auditor cognizant of the prime or higher tier contractor

is responsible for obtaining adequate audit coverage of subcontracts, either from the

prime contractor or from the cognizant Government auditor (see 6-310.4 for guidance

on subcontract coverage by the prime auditor).

c. Contractors may have both DoD and non-DoD contracts which may affect the

scope of audit because of differences in procurement regulations. Some non-DoD

agencies request and reimburse DCAA for audit services; others do not. The

requirement for our services on non-DoD contracts should be confirmed by a review of

the contract terms or discussion with the appropriate contracting officer or Office of the

Inspector General (see 1-300 and 15-100 for guidance on audit services for non-DoD

agencies).

6-603.2 Reserved **

6-603.3 Procedures and Internal Controls **

The adequacy of the contractor's policies, procedures, and internal controls

increases the auditor's reliance on cost representations and reduces the extent of

testing and verification which might otherwise be required to express an opinion on the

acceptability of indirect costs. Refer to section 5-1000 for guidance on auditing

contractor indirect/other direct cost systems and related internal controls. The

permanent files should also provide information on the contractor's internal controls and

problem areas disclosed during ongoing audits and should be reviewed during

determinations of audit scope.

6-603.4 Past Experience and Changed Conditions **

a. Past experience can be a significant determinant of scope. Reviews of prior

audits not only provide the accounts where costs have been questioned in the past, but

also the accounts where costs have been voluntarily deleted. If past experience

Page 134 of 227

indicates good internal control over unallowable costs and minimum costs questioned,

transaction testing can be reduced if the auditor can determine that the controls are still

in place. A comparative analysis of cost accounts by year provides an indication of

significant changes in cost account activity or changes in methods of allocation.

b. Changed conditions affect the reasonableness of costs and the equitable

distribution of indirect costs. Changes in conditions may significantly affect the

development of indirect cost rates. These changes may include the award of a

significant cost-reimbursement contract when prior Government contracts were primarily

of the firm-fixed-price type; a shift in emphasis from research to production, which may

require reclassifying indirect costs into different departments; or changing the method of

allocating and distributing indirect costs. Further, significant variations in levels of

production and technological modernization of manufacturing facilities may require an

evaluation to determine the effect on facilities, labor, and indirect costs.

6-603.5 Contract Terms **

a. As discussed in 6-603.1(c) above, a mixture of DoD and non-DoD contracts

may result in increased scope to accommodate the differences in procurement

regulations. The contract briefs state the procurement regulations which are applicable

and they may also indicate special contract terms or conditions on cost allowability or

allocability which may increase scope. The contract briefs may indicate advance

agreements made by the contracting officer affecting allowability or allocability, the most

common of which are IR&D/B&P agreements and precontract costs (see FAR 31.109

for a discussion of advance agreements).

b. The auditor must identify the contractor's status with respect to CAS; i.e., not

covered; subject to modified coverage (CAS 401, 402, 405 and 406); or fully covered

and required to file a disclosure statement. DMIS CAS Compliance Testing Reports

maintained for each CAS-covered contractor (see 8-305) identify the status of a

contractor's compliance with CAS and pinpoint specific areas requiring consideration in

establishing the audit scope.

6-603.6 Multi-Year Auditing **

a. Based on the 2018 NDAA, enacted December 12, 2017, multiyear auditing is

conducted only:

(1) To address outstanding incurred cost audits for which a qualified incurred

cost submission was submitted to DCAA more than 12 months before the date of the

NDAA enactment; or

(2) When the contractor being audited submits a written request, including a

justification for the use of multiyear auditing, to the Under Secretary of Defense

(Comptroller).

b. The FAO must discuss with the contractor any potential multiyear audit that

includes an adequate submission received after December 12, 2016. If the contractor

chooses to participate and request a multiyear audit, the FAO should advise the

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contractor that DCAA and the Comptroller’s office have arranged for requests to be

collected at DCAA and forwarded to the Comptroller. DCAA has established a

dedicated mailbox, Multiyear@dcaa.mil to collect requests to forward to the Comptroller

office. The Comptroller requires that requests must be in the form of an official letter

rather than through email.

c. Auditors should document the results of the discussion with the contractor,

including those instances in which the contractor does not want to request a multiyear

audit, and include a copy of the request letter (if applicable) in the working papers

d. Multi-year auditing techniques should be based on the following guidelines:

(1) Tests of details must be performed in all years in order to obtain sufficient

appropriate evidence to provide a reasonable basis for the conclusions and opinion

stated in the report (i.e. opinion on all indirect and direct costs for each audited year).

(2) The audit approach for each year should be risk-based and based on the

auditor’s documented risk assessment and understanding of the contractors

systems/internal controls. For example, the auditor may select an account in one year

for the initial detailed testing and then adjust (expand or limit) the level of testing

required for that account in the remaining years based on the results for the one year of

testing. Alternatively, the auditor may sample a homogeneous population of like

transactions across all years for detailed testing. Auditor should clearly document their

rationale and judgments used for determining the nature, timing and extent of the audit

procedures performed.

(3) Transaction tests of any new accounts should be performed in the year

they first appear, if the accounts are material.

e. Substantive tests of details must be performed on significant and/or sensitive

account balances and transaction classes as identified in the transaction testing plan.

Auditors may employ, substantive test of details such as substantive data analytics,

audit sampling, judgmental selection, or a combination of these methods to accomplish

the audit objectives consistent with the assessed level of risk. As a possible audit

approach for consideration, auditors may perform statistical sampling on one year and

use the results to plan the audit approach (i.e., statistical sampling or judgmental

selection) and the extent of testing in the other years involved in the multi-year audit.

For example, if statistical sampling is used in one year and it yields significant findings,

the best approach for the other years will likely also be statistical sampling with sample

sizes consistent with the audit risk identified in the first sampling application. In

contrast, if statistical sampling is used in one year and it yields few findings, auditors

may consider limiting testing in the other years to only those transactions determined to

be of the most risk (i.e., judgmental selection). When utilizing statistical sampling, the

auditor must ensure the findings are appropriately assessed before projecting. For

guidance on audit sampling and judgmental selection refer to 4-600.

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f. Some of the possible advantages of multi-year auditing include increased

efficiency and effectiveness in designing and applying audit procedures while allowing

for one set of working papers and one audit report.

6-604 Audit and Evaluation of Contractor's

Policies, Procedures, and Internal Controls **

a. Chapter 5, 5-100, presents general guidance for the audit and evaluation of a

contractor's policies, procedures, and internal controls. Guidelines applicable to the

audit and evaluation of policies, procedures, and internal controls as they relate to

indirect/other direct costs are discussed in 5-1000.

b. Sources for the audits of internal controls located in the contractor permanent files

(see 4-405.1). The Internal Control Audit Planning Summary, Disclosure Statements,

and DMIS CAS Compliance Audits and CAS Tracking of Noncompliances reports

should be evaluated for incurred cost audits. Inadequate internal controls found during

incurred cost audits should be annotated on the Internal Control Audit Planning

Summary. Noncompliances with CAS should be reported in a separate report (activity

code 19200) as discussed in 8-302.7c.

6-604.1 Effect of Changed Conditions **

The auditor should evaluate changes in procedures and practices for charging

direct or indirect costs. Such changes could result in circumventing cost targets or

ceilings or produce inconsistencies in the treatment of direct and indirect costs,

especially between cost reimbursable and other contracts or between Government and

other contracts.

a. Determining Changed Conditions. A review of corporate minutes, which

generally record top management decisions, may disclose changes having an impact

on indirect cost. Discussions with contractor personnel and physical plant observations

(see 6-608.2a) also provide information on changed conditions. Today, physical plant

observations take on a new importance in view of contractors' current trend toward

modernization of manufacturing facilities. In addition, comparisons of the current claim

with prior year amounts (see 6-608.2c) and a review of the permanent files may

disclose changes.

b. Reporting Changed Conditions. As a continuing audit responsibility, the

auditor should test the internal controls and procedures for reporting changed conditions

which affect indirect costs. When a change in indirect cost method is proposed by a

contractor, the effect (in dollars) on existing contracts should be studied and presented

by the contractor as a part of its overall support for the change. The contractor should

have a procedure requiring this support and identifying any required reporting. For

CAS-covered contractors, the reporting requirements for accounting changes are in 8-

303.3 and FAR 52.230-6(a). There is no similar requirement for non-CAS-covered

contractors; however, a similar analysis will assist the auditor in evaluating the proposed

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change. Every effort should be made to obtain this information from the contractor;

otherwise, the auditor should estimate the impact.

c. Evaluation of Changes. When changes are identified, they should be

evaluated to determine that:

(1) they comply with CAS (see 8-303.3), if applicable, and

(2) they do not have the effect of improperly circumventing cost targets or

ceilings of certain contracts or other significant cost categories.

6-604.2 Voluntary Management Reductions **

Contractors with weak or ineffective controls to separately identify and exclude

unallowable costs frequently attempt to reduce their risk of noncompliance by using

alternative procedures. The most common procedure is the application of bottom line

reductions to estimate the amount of unallowable costs. These reductions, generally

referred to as voluntary management reductions, are often unsupported estimates and

do not identify specific unallowable costs. The use of this type of reduction is not an

acceptable alternative to an effective system of controls. Cost Accounting Standard 405

and FAR 31.201-6 (accounting for unallowable costs) require contractors to specifically

identify and exclude unallowable costs from incurred cost proposals submitted to the

Government. The auditor should not offset any unallowable costs found during the

audit with unsupported voluntary management reductions. Since the auditor does not

audit all transactions, the probability exists when contractors have ineffective controls

that the actual amount of unallowable costs may exceed the management reduction.

The auditor should evaluate the contractor's reasons for using a management

reduction factor and determine if any weaknesses exist in the contractor's internal

control screening process, including the failure to provide for the identification of directly

associated unallowable costs (see 8-405.1). The auditor should also prepare

appropriate CAS/FAR noncompliance and internal control deficiency reports when the

contractor uses management reductions in lieu of having adequate controls to identify

and segregate unallowable costs.

6-605 Indirect Cost Base Period **

a. The contractor must select a time period to be used as a base period (cost

accounting period) for accumulating and reporting costs. The base period for the

allocation of indirect expenses to operations is generally the period during which the

expenses were incurred (matching principle) and usually represents a calendar year or

a fiscal year.

(1) For non-CAS-covered contracts, the base period for allocating indirect costs

must be determined in accordance with FAR 31.203(g)(2). The base period will be the

contractor’s fiscal year used for financial reporting purposes in accordance with

generally accepted accounting principles.

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(2) For contracts subject to full or modified CAS coverage, the criteria and

guidance in CAS 406 (8-406) must be used for selecting the cost accounting periods

used in allocating indirect costs (FAR 31.203(g)(1)). Instances of noncompliance with

CAS 406 should be reported to the cognizant Federal agency official (CFAO)

immediately (see 8-300 for guidance on reporting noncompliances).

b. Quick-closeout procedures which allow the final period of a contract to be closed

at other than final rates for the full year are discussed in 6-611.2 and 6-1010.

6-606 Indirect Costs Allocation Methods -- Bases

and Pools **

6-606.1 General Information **

a. Indirect costs should be accumulated by logical (homogeneous) cost

groupings (pools), with due consideration of the reasons for incurring such costs, and

allocated to cost objectives in reasonable proportion to the beneficial or causal

relationship of the pool costs to the final cost objective (FAR 31.203 (c)). The auditor

should determine that the allocation bases used by the contractor for the allocation of

indirect costs are equitable and consistent with any applicable CAS requirements,

generally accepted accounting principles, and applicable provisions of the contract.

Guidance on the verification of the activity base is in 6-610. Guidance on verification of

the rate computation is in 6-611. Guidance on the transitional method for G&A expense

under CAS 410 is provided in 8-410a.

b. Knowledge obtained from an audit of the internal control structure (see 5-1005)

may reduce the extent of audit effort. The auditor must make a thorough study of the

indirect cost activity, including the activity bases used for allocation and the costs to be

allocated, to determine whether the activity base chosen by the contractor is appropriate

for cost allocation and results in a reasonable measure of the activity. The base should:

(1) be a reasonable measure of the activity,

(2) be measurable without undue expense, and, except for residual G&A

expense, and

(3) fluctuate concurrently with the activity which is the source of the cost.

c. When the methods of allocation have been tested over an extended period

and determined to be satisfactory, the auditor presumes that these procedures and

methods are still satisfactory. However, when the nature of a business changes

substantially because of a change in volume of commercial or Government business, or

because of technological modernization of the manufacturing facilities, the existing

methods of allocating indirect costs may not be appropriate and the auditor must

evaluate them in accordance with existing conditions. If the contractor's method

appears to be sound and produces equitable and objective results, it should be

accepted as provided for in FAR 31.203 or applicable CAS (403, 410, 418.50(c)).

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Conversely, a more appropriate basis for allocation purposes should be used when it is

determined that the contractor's method produces inequitable results and the amounts

involved are significant. Such a condition would result in a FAR 31.203(c) or applicable

CAS noncompliance (see 8-300).

d. Part IV of the contractor's disclosure statement provides information on the

contractor's bases and pools, including a functional or departmental breakdown of

indirect expenses. An audit of the disclosure statement (or equivalent data from non-

CAS-covered contractors) will frequently assist in determining whether cost allocations

are equitable. Any differences or inadequacies should be identified and reported to the

cognizant Federal agency official (CFAO) in accordance with 8-200. If the contractor is

not required to disclose its practices, a comparison should be made between the claim

and the contractor's written policies or procedures.

6-606.2 Composition and Number of Pools **

a. The number and composition of pools should be governed by practical

considerations (FAR 31.203(c)) and/or CAS (418, 403, and 410).

(1) Proper allocation of manufacturing overhead generally requires the use of

departmental or burden center rates. However, the use of a single plant-wide rate may

be acceptable when it can be demonstrated that its use will result in equitable

allocations: for example, when a single product is manufactured; when several products

are manufactured but each requires proportionately the same amount of overhead work;

or when the contract activity is so small that costs of such segregation outweigh the

benefits received.

(2) When the contractor's accounting system does not provide for the

segregation of engineering expenses from the total manufacturing pool, and when

engineering costs represent significant costs to the Government, the auditor should

make appropriate tests to determine the equity of the combined allocation. If the

combined allocation is not equitable, the auditor should determine separate rates. For

example, engineering effort may not be required on commercial or Government

contracts, or it may not apply to contracts in the same ratio as manufacturing labor.

(3) Contractors modifying their accounting systems to an advanced cost

management system are adopting well thought out plans for distributing and identifying

costs to objectives. The shift to an increasing number of cost pools is not for the

purpose of fragmenting the existing pools and bases but to portray more accurate

product cost. During the accounting system development phase, contractors should

consider the cost benefit relationship between a large number of cost pools and better

costing in striking a reasonable balance. Auditors should consider and, if necessary,

discuss the cost benefit analyses at progress briefings conducted during the

implementation period.

b. When a contractor's activities are decentralized, the use of separate indirect

cost rates for each geographic location will normally produce more equitable allocations

of indirect cost than the use of composite or company-wide rates. Overhead rates

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determined for offsite activities should be based on eliminating from the overhead pool

those types of indirect costs which do not benefit offsite activities. For example,

occupancy costs may be eliminated from offsite pools because the contractor uses

Government facilities.

c. The manner in which contract prices were negotiated may have a significant

bearing on the method for absorbing costs on individual contracts or groups of

contracts. Advance understandings or "ground rules" may be established by agreement

between the contracting officer and the contractor to facilitate final cost determination.

(See FAR 31.109 for a description of advance agreements.)

d. The cost of money (CAS 414) is an imputed cost which is identified with the

total facilities capital associated with each indirect cost pool and is allocated to contracts

over the same base used to allocate the other expenses included in the cost pool. The

cost of money may be considered to be an indirect expense associated with an

individual cost pool but should be separately identified. The cost of money is subject to

all of the same allocation procedures as any other indirect expense (see 8-414).

6-606.3 Allocation Bases For Overhead and Service Centers **

a. Overhead ordinarily includes costs incurred to support direct labor or

acquisition, storage, and issuance of direct materials. Therefore, overhead is ordinarily

allocated to final cost objectives without any intermediate allocations. Service centers

are departments or other functional units which perform specific technical and/or

administrative services for the benefit of other units. Their cost can be allocated

partially to specific final cost objectives as direct costs and partially to other indirect cost

pools, usually based on units of output.

(1) When CAS is applicable, the auditor should refer to the requirements of

CAS 418 and implementing audit guidance in 8-418 in addition to this section. Even

though CAS does not apply, the auditor will find the guidance in CAS 418 to be useful in

evaluation of allocation bases; however, FAR, not CAS, must be cited as a reason for

questioning the appropriateness of the base.

(2) In the evaluation of an allocation base for overhead or service center

costs, the auditor should refer to the guidance in CAS 418.50e for pools which do not

contain material amounts of the costs of management or supervision of the base

activities and CAS 418.50d for those which do. CAS 418.50e recommends a hierarchy

of bases, the most preferred being measures of resource consumption followed by

measures of output and finally by a surrogate measure which varies in proportion to

services received. Since neither consumption nor output of managerial and supervisory

effort can be measured in terms of the relative benefit conferred on differing elements of

the activity base, CAS 418.50(d)(1) merely requires that the base be representative of

the activity being managed or supervised. CAS 418.50(d)(2)(i) requires that direct labor

hours or direct labor dollars be used for overhead allocation except under special

circumstances as noted below, and that selection between the two should be based on

which is the more likely to vary in proportion to the costs included in the pool.

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b. Acceptable activity bases for apportionment of overhead and service

department costs include among others, direct labor hours, direct labor costs, direct

labor plus fringe benefits, prime costs, direct material cost, value or units of production,

floor space, cubic content, meter readings, and machine hours. Any one or a

combination of these may be acceptable in a particular case and unacceptable in

another. The following paragraphs contain guidance to assist the auditor in evaluating

the more common methods of allocating overhead and service center costs.

(1) Direct Labor Hours. Direct labor hours is an acceptable base for

allocation of overhead costs when the employees are largely interchangeable such as in

a manufacturing operation. The basic data for using direct labor hours usually are

available through job tickets. However, if the cost of accumulating the data is

prohibitive, the use of this basis is not recommended.

(2) Direct Labor Cost. This activity base is used for allocating overhead

because data are readily available and the method is simple and economical. Labor

costs are usually controlled by payroll records and the general books of account, and

the base is subject to audit verification. This basis is usually acceptable at a

manufacturing location when labor rates are relatively uniform and when production

labor is a significant element of the product cost.

(a) This basis is often used at non-manufacturing locations. Employees at

such locations have widely differing skills and salaries which are correlated to their

technical expertise, which in turn is the subject matter of contracts with such locations.

Related overhead is primarily supervision and occupancy, both of which tend to vary

directly with the cost of professional labor.

(b) When direct labor cost is the basis for allocating costs, the auditor

should normally eliminate all overtime and shift premium costs from the base. However,

overtime and shift premium costs need not be excluded from the base when:

(i) the amount of audit work required does not warrant it or

(ii) equitable results will be obtained even though these additional

costs are included.

engineering costs at a manufacturing location, adequate tests should be made of the

salary or wage levels of employees engaged on Government contracts compared to the

overall engineering salary and wage structure. If the average wage of employees

engaged on Government contracts is substantially different from the overall average,

the direct labor cost method ordinarily will not be acceptable. In such instances, the

auditor should consider recommending a direct engineering labor hour base.

(3) Direct Material Cost. Direct material cost may be used to allocate costs of

material handling (purchasing, receiving, or shipping) departments. It is particularly

important that the auditor analyze the pool and base relationship. For example, total

material cost may not be an appropriate base if it includes significant costs for items

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which are not received at the contractor's plant but are drop shipped directly to the end

user.

(4) Unit of Product. The unit of product method is perhaps the simplest form

of allocation because it distributes overhead equally to each unit of product

manufactured during the period. However, the use of this method is limited to

companies producing a single product, or a few products which contain elements such

as weight, dimension, or other measure common to all the products produced.

(5) Floor Space, Cubic Content, and Meter Readings. Floor space area,

value of space, cubic content, or meter readings may be used to allocate certain types

of indirect costs on a plant-wide basis. One or more of these bases may be used to

allocate service department expenses to producing departments or to cost centers.

(6) Machine Hours. The use of machine hours as the basis for allocating

indirect costs may be appropriate when the principal factor in production is the use of

machinery. It is most frequently used to allocate the indirect costs of a manufacturing

department or service center using large machines. Today's trend toward technological

modernization of manufacturing facilities tends to intensify machine orientation on the

factory floor. As a result, careful consideration must be given to the suitability of

overhead allocation bases. With the movement toward a machine orientation, the use

of machine hours and other machine oriented bases (such as process time and

operation movements) is likely to become relatively more appropriate. Objections to the

use of machine hours as a basis for allocating overhead costs include the expense of

accumulating special cost data not otherwise required. However, with the advent of

machinery encompassing the ability to accumulate performance data, these objections

may not continue to be applicable.

c. Some advanced cost management systems will place a stronger focus on the

activities of a business. For businesses that made technological progress, this means a

shift to more machine oriented allocation bases, such as machine hours, process time,

and operational movements. In other areas of the business operations, appropriate

allocation bases may be transaction volume or services rendered, such as space

utilization, plant layout, engineering change notices, and purchase requisitions.

Selection of appropriate allocation bases which have a causal or beneficial relationship

with the pooled costs is no different for an ACMS than for traditional accounting and is

compatible with the requirements of CAS 418.50(e).

6-606.4 Allocation Bases for General and Administrative Expense Other

Than Corporate/Home Office Expense **

a. G&A expenses are any management, financial, and other expenses which are

incurred by or allocated to a business unit and which are for the general management

and administration of the business unit as a whole. When CAS 410 is applicable, the

auditor should refer to the requirements of the standard and implementing audit

guidance in 8-410. When CAS 410 does not apply, the auditor may refer to CAS 410 in

conjunction with the guidance in this section. For audits of corporate/home office

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expense allocations, and G&A expense allocation under facilities contracts, see 6-606.5

and 6-606.6.

(1) The pool grouping should be assessed using the principles set forth in

FAR 31.201-4, Allocability, and 31.203, Indirect Costs. The expenses in the G&A pool

should represent only the cost of those activities that are necessary to the overall

operation of the business, although a direct relationship to any particular cost objective

cannot be shown. The cost of those activities incurred specifically for a contract or that

can be distributed to both Government and other work in reasonable proportion to the

benefits received should be removed from the G&A pool and distributed to the final cost

objectives on a more appropriate basis. Expenses, which are not G&A expenses but

are insignificant in amount may be included in the G&A expense pool.

(2) The distribution base should be evaluated to assure that it is common to

all cost objectives to which the G&A pool is to be allocated. Per CAS 410.50(b)(1), the

G&A allocation base should be a cost input base representing the total activity of the

business unit. Cost input bases are discussed in 6-606.4b(1) and include total cost

input, value added and single element. CAS also permits special allocations under

certain conditions (CAS 410-50 (j)) and permits variants of the foregoing cost input

bases if they are representative of the total year's business activity and produce an

equitable distribution of the G&A expenses to all final cost objectives (CAS 410

supplement). A more appropriate basis for allocation purposes should be used if it is

determined that the selected base does not adequately represent the total year's

business activity or results in an inequitable distribution of the G&A expenses to final

cost objectives, and the amounts involved are significant. Such a condition would result

in a FAR 31.203(c) or applicable CAS non-compliance (see 8-300). For reporting

CAS/FAR noncompliances found during the audit, auditors should follow the guidance

in 10-808.

(3) FAR 31.203(c) requires that the contractor accumulate indirect costs by

logical cost grouping so as to permit use of an allocation base that is common to all cost

objectives to which the cost grouping is to be allocated. The FAR further states, “The

base selected shall allocate the grouping on the basis of the benefits accruing to

intermediate and final cost objectives”. If a contractor does not have CAS-covered

contracts and has a single pool, the auditor must evaluate its allocation base against

this requirement.

b. The subparagraphs below provide comments on distribution bases which may

be proposed for allocating G&A expense to contracts/jobs where Cost Accounting

Standards do not apply.

(1) Cost Input. Cost input is the cost, except G&A, which for contract cost

purposes is allocable to the production of goods and services during the cost

accounting period. The most often used bases are: total cost input (TCI), all costs

excluding G&A; value-added cost input, all costs excluding material, subcontracts, and

G&A; and single element cost input. Cost input bases are generally acceptable for

Government contracts because they express the causal and beneficial relationship

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between G&A expenses and all of the final cost objectives of a cost accounting period

(matching principle).

(2) Cost of Goods Sold. The cost of goods sold base is often identical to TCI,

and when identical it is acceptable. Its advantage is that the amount is generally

available from the accounting records and does not require separate computation. Cost

of goods sold bases may be unsatisfactory when the G&A expense allowable under

Government contracts is more closely related to production for the period than to

products distributed and sold. Distortions are most likely to result when some of the

contractor's products require a long manufacturing cycle, or when commercial items are

produced for stock or leasing rather than to fill sales commitments. G&A expenses

which are not clearly a part of production may not be applied to inventory because to do

so would violate generally accepted accounting principles. Distortion may also result if

a contractor classifies all costs incurred under cost-type contracts as sales when the

costs are incurred, but does not record sales under fixed-price contracts and other work

until shipment of the completed product.

(3) Cost of Sales. Cost of sales includes selling costs whereas cost of goods

sold does not. The cost of sales base is inequitable because the contractor is

precluded from recovering allowable selling costs and must allocate G&A to all selling

costs. All other considerations affecting cost of goods sold apply to cost of sales.

(4) Cost of Goods Manufactured. Costs of goods manufactured equates to

costs of goods sold before the adjustment for the difference between the beginning

finished goods inventory and the ending finished goods inventory. Cost of goods

manufactured is generally not an acceptable allocation base for G&A expense under

Government contracts because it does not adequately represent the cost of production

for the accounting period. Cost of goods manufactured includes prior period costs

applicable to goods in process at the beginning of the accounting period and excludes

current period costs applicable to goods remaining in process at the end of the

accounting period. Distortions are most likely to result when the contractor's products

require varying manufacturing cycles, some longer than others, or inventories of raw

materials and work in process vary significantly between the beginning and end of the

accounting periods.

(5) Total Sales. Total sales as a basis for allocating G&A expense is

generally not acceptable for Government contracts because:

(a) the concurrence of sales with production usually varies between the

items produced for the Government and those produced commercially,

(b) the margin of profit may vary appreciably among contracts and

between Government and other work, and

contain price revision terms is not known until the work has been completed and the

price negotiated.

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6-606.5 Allocation Bases – Corporate and Home Office Expense **

a. When CAS 403 applies, reference should be made to the requirements of the

standard and implementing audit guidance in 8-403. When CAS 403 does not apply, it

may be used as general information in conjunction with the guidance in this section.

b. Home office expense is the cost of administering the overall operations of a

multi-plant or multi-segment company. Home offices typically establish policy for and

provide guidance to the segments in their operations. They usually perform

management, supervisory, or administrative functions, but may also perform service

functions in support of the operations of the various segments. The costs may include:

(1) those incurred for the benefit of a specific segment, such as specialized

consulting services or leases for specific facilities;

(2) those incurred for the benefit of several but not all segments, or for several

segments in differing proportions, such as a central computer center or similar service

operations or fringe benefit costs such as pensions and insurance;

(3) those incurred for the common benefit of all segments, such as board of

directors expenses or top executive salaries.

Costs of the third type, often referred to as "residual" corporate/home office

expense, are typically allocated to all segments over a common allocation base except

as discussed in d. below. Costs of the first two types, where significant, require

separate allocation for equitable costing of Government contracts at the various

segments.

c. The segment auditor should identify all type (1) and type (2) expenditures

allocated or charged to the segment, and should request audit assistance

simultaneously with the request for verification of the corporate (type (3)) allocation.

Whether or not assist audit requests have been received, the corporate auditor should

initiate the audits of charged and allocated expense without delay. The corporate

auditor is also required to audit and report on significant matters contained in the

corporate financial statements, minutes, SEC filings, and tax returns, and to furnish an

information copy of the published financial statements to the segment auditors.

d. To evaluate the bases used by the contractor to distribute home office

expenses, the auditor should carefully evaluate the organizational structure and

operations of the corporate office and each corporate segment, including details of the

type of service and support rendered by the corporate office to each segment. This

may require close cooperation among the contract auditors cognizant of the company

sites. (See 15-200 for information on the contract audit coordinator (CAC) program

which has been established to facilitate this coordination within DCAA.) In addition, the

corporate/home office auditor is responsible for the necessary audits of segments not

involved in Government contract work. The objective is to see that the contractor's

allocations proportionately distribute home office costs to all segments of the business

on the basis of the relative benefits received. Use the applicable contract cost

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principles (such as FAR 31.201-4, 31.202, and 31.203) as criteria to evaluate the

contractor's method.

e. Residual expenses generally have no discernible direct benefit to a particular

segment but are necessary to the overall business operations. They may be

categorized as costs relating to the prudent management of all resources at the

disposal of the corporation. Residual expenses may include the salaries, fringe

benefits, occupancy costs, taxes, and other administrative expenses of the board of

directors, executive committees, corporate officers, and administrative/executive

management officials. The basis of allocation of residual expenses should reflect the

total activities of all segments of the business. However, certain segments may require

special allocations of residual expense if their operations are relatively self-contained or

self-sufficient and/or require minimal administrative support from the corporate/home

office. Conversely, a segment may require special allocation in amounts greater than

the average rate if it is highly dependent upon the home office staff for general

administrative support. (See 6-606.6 regarding allocations to GOCO activities.)

f. The form of the business (foreign or domestic), the extent of ownership (wholly

- or partially-owned), or the accounting treatment for financial accounting purposes

(consolidated or unconsolidated) are not basic criteria for determining whether a

particular segment should be included in or excluded from the residual allocation base.

Also, the fact that an individual contract or group of contracts does not permit recovery

of corporate office expenses is not a reason to exclude the operating segment

performing the contract(s) from the base of allocation. Once an appropriate base for

distributing indirect costs has been accepted, it should not be fragmented by removing

individual elements (FAR 31.203(d)). Also see CAS 410.50j for a discussion of special

allocations. To the extent that the home office provides necessary support for the

segment, a proportionate share of the residual expenses should be allocated to that

segment.

6-606.6 Allocation Bases for Residual Corporate/Home Office Expense to

GOCO Activities **

a. Special attention should be given to the appropriate allocation of residual

corporate/home office expense to Government-owned contractor-operated (GOCO)

plants. Contractor's GOCO activities are usually conducted on a basis substantially

independent of supervision by higher corporate echelons. In addition, less

administrative support is usually received from the central office since many corporate

administrative services are paralleled by the GOCO administrative activity. In such

circumstances, it would not be equitable to distribute a share of all the higher level

supervisory or administrative expenses to these plants on a proportionate basis by any

of the methods commonly used to allocate residual corporate/home office expense to

segments.

b. Each auditor at a GOCO plant will provide the corporate/home office auditor

information on the nature and extent of administrative functions performed at the GOCO

plant. The home office auditor and the contractor will reach agreement on whether

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administrative functions performed at the GOCO duplicate home office functions, so that

a suitable corporate allocation structure is developed for GOCO activities.

c. If it is appropriate to allocate less residual expenses to a GOCO, the contractor

may accomplish this by developing two expense rates as follows:

(1) a basic rate reflecting those corporate expenses which apply to all work of

the contractor including GOCO plant operations, and

(2) a rate in addition to the basic rate reflecting those corporate expenses

which apply to all work of the contractor except GOCO plant operations. Figure 6-6-1 is

an example of the development of such rates.

d. Where CAS 403 applies, any special allocations of residual corporate/home

office expenses to GOCO activities are established by agreement between the

contractor and the Government in accordance with CAS 403.40(c)(3) and 403.50(d).

Only a contracting officer may execute such an agreement, but the contract auditor will

normally evaluate the proposed method before an initial agreement. The auditor will

evaluate the continuing appropriateness of the contractor's method during each audit

cycle, and advise the contracting officer if any formal agreement warrants revision.

Figure 6-6-1 - Example of Corporate Expense Rates for GOCO Activities **

Rate Calculations

Totals

Basic

Additional

Residual Corporate Expenses:

Basic (applicable to all segment activities)

$ 20,000

Balance (applicable to non-GOCO segment

activities)

$ 40,000

$ 60,000

$ 20,000

$ 40,000

Base of Allocation:

GOCO segment activities

$200,000

$ 200,000

—

All other segment activities

$800,000

$ 800,000

$800,000

$1,000,000

$800,000

Rates

—

Note: In this illustration, the corporate expense rate applicable to GOCO activities is

2%; the rate applicable to other activities of the contractor is 5%.

6-607 Reserved **

6-608 Indirect Costs - Transaction Testing Plan **

6-608.1 General Guidance **

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a. Indirect costs are incurred as a result of business decisions made at all levels

of management. These decisions may be based on established policies or may be a

manager's choice among several options for achieving an objective. The auditor should

consider the reasons underlying management decisions when a specific cost item and

the Government's interest in the total allocated portion of indirect costs is significant.

b. The audit objectives are to:

(1) ascertain the extent to which the contractor's policies are being

implemented at the operating level,

(2) determine whether the contractor is maintaining adequate control over the

level of indirect expenditures,

(3) ascertain and evaluate significant fluctuations in the ratios of the accounts

to the allocation base, and

(4) determine whether the contractor has excluded from expense pools costs

which are unallowable because of the provisions of law, regulations, or the contract;

unreasonable in nature or amount; inapplicable to the Government operations; or

inapplicable to the indirect cost pool or period being audited.

This section provides guidance on the techniques for selecting accounts to be

analyzed and the basis for questioning costs.

c. A transaction testing plan should be prepared to document evaluation of the

contractor's annual incurred cost proposal. This plan should fully consider all significant

costs, both direct and indirect. The extent of required transaction testing should be

based on consideration of all the following factors:

(1) assessment of control risk,

(2) prior audit experience

(3) materiality,

(4) using the work of others, and

(5) results of the preliminary audit procedures

d. Regardless of the assessed level of control risk at a major contractor, the

auditor should perform substantive tests for significant account balances and

transaction classes. Substantive tests include both analytical procedures such as the

comparative analysis and transaction testing. The auditing standards do not envision

any circumstance where the assessed level of control risk would be low enough to

eliminate the need for substantive testing; however, the level of substantive testing

should be tailored based on the criteria discussed in c. above. Accounts/transactions to

be tested can be selected considering the techniques described in 6-608.2. Sensitive

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accounts should be audited frequently, or on an annual basis as appropriate, while less

sensitive accounts should be selected on a rotating basis.

e. At nonmajor contractors, transaction testing of significant indirect expense

account balances and transaction classes that are considered medium or high risk

should be completed for each contractor fiscal year that is audited. At nonmajor

contractors subject to low risk sampling, transaction testing is required for proposals

selected for audit in accordance with 6-104.2. Transaction testing is required to

determine and document that the contractor’s incurred cost proposals should continue

to be classified as low risk. The level of transaction testing performed should be based

on the auditor’s assessment of materiality and other risk factors and must be

documented in the working papers. When multi-year auditing techniques are used,

transaction testing should be performed in accordance with 6-603.6b. Transaction

testing should not be performed on contractor fiscal years classified as low risk and not

selected for audit.

f. Movement to an Advanced Cost Management System (ACMS) can encompass

a large number of cost pools (see 6-606.2). Successful accomplishment of audits

encompassing a large number of pools depends upon the application of the basic audit

concepts of materiality and risk assessment during the audit planning stages. First, look

for the strength of internal controls over the system itself (see 5-1000 Audit of Indirect

and Other Direct Cost System Internal Controls). Then, determine the areas of risk and

materiality. Are they concentrated in several pools, or are they concentrated in several

key accounts spanning all pools? Place audit resources where a vulnerability

assessment indicates the greater risk and materiality. Using a combination of auditor

judgment and statistical sampling techniques, evaluate the high-risk/materiality pools.

Consider auditing the high-risk/materiality pools more frequently and the low-risk pools

on a rotating basis. As an alternative, determine if there are sensitive accounts which

span all pools, and perform the audit focusing on these accounts.

In addition, determine if the contractor's internal auditors will also be performing

reviews on the cost pools. Coordination with these auditors, after determining the

coverage and reliability of their efforts, may provide assistance and minimize potential

duplication. Finally, audit tools, such as downloading information from the contractor's

computer to assist the audit process, hold great promise as an effective approach to

manage an audit of a larger number of cost pools efficiently.

6-608.2 Techniques for Selecting Accounts **

The basis for determining the specific areas to be selected for detailed evaluation

and testing and the scope of the audit should be determined by plant observations,

consideration of management decisions, and account analysis.

a. Plant Observation. Plant observations are an integral part of the audit of

indirect costs. They provide valuable indicators of accounts to be analyzed and/or

areas of high risk. In performing the observations of a contractor's plant, the auditor

should consider the following:

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(1) When the contractor maintains segregated cost centers, the auditor

should observe the manner in which physical and accounting segregation is

accomplished, particularly when Government contracts and commercial production are

performed in the same general area. The extent of observation should be influenced by

the degree of control established by the contractor to preclude the interchange of

operations. The observations should assist in ascertaining which pools, cost centers,

and accounts require the greatest emphasis during the audit.

(2) The auditor should determine the manner in which the contractor

establishes new production lines and should inquire into all aspects of a new line, noting

any similarity between the contemplated production and the production currently in

process. Again, this will assist in determining the pools, cost centers, and accounts

requiring the greatest emphasis during audit.

(3) The auditor should observe the existence of idle facilities and determine

whether idleness results from ordinary maintenance, lack of work, temporary machinery

breakdown, or faulty production planning. Guidance on the allowability of idle facilities

and capacity is provided in FAR 31.205-17.

(4) The auditor's physical observation program should include inquiries into

the reasonableness of rework and scrap generated. When it is determined that there is

an unreasonable amount of rework or scrap, the auditor should ascertain the causes.

The audit of rework and scrap costs may require the assistance of Government

technical personnel.

(5) The auditor should observe the contractor's manufacturing facilities to

develop a better understanding of the contractor's manufacturing processes and monitor

the trends in manufacturing practices and processes (5-108d). Some contractors have

accomplished substantial technological advancements on the factory floor. These

changes in manufacturing operations can cause changes in the flow of costs. Factory

observations should assist in identifying the expense pools requiring further evaluation.

b. Effect of Management Decisions. The auditor should review executive or

directors' minutes, company newsletters, and internal and external audit reports for

indicators of accounts to be audited. These may disclose audit leads, such as the

following:

(1) a lag in reducing indirect costs during periods of declining production,

including the retention of supervisory and technical personnel when their services are

not required at that time or in the foreseeable future,

(2) unwarranted increases in the number of and in the salaries of executives,

indirect personnel, and engineers,

(3) the imposition of additional tiers of supervision without apparent need

except as a means of retaining technical and supervisory personnel,

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(4) continuing liberalization of fringe benefits as a means of recruiting and

retaining technical and administrative personnel,

(5) increased depreciation costs, attributable to high-cost plant expansion or

changes in the method of computation,

(6) the inclusion of depreciation of idle or excess facilities during a declining

production period,

(7) the leasing of facilities under "sale and leaseback" or "lease in lieu of

purchase" agreements in excess of ownership costs,

(8) unusual increases in expenses such as plant rearrangement,

rehabilitation, relocation, and leasehold improvements,

(9) expansion of training programs, recruitment programs, and public relations

expenses,

(10) unusual increases in contractor initiated research and development

programs and bid proposals, particularly during periods of declining production,

(11) investments in automation, modernization of manufacturing facilities, or

mechanization,

(12) a major shift in the nature of or the methods used in the production

processes,

(13) increasing costs for maintaining or overhauling old productive equipment

in lieu of investing in new equipment, and

(14) internal control weaknesses disclosed by internal or external audits. In

addition, unallowable, unreasonable, excessive, or incorrectly classified costs may be

generated as a result of a contractor's policies and management decisions underlying

the policies. (See 6-604 for comments on the evaluation of policies, procedures, and

internal controls.) For example, a contractor's policy for recording costs may be

designed to provide flexibility in charging engineering costs directly to contracts, IR&D

and B&P, or to overhead depending on monetary limitations of contracts or advance

agreements. When a contractor's policy is questioned, the auditor should evaluate the

probable consequences of continuing the questioned policy and make appropriate

recommendations. Such cases may be reportable under the provisions of 4-700

(detection and reporting of fraud, other unlawful activity, or improper practices).

c. General Account Analysis

(1) Nomenclature Review. Using a copy of the contractor's post-closing trial

balance, which has been reconciled in accordance with the guidance in 6-610, the

auditor should select for thorough analysis those accounts which are new and/or

significant in amount, vary from developed trends, or which on the basis of

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nomenclature review or past experience appear to be sensitive in nature and likely to

contain questionable costs. However, categories of indirect expense should not be

accepted or rejected solely on the basis of a nomenclature review. The actual content

of accounts being evaluated must be established through testing of transactions.

(2) Comparative Analysis. The auditor should also compare the claimed

amounts of the various accounts with the amounts claimed and/or expended in prior

years and the amounts shown in the current year's budget. The comparisons should

disclose:

(a) whether there have been significant changes in the dollar amount of

claimed individual expense items that may not be comparable to a change in the level of

operations;

(b) whether there are unexplained differences that may require a more

intensive evaluation, additional testing, and verification;

periodic comparisons with budgeted amounts;

(d) whether there have been reclassifications of costs or changes in cost

accounting practices; and

(e) whether the expense is recorded in the proper account identified with

the cost center, department, or expense pool that derives the benefit.

When the pattern indicates a tendency for indirect costs to increase in

comparison to direct costs, the auditor should determine the factors which are

contributing to the increases (see the list of factors affected by management decisions

in 6-608.2b above). The audit of account detail and individual transactions must include

a determination of the sources of journal entries and testing to ensure propriety.

Significant and sensitive adjusting entries should be evaluated (e.g., journal entries

reclassifying direct to indirect costs).

(3) Quantitative Methods. The use of graphic and computational analysis

techniques can be helpful in the audit of incurred costs. The auditor may be able to

detect trends or correlations which permit the focus of attention on indirect expense

accounts, pools, departments, or other segments of cost which appear to be

unreasonable or out of line. Further, sampling and IT techniques (such as data retrieval

software) will assist the auditor in selecting transactions for evaluation. Consideration

should be given to the use of these techniques during incurred cost audits.

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d. Specific Account Analysis. In addition to the areas discussed below, the

Selected Areas of Cost Guidebook discusses items of cost and accounting methods

requiring special attention. This chapter should be reviewed to assure adequate

coverage of any applicable items. Special attention should be given to the discussion of

IR&D and B&P costs because of its general applicability at most locations.

(1) Contingent Expenses. Items charged to indirect expenses, not

representing actual costs but rather a provision for contingencies, should be excluded

from allowable costs. The auditor should refer to FAR 31.205-7.

(2) Indirect Labor. The audit of labor costs is discussed in Section 4 of this

chapter. Recruitment costs are also discussed in Section 4 because they are closely

related to the budgeting of labor costs and the determination of personnel requirements.

(3) Indirect Material. Priced or quantitative year-end inventory records should

be audited to determine whether increasing costs indicate a trend towards a buildup of

supply inventories. When contractors account for supply items as an expense at time of

purchase, a comparison should be made of the amounts expended for various

categories of supplies for the current and several preceding periods. Further discussion

of the audit of material costs is contained in Section 3 of this chapter.

(4) Miscellaneous Charges. Miscellaneous charges to indirect costs may

result from transactions of earlier or future periods. Included in this category are

depreciation expenses, amortization of prepaid costs, and accruals of liabilities. Entries

representing the write-off of prepayments or the establishment of accrued liabilities

should be tested for propriety, reasonableness, allocability to the period, accuracy of

computation, correctness of account distribution, and sufficiency of documentary

support. The extent of verification should depend on the significance of the dollar

amount and the extent to which the Government participates in the cost.

(5) Miscellaneous Income and Credits. The auditor should evaluate the

contractor's financial statements, tax returns and adjusting entries in the general ledger

or other subsidiary ledgers to identify any income or credits in which the Government

should share as well as to evaluate the exclusion of any adjustments not reflected by

the contractor in contract costs. (See 6-610 for guidance on the verification of the base

and pool to the accounting records.)

(a) The auditor should identify the nature of all income received from

sources other than sales of the contractor's normal products. It is preferable that

income, refunds, or credits applicable to a Government contract, such as purchase

discounts, income from sale of scrap, and rental income, be credited directly to the

contract. However, if the income, refunds, or credits are not significant and the

contractor's accounting treatment is equitable, these may be apportioned between

commercial and Government work through reduction of indirect cost pools or some

other equitable method. The extent of audit in this area will depend on the effectiveness

of the contractor's accounting procedures. Thus, the early identification of system

weaknesses is of prime importance.

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(b) Additional items which may be pertinent as credits or refunds under

Government contract costing include: refunds of various state and local taxes such as

franchise, personal property, and income taxes; royalty expenses which have been

accrued but remain unpaid; workers compensation rate adjustments; and credits or

reduction in rates of employer contribution to pension plans, death benefit plans, and

similar group insurance plans, following accumulation of reserves built up through

excessive rates, reversionary credits, or in some other manner.

6-608.3 Basis for Questioning Costs **

Expenses may be questioned based on allowability, allocability, and/or

reasonableness.

a. Allowability. FAR 31.201-2 defines allowability. Certain costs are rendered

unallowable by provisions of pertinent laws, regulations, contract clauses, or mutual

agreement and cannot be included in prices, cost reimbursements, or settlements under

government contracts to which they are allocable. The contractor must certify that its

indirect cost claim contains no unallowable costs. The contractor's claim should be

examined to ensure that all directly associated costs have also been removed.

(1) The criteria for a determination of allowability, is provided in FAR Part 31.

When the auditor’s questioned cost is based on a selected cost principle criterion, the

auditor must reference the applicable provision of FAR 31.205. A description of these

and other items, and the criteria for a determination of allowability, is provided in FAR

Part 31 and in the ‘Identification of Expressly Unallowable Costs’ schedule (see

Appendix A).

(2) When certain costs are specifically identified in the contract as being

unallowable, the contract may also provide criteria that must be met before a cost is

considered allowable or limitations that cannot be exceeded. For example, the contract

may state that subcontracts or travel must be approved by the contracting officer prior to

the incurrence of the cost or it may state that overtime is allowable up to a specific dollar

amount only. Contract briefs should be prepared to identify these clauses.

(3) Certain costs or portions of cost may be identified as unallowable based

on advance agreements negotiated by the ACO, such as use charges for fully

depreciated assets (FAR 31.205-11(f)).

(4) As defined in FAR 31.001, certain costs have been identified to be

expressly unallowable. FAR 31.201-6(a) requires that contractors affirmatively

"exclude" costs which are "expressly unallowable”. If the contractor included expressly

unallowable costs in the final indirect cost settlement proposal, the auditor should

question the costs and advise the ACO that the costs are subject to the penalty

provisions at FAR 42.709. Refer to 6-609 and Appendix A-100 for additional guidance

on how to determine if a cost is expressly unallowable.

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b. Allocability. FAR 31.201-4 defines allocability. Costs may be questioned

because they are not allocable to government contracts. Cost Accounting Standards

provide criteria on the allocability of costs for CAS-covered contracts. For non-CAS-

covered contracts FAR provides certain criteria. The following are examples of

allocability issues.

(1) Out-of-Period Costs. In addition to recognizing the relationship of an

incurred expense to its objective, the auditor must relate the time factor (period to which

the expense is applicable (FAR 31.203(g)) in the manufacturing process. Not all

expenses incurred during a given period may be allocable in their entirety to the items

produced during that period. Therefore, the audit effort should be directed to

ascertaining whether costs such as indirect labor, payroll taxes, vacation expense,

retirement accruals, bonuses, insurance, maintenance and repairs, depreciation,

amortization of leasehold improvements, and similar indirect expenses included in the

indirect cost accounts have been properly accrued or deferred. The object of the test is

to disclose those indirect costs which have been assigned to a current period when the

cost was incurred for the purpose of benefiting a future or past period. Year-end

adjustments and adjustments involving prior cost periods must be evaluated to

determine materiality and applicability to current costs. Year-end adjustments may

have a significant effect on the expense pool or bases for the allocation of indirect costs.

The auditor's evaluation should insure that the contractor's year-end adjustments

actually result in a more precise allocation of indirect expenses.

(2) Consistent Classification. Consistency in the composition of indirect cost

pools must be considered in determining the validity of the indirect cost pool as a whole.

When the contractor's procedures provide that specific items of costs are charged

directly to government contracts, the auditor must, prior to accepting the residual costs

(6-606.5b & e) in the indirect cost pool, ascertain whether similar costs are also charged

directly to the commercial work. Items which can be identified directly with other

classes of work must be excluded from the expense pools if items identifiable with

government contracts are charged directly (see FAR 31.202 and 31.203 or CAS 402).

c. Reasonableness. FAR 31.201-3 defines reasonableness. A cost may be

considered unreasonable because it was not incurred in the most cost-effective manner.

For example, the contractor may be providing its own guard service when outside

vendors may be able to provide the service at a lesser cost. A prudent business person

would acquire goods and services to minimize cost and maximize profits, however cost

is not the only factor in a business person’s decision making process. If an auditor

believes that a cost is unreasonable, he or she should make inquiries into the

contractor’s decision. Materiality should be a consideration.

6-609 Penalties on Expressly Unallowable Costs

6-609.1 Statutes and Regulations **

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a. Penalty provisions for the submission of expressly unallowable costs are

included in 10 U.S.C. 2324(a) - (d). FAR 42.709, implementing this statutory penalty

provision, requires that penalties be assessed if a contractor claims an expressly

unallowable indirect cost in (1) an indirect cost settlement proposal, or (2) the final

statement of costs incurred or estimated to be incurred under a fixed-price incentive

contract, on covered contracts. FAR 42.709-7 requires the use of the clause at 52.242-

3, Penalties for Unallowable Costs, in covered contracts which include all contracts in

excess of the following, except Fixed-Price contracts without cost incentives or any Firm

Fixed price contracts for the purpose of commercial items:

• $650,000 for contracts issued on or after September 28, 2006 and before

October 1, 2010;

• $700,000 for contracts issued on or after October 1, 2010;

• $750,000 for contracts issued on or after October 1, 2015 and

• $800,000 for contracts issued on or after October 1, 2020.

b. Level of Penalties. There are two levels of penalties to be assessed.

(1) The first-level penalty (FAR 42.709-2(a)(1)) applies to costs that are

expressly unallowable. This penalty is equal to the amount of expressly unallowable

costs plus interest on such costs which were paid to the contractor.

(2) The second-level penalty (FAR 42.709-2(a)(2)) applies to costs which

were determined to be unallowable before the indirect cost settlement proposal

submission as described in FAR 42.709-3(b). This penalty is equal to twice the amount

of such disallowed costs.

c. Definitions

(1) Expressly unallowable costs are defined in FAR 31.001 as, a particular

item or type of cost which, under the express provisions of an applicable law, regulation,

or contract, is specifically named and stated to be unallowable. In most instances costs

which are unallowable solely because they are unreasonable or unallocable would not

be considered expressly unallowable. The term "expressly unallowable costs," as it is

used in the penalty regulation, includes only those indirect costs that are expressly

unallowable under FAR 31.2, or applicable agency supplement (such as DFARS 231),

that a contractor has included in a final indirect cost rate proposal or final statement of

costs incurred or estimated to be incurred under a fixed price incentive contract. In

order for a cost to be expressly unallowable, the cost principle must state in direct terms

that the costs are unallowable, or leaves little room for interpretation or differences of

opinion as to whether the particular cost meets the allowability criteria. The government

must show that it was unreasonable, under all the circumstances, for a person in the

contractor’s position to conclude that the costs were allowable. It does not include any

costs that are unallowable because they violate any other regulatory requirement or

contract term, unless such regulation or contract term is also included in the cost

principles. Therefore, there could be situations where a cost may be expressly

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unallowable but not subject to penalties. See Appendix A-100 for a listing of expressly

unallowable costs and additional guidance.

(2) "Cost determined to be unallowable before proposal submission" means

(for purposes of the second-level penalty) that the contractor had a formal written

determination describing the particular unallowable costs that became final prior to the

submission. FAR 42.709-4(b) provides four examples evidencing prior determination of

unallowability:

(i) an unappealed DCAA Form 1;

(ii) unappealed contracting officer’s final decision;

(iii) court or Board of Contract Appeals decisions involving the contractor

(precedents involving other contractors or similar costs will not be sufficient to sustain a

second-level penalty); and

(iv) a determination of unallowability of cost, or “mutually agreed-to-be-

unallowable costs” under FAR 31.201-6.

(3) "Mutually agreed-to-be-unallowable costs" as provided under

FAR 31.201-6(a) must be specifically designated as unallowable by an agreement

between the government and the contractor. Generally, the agreement would be in

writing and describe the costs in sufficient detail to conclusively identify the costs in

future proposals or claims. Mere agreement or concession by the contractor to a

reduced overhead rate in the settlement process does not constitute agreement on the

treatment of specific elements of cost, unless those elements of cost are specifically

identified in the agreement and determined to be unallowable costs. In situations where

a contractor continues to include similar costs in its incurred cost proposals, after

conceding the costs in prior years but refuses to enter an agreement with the

government that the costs are unallowable the auditor should consider recommending

that the Contracting Officer issue a Notice of Intent to Disallow the costs. If a contractor

and the government agree that a specific cost is to be considered unallowable in future

proposals and claims, in order to ensure the intent of the parties is clear, the auditor

should recommend to the ACO that the agreement be documented in a separate written

agreement.

d. Formal Initiation of Audit. Since the regulations allow the contractor to

withdraw its final indirect cost rate proposal before formal initiation of the audit in an

effort to avoid penalties, it is important that the auditor establish verifiable evidence that

the contractor is aware when the audit begins. FAR 42.709-6(a) provides that an audit

will be deemed to be formally initiated when the government provides the contractor

with written notice, or holds an entrance conference, indicating that audit work on a

specific final indirect cost proposal has begun.

6-609.2 General Guidance **

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a. General Responsibilities. Regardless of whether the rates are audit-

determined or procurement-determined, the ACO determines whether or not a penalty

should be assessed and issues a demand letter to the contractor for the amount

determined.

The auditor is responsible for communicating all unallowable costs

potentially subject to penalties to the ACO, regardless of materiality. Even if an audit

report has been issued or the rates have been negotiated, the government may still

assess a penalty if it is subsequently determined that the claim included unallowable

cost subject to the penalty provision. Any such information which becomes known to

DCAA should promptly be communicated to the contracting officer. The communication

of the expressly unallowable costs needs to be documented and provide the ACO

sufficient information to make the penalty determination pursuant to FAR 42.709. In

addition, the auditor is responsible for referring the matter (DCAA Form 2000) to the

appropriate criminal investigative organization for review and for appropriate

coordination of remedies, if there is evidence that the contractor knowingly submitted

unallowable costs. See FAR 42.709-4(b)(1)-(4). Coordinate any potential notification to

the procuring or administrative contracting offices regarding the fraud referral with the

DCAA Justice Liaison Auditor (JLA) who will recommend a course of action. See 4-

702.4 for guidance on DCAA Form 2000.

The auditor has no authority to impose the penalty, recover it against subsequent

public vouchers, recommend the supplemental penalty, or waive the penalty. This

authority rests with the ACO.

b. The penalty statutes and implementing regulations do not flow down to

subcontracts.

c. When a contractor division submits an indirect cost settlement proposal that

includes unallowable costs subject to penalty, any such costs allocated to interdivisional

work performed under another division's covered contracts are also subject to penalty.

d. When a contractor uses statistical sampling to identify unallowable costs, FAR

31.201-6(c)(3) specifically provides that when any of the sampled items are subject to

penalty, as defined in FAR 42.709, the projected amount from those sampled items are

also subject to the same penalty provisions. FAR 31.201-6(c)(3) applies when the

contractor fails to exclude the projected amount associated with sample cost items

subject to penalty from its proposal.

e. Voluntary Management Reductions. A contractor may not avoid a penalty by

applying a voluntary management reduction that does not specifically identify the

unallowable costs excluded from the proposal (see 6-604.2).

f. FAR 31.201-6 requires a contractor to identify and exclude any expressly

unallowable costs from its final settlement proposal. If a contractor submission includes

a significant amount of costs that may be expressly unallowable costs, the audit report

should address the contractor's failure to identify and remove those unallowable costs

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from its certified final indirect cost proposal; i.e., was the failure a one-time occurrence

or a systemic deficiency. If there is a systemic deficiency in the contractor's internal

controls or its process for screening unallowable costs, a separate report should be

issued detailing the unsatisfactory condition. See 5-110 & 5-111.

g. Whenever a significant amount of costs that may be unallowable are identified,

the circumstances of the questioned cost and its inclusion in the final indirect cost

settlement proposal should be considered to determine if it is appropriate to issue a

DCAA Form 2000. See 4-700 for guidance on DCAA Form 2000.

6-609.3 Audit Requirements **

a. As indicated in 6-609.1c(1) above in order for a cost to be expressly

unallowable the costs that the audit team are questioning has to be an indirect costs

that is expressly unallowable under FAR 31 or applicable agency supplement.

Additionally, the government must show that it was unreasonable under all the

circumstances for a person in the contractor’s position to conclude that the costs were

allowable. Thus, a cost principle makes costs expressly unallowable 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. The auditor should request that the contractor identify all

contracts that contain or should contain the FAR penalty clause (FAR 52.242-3) in the

submitted schedule of auditable contracts. Absence of the penalty clause in a contract

does not prevent the Government from assessing the penalty. A contractor is bound by

the required clause even though the clause is inadvertently omitted, because the

statutes make it a mandatory clause.

b. A listing of cost principles that identify expressly unallowable costs that audit

teams can use for assistance with making determinations regarding whether statements

in cost principles identify expressly unallowable is provided Appendix A. If an audit

team questions costs based on a cost principle that is on the list, it generally should

treat the questioned costs as expressly unallowable and subject to penalties. This is not

a comprehensive list. There could be rare situations where costs questioned based on a

cost principle that is not included on the list may be expressly unallowable. In situations

where an audit team thinks that may be the case, it will need to perform additional

analysis and should elevate the issue to its regional or CAD point of contact and, if the

regional staff agrees, it should elevate the issue to the Policy Incurred Cost Division.

c. The audit team has no authority to waive penalties; therefore, if the audit team

concludes that any claimed costs may be expressly unallowable and subject to penalty,

it must communicate all potentially unallowable costs subject to penalties to the

appropriate ACO, regardless of materiality. The communication of the potentially

expressly unallowable costs needs to be documented and provide the ACO sufficient

information to make the penalty determination pursuant to FAR 42.709. When

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determining whether the issues related to the specific costs that may be expressly

unallowable result in a material reservation about the subject matter, in addition to

considering that the costs are unallowable, the audit team should also take into

consideration the potential noncompliance with the contract term in FAR 52.242-3(c).

FAR 52.242-3(c) states, "The Contractor shall not include in any proposal any cost that

is unallowable, as defined in Subpart 2.1 of the FAR, or an executive agency

supplement to the FAR." If the potentially expressly unallowable costs result in a

material reservation about the subject matter and the audit team therefore question the

costs in the report, the communication would be provided in the report. The audit team

can inform the ACO in the notes to the exhibit with a summary identifying questioned

costs within pools by potential penalty class and amount. If the expressly unallowable

costs do not result in a material reservation about the subject matter and the audit team

therefore do not question the costs in the report, the communication can be

documented through either e-mail or memorandum to the ACO. The report note, email

or memorandum to the ACO should contain sufficient information necessary to

determine which unallowable costs are subject to penalties and to allocate the penalties

to covered contracts. Since the ACO determines whether a penalty is to be imposed,

the auditor should not calculate the amount of penalty until requested by the ACO. If a

second-level penalty is recommended, the report, email or memorandum should cite the

specific prior penalty determination relied upon for the recommended second penalty.

d. If an incurred cost proposal of a home office or interdivisional segment,

allocates indirect costs that may be considered expressly unallowable to other entities,

the audit team at the allocating entity must assist the audit team at the receiving entity,

in reporting the potentially expressly unallowable costs. The audit team, of the

contractor entity allocating the costs, needs to inform the receiving contractor entity

audit team, regardless of amount, its recommendation concerning costs that may be

unallowable and subject to penalties. The communication between the audit teams

must be in writing. Additionally, if the issues related to the costs that may be expressly

unallowable result in a material reservation about the subject matter, the audit team of

the contractor entity allocating the costs would inform the other entity audit team in the

report. The audit team can provide the information in the notes to the exhibit with a

summary identifying questioned costs within pools by potential penalty class and

identify the allocable share for each other entity. If the issues related to the costs that

may be expressly unallowable do not result in a material reservation about the subject

matter of the audit report, the audit team should inform the other entity's audit team in

either an e-mail or memorandum. The audit team does not have to provide the

information in a specific format but it has to document the communication and provide

sufficient information to the other entity's audit team so that they can provide sufficient

information to the ACO so that the ACO can fulfill their FAR 42.709-3(a) responsibility to

make determinations whether penalties should be assessed.

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e. If a statistical sampling application is used to project questioned cost and the

sample includes unallowable costs that may be subject to penalty, that portion of the

sample that may be subject to penalty, shall be projected to determine the total

recommended costs that may be subject to penalty. The total recommended costs that

may be subject to penalty should be the point estimate of that projection. The audit

report presentation of statistical sampling results should be in accordance with 4-

602.10h.

f. Reporting requirements are further discussed in 6-708.4. Sample paragraphs

to include in the summary of audit results including the required information to include in

the exhibits and schedules appear in 6-708.5.

g. Computation of Penalty. Since the ACO determines whether a penalty is to be

imposed, the audit team should not allocate costs that it identifies as subject to penalty

to covered contracts or calculate the amount of the penalty and applicable interest until

the ACO has made such a determination and requested assistance. If the ACO

requests assistance, the audit team should have them identify the unallowable costs

they determined to be subject to penalty and the covered contracts to which the

contractor allocated the costs. The audit team can provide assistance, as requested, to

calculate the actual penalties to be assessed to applicable contracts including the

recommended period, rate, and base for assessment of interest.

(1) Cost Portion of Penalty. The cost portion of the penalty is associated with

indirect costs that were proposed as part of indirect cost pools to be allocated over

specified allocation bases. The costs subject to penalty may be expressed as a rate

applicable to the same allocation bases. Calculation of the assessed penalty requires

identification of the portion of the allocation bases applicable to covered contracts 4

(see 6-609.1a).

(2) Interest Portion of Penalty. Audit teams may use the Expressly

Unallowable Cost Penalty Interest Calculator to compute the interest portion of the

penalty. Expressly Unallowable Cost Penalty Interest Calculator is maintained in the

DCAA Software / Applications Library on the DCAA Intranet Web Site at

https://intranet.dcaa.mil/SitePages/Software%20Applications%20Library.aspx. When

calculating the interest portion of the penalty, consider the following:

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(a) Base. The base subject to interest penalty depends on the amount of

unallowable costs subject to penalty that the government has paid to the contractor. In

most situations, contractor's bill the government using provisional billing rates. If the

provisional billing rates for the contractor's fiscal year, are less than the rates included in

the contractor's incurred cost submission, which includes unallowable costs, for that

year, then the contractor would not have billed the government the total amount of

unallowable costs subject to penalty. If the total amount of interim billings paid for the

period is less than the total claimed indirect expenses. In that situation, assume the

contractor was reimbursed for its incurred indirect costs in the following order:

(i) the allowable indirect costs agreed upon in the final rate settlement,

(ii) costs disallowed from the contractor's rates as part of the

settlement process that are not subject to a penalty, and

(iii) costs disallowed in the rate determination that are subject to

penalty.

If the contractor's billing rates are adjusted and it significantly impacts the

amount of unallowable costs subject to penalty that the government has paid the

contractor, reflect the adjustment in the calculation of interest as another payment of

unallowable costs subject to penalty. If it is an increase, treat it as a positive amount. If

it is a decrease treat it as a negative amount. Similarly, if the contractor bills a significant

amount of costs or submits a credit invoice for costs out of the normal billing period for

the fiscal year whose incurred cost submission claimed the unallowable costs, treat the

calculation as another payment or credit of unallowable costs subject to penalty. The

normal billing period for a contractor with a calendar year fiscal year is usually February

through January of the next year.

(b) Period. Typically, contractors use the same provisional billing rates for

the entire period in which the unallowable costs subject to penalty were incurred.

Therefore, calculate the applicable interest assuming all paid unallowable costs subject

to penalty were paid at the midpoint of the billings for the year in which they were

incurred; unless it is obvious that using the midpoint does not properly reflect when the

unallowable costs subject to penalty were paid. For contractors with a calendar year

fiscal year the midpoint would be July 31. Billings are usually done for the prior month

or biweekly period. Additional considerations regarding provisional billing rates are

discussed in (a) above. If the ACO issued a demand letter, interest should not be

computed after the date of the letter or the date of repayment by the contractor,

whichever is earlier. The ACO uses different interest calculation procedures for the time

period after the demand letter is issued. If the end point of the interest computation

period is unknown at the time the auditor is making the calculation, provide the simple

interest incurred to the end of the current month and the monthly interest rate applicable

to the outstanding balance of paid penalized costs so that the ACO may adjust the

calculations as necessary when the ending date is known.

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according to Public Law 92-41 (Cost-of-Money rate, see 8-414.2).

6-610 Direct and Indirect Cost Verification **

Guidance on the selection of the allocation (activity) bases is in 6-606. Guidance on

the audit of the costs included in these bases (labor, material, other direct costs, and

indirect costs) is in this and the following sections of this manual: 6-400, 6-300, 6-500,

and 6-609. Guidance on the policies, procedures, and internal controls is in Chapter 5

(accounting system, allocation methods, preparation of submissions, etc.). Guidance

on the verification of the base and pool is provided in this section.

6-610.1 Reconciliation to Records **

The auditor should examine incurred cost proposals to verify that the costs

claimed reconcile to the contractor's job cost subsidiary ledgers or other comparable

records by major cost element (material, subcontracts, intracompany charges, other

purchases, labor, indirect, other charges and credits, etc.). The subsidiary ledgers

should be reconciled to general ledger control accounts or records which will provide

assurance that the costs have been properly presented.

6-610.2 Verification of the Base **

a. The auditor must be assured that the costs (or hours or other factors) included

in the activity base comprise all costs (or hours or other factors) contemplated when the

base was selected, and no other. For example:

(1) If direct labor cost is selected as a base for distribution of manufacturing

overhead, the following items should be considered: Is the total overtime pay to be

included or is the base to include straight-time pay only? If the company pays a bonus

for night shift work, is this bonus included in the base? Does offsite labor take a full

share of the allocation? Is "purchased labor" in the base, if worked at the contractor's

plant? If worked at the vendor's plant? Is premium pay for hazardous duty excluded?

(2) Does the base for distribution of home office expenses include the activity

of subsidiary companies (domestic and foreign) when applicable?

(3) Has the contractor charged salaries or wages of engineering personnel

devoted to its own engineering projects to overhead accounts, or otherwise excluded

them from engineering direct labor bases? If so, such costs should be reclassified to

the direct engineering labor base.

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(4) For CAS-covered contractors, a comparison should be made with the

Disclosure Statement, section 4, to assure the adequacy of the description of the bases.

Disclosure Statement inadequacies and noncompliances should be reported in

accordance with the guidance in 8-208g and 8-302.7, respectively.

b. Composition of the bases should be compared with the preceding period. If

there are differences, the effect of the changes should be determined and the

reasonableness and equity of the results evaluated.

c. Once an appropriate base for distributing indirect costs has been accepted, it

should not be fragmented by removing individual elements. All items properly

includable in an indirect cost base should bear a pro rata share of indirect costs

irrespective of their acceptance as Government contract costs (FAR 31.203(d)). For

example, unallowable overhead costs, including those voluntarily deleted by the

contractor, must remain in the cost input base so that they absorb their portion of the

G&A cost.

d. The portion of the base which applies to cost-type Government contracts

should be reconciled with the contractor's billings (interim and final reimbursement

claims). This is significant because the adjustments resulting from the determination of

actual indirect costs will be based on the data contained in the claims submitted (see 6-

1000 for guidance on interim and final reimbursement claims). The preparation of

cumulative cost summaries will facilitate this reconciliation. These cumulative cost

summaries should be provided with the contractor's indirect expense proposal.

e. Movement to an ACMS can encompass the use of new types of allocation

bases (see 6-606.3). During review of an allocation base, determine what the base

measures (resource consumption, output), and then determine if the contractor is

capable of objectively measuring the base now and in the future. Because the

proposed base may represent a totally new method of cost allocation, the contractor

may not be able to support the proposed base with accumulated historical data. The

contractor may have to support the proposed base with a combination of documentation

such as production projections, historical data, employee interviews, manufacturer

machine capability and specifications, and engineering analyses. Auditors should be

open to verifiable forms of documentation which may be generated by the new system.

Next, determine if the base provides for an equitable distribution of cost and if there is a

beneficial or causal relationship between the pool and the base. Given the evolution to

a strong technological orientation, the auditor may require technical assistance in

evaluating the appropriateness of the proposed allocation bases. For example, one

contractor proposed to allocate fabrication costs on operation movements. The

operation movements encompassed functions which varied in difficulty and process

time. However, with technical assistance it was determined that operation movements

were an equitable base.

6-611 Quick Closeout - Indirect Cost Rate

Calculation and Cost Distribution **

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6-611.1 General Guidance **

a. When the indirect cost pools have been verified and the activity bases for

distribution have been accepted, the auditor should then verify the accuracy of the rate

calculation and the distribution of indirect costs to Government contracts.

b. Contractors may develop indirect cost rates (pool/base) for application to the

contract base, or may distribute indirect cost on a percentage basis (contract base/total

base). Both methods produce the same results. There is no specific criterion for the

number of decimal places by which to extend the rate. Generally, rates are extended to

two places past the decimal point; however, if the costs are significant, the rates may

need to be extended further.

6-611.2 Quick-Closeout **

a. During the course of a fiscal period, many contractors perform numerous

Government contracts as a continuing part of their activities. The direct and indirect

costs incurred on an individual contract in the last fiscal period of its performance may

be relatively small in amount, particularly if the contract is physically completed in the

early portion of the fiscal period. In such cases it is generally mutually advantageous to

the Government and the contractor to expedite the indirect cost settlement and close

such contracts as soon as possible without waiting until after the end of the fiscal period

and the subsequent final determination or negotiation of indirect cost rates for the entire

period (See 6-1010 for more information on Quick-Closeout Procedures). Certain

special conditions and requirements for closing terminated and completed cost-

reimbursement type contracts on an expedited basis are presented in 12-407 and

6-711, respectively.

b. Because of the small amount of contract costs involved, the use of these

procedures should result in only an insignificant difference in the amount of indirect cost

applied to the contract for the closeout period as compared with the amount which

would have been applied if the contract were not closed until after the annual or other

periodic rate was established. Consequently, except as stated in paragraph 12-407, no

adjustment to compensate for any such difference need be made in computing the

periodic indirect cost rate to be applied to other contracts performed during the period.

6-612 Indirect Cost Limitation for Basic Research

Awards **

The DoD Appropriations Acts for FYs 2008-2010 limit payments of indirect costs to

35 percent of the total costs of a DoD contract, grant, or cooperative agreement for

Basic Research. When applying the limitations for the 2010-2011 awards, brief the

awards to determine if they contain language that carries forward the provision into the

subsequent year’s costs. Request the contractor to demonstrate its procedures for

compliance with the 35 percent indirect cost reimbursement rates limitation.

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For awards that were made in 2011 and later, the 35 percent limitation does not

apply to the reimbursement of indirect costs under a DoD contract, grant, or cooperative

agreement for Basic Research.

For awards that were incrementally funded using both appropriated funds that are

not subject to the indirect cost limitation, and FYs 2008-2010 appropriated funds that

are subject to the limitation, auditors should verify that the contractor’s accounting

records and processes clearly identify those years when the limitation applies and that

the limitation is appropriately applied.

6-700 Section 7 - Administrative Procedures for Establishing Indirect

Costs Rates **

6-701 Introduction **

This section describes the administrative methods and procedures commonly used

to establish interim billing rates and final indirect cost rates. Because indirect costs can

only be definitely established at the end of the contractor's fiscal accounting period,

special procedures are needed to reimburse contractors on an interim basis for the

approximate indirect costs incurred and then to finalize the indirect cost rates after the

end of the contractor's accounting period.

6-702 Definitions **

a. The term indirect cost means any cost not directly identified with a single final cost

objective (i.e., a function, contract or other work unit for which cost data is measured),

but identified with two or more final cost objectives or an intermediate cost objective. It

includes, but is not limited to, the general groups of indirect cost such as those

generated in manufacturing departments, engineering departments, tooling

departments, general and administration departments and, if applicable, indirect costs

accumulated by cost centers under these general groups. For contractors using fund

accounting systems (mainly educational institutions), the term includes, but is not limited

to, the general groups of expenses such as general administration and general

expenses, maintenance and operation of physical plant, library expenses and use

charges for buildings and equipment. (See FAR 31.203 for further discussion of indirect

costs.)

b. The term final indirect cost rate means a percentage or dollar factor which

expresses the ratio of the allowable indirect expenses to the direct labor, manufacturing

cost, cost incurred or other appropriate base for the contractor's fiscal period

customarily used for the computation of indirect cost rates. Unless subject to a

qualification related to an ASBCA case or similar item, once established and agreed

upon by the Government and the contractor, an indirect cost rate is not subject to

change. Final indirect cost rates are usually established after the close of the applicable

fiscal period under one of the methods described in 6-703.

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c. A billing rate is an indirect cost rate established temporarily for interim

reimbursement of incurred indirect costs and is adjusted as necessary pending

establishment of the final indirect cost rates. Billing rates are intended to approximate

the expected final rates. The contracting officer or auditor responsible for determining

the final indirect cost rates ordinarily will also be responsible for determining the billing

rates.

6-703 Approaches to Establish Indirect Costs **

In general, billing rates and final indirect cost rates are used in reimbursing indirect

costs under cost-reimbursement contracts and in determining progress payments under

fixed-price contracts. Except for cost-sharing contracts, contracts with rate ceilings, and

use of the quick-closeout procedures (see 6-711.1), methods commonly used to

establish indirect costs are as follows:

a. By Audit Determination-The actual final indirect cost rates are determined by the

auditor as a result of audit or accepted as proposed based on the results of the low risk

sampling process. Under this method, the auditor's determination is definitive, subject

to the appeal procedures available to the contractor. The procedures for audit

determination are in FAR 42.705-2 and DFARS 242.705-2.

b. By Contracting Officer Determination-The final indirect rates are arrived at by

negotiation between the Government and the contractor based on a proposal submitted

by the contractor and an advisory indirect cost audit report or low risk memorandum, if

applicable, issued by the contract auditor. The locations at which rates will be

determined by contracting officers, the procedures for the conduct of negotiations and

the applicable contract clauses are stated in FAR 42.705-1 and DFARS 242.705-1.

c. As an alternative to b. above, research contracts with educational institutions may

provide for predetermined fixed rates and/or negotiated fixed rates with carry forward

provisions. As in b. above, the rates are established by negotiation and contractual

agreement between the Government and the contractor to cover a specified future

period (see Chapter 13).

d. Special Procedures for Changing the Rate Settlement Process from Contracting

Officer Determined to Audit Determined:

(1) Audit determination may be used for uncompleted audits of contractor indirect

cost rates covered in FAR 42.705-1 to be negotiated when the contracting officer (or

cognizant Federal agency official (CFAO), and the auditor agree that the indirect costs

can be settled with little difficulty and any of the following circumstances apply:

(a) the contractor has primarily fixed-price contracts with only minor

involvement in cost-reimbursement contracts,

(b) the administrative cost of contracting officer determination would exceed

the expected benefits,

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problems, and

(d) the CFAO” and auditor agree that special circumstances require auditor

determination.

In some cases, more than one meeting with the CFAO may be needed to finalize

a change to audit determined rates. Once the final decision is made to change to audit

determined rates, the auditor should ensure that the contractor has been notified of the

change.

(2) The preceding guidance also applies to contractor fiscal years (CFYs) for

which the incurred cost report has already been issued if the following conditions are

met:

(a) CFAO negotiations of the CFY rates have not started, and

(b) the CFAO and the auditor believe that changing the CFY over to the audit

determined rates and supplementing/replacing the original audit report will save

collective time and effort.

6-703.1 The DoD Approach **

Procedures for establishing indirect cost rates for DoD contracts related to

educational institutions, nonprofit organizations, and state or local governments are in

FAR 42.705-3 through 42.705-5. Essentially, these rates are established by contracting

officer negotiation using applicable requirements in 2 CFR 200.

6-703.2 Non-DoD Procedures **

FAR 42.7 provides that final indirect cost rates on non-DoD contracts will be

established by either audit determination or contracting officer negotiation as provided

by the terms of the applicable contract. Audit recommendations concerning non-DoD

contracts are usually advisory in nature as most of these contracts give the contracting

officer responsibility for establishing the final indirect cost rates. The guidance in

10-210.1 and 10-506 pertaining to the distribution of indirect cost audit reports should be

followed to ensure that all interested non-DoD parties receive a copy of the report.

Additional comments on special administrative procedures related to non-DoD agencies

are given at 15-100.

6-704 Effect of Contract Type on Indirect Cost

Recovery **

6-704.1 Cost-Reimbursement Contracts **

a. Cost-reimbursement contracts provide for payment of the allowable incurred

costs (including interim/final indirect costs) to the extent prescribed in the contract.

These type contracts establish an estimate of total cost for obligating funds, which also

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serves as a ceiling that the contractor may not exceed (except at its own risk) without

the approval of the contracting officer. These contract provisions are set forth in an

"Allowable Cost and Payment" clause (FAR 52.216-7) as provided in FAR 16.307. A

major portion of this clause discusses the administrative procedures to be used in

paying interim indirect costs and establishing final indirect cost rates. In general, this

portion of the clause provides that:

(1) Final indirect cost rates will be established as detailed in FAR 42.7.

(2) The contractor shall submit within the six-month period after the close of

its fiscal year, an adequate final indirect cost rate proposal. Reasonable extensions, for

exceptional circumstances only, may be requested in writing by the contractor, and

granted in writing by the contracting officer.

(3) The proposed rates shall be based on the contractor’s actual cost

experience for that period.

(4) Once agreement is reached, a written understanding shall be executed

setting forth the final rates.

(5) If agreement is not reached on the final cost rates, this shall be a dispute

within the meaning of the Disputes clause.

b. In addition to the "Allowable Cost and Payment" clause, FAR 42.802 provides

that cost-reimbursement type contracts will also include the clause at FAR 52.242-1,

Notice of Intent to Disallow Costs. This clause gives the procedures that can be used in

disallowing costs if the Government questions a cost.

c. Indirect costs may be reimbursed under cost-type contracts either by:

(1) the actual cost method (audit determination),

(2) negotiated rate method (contracting officer determination), or

(3) negotiated fixed rates with carry forward of under or over-recovery

provisions under R&D contracts with nonprofit educational institutions (see Chapter 13).

6-704.2 Fixed-Price Contracts **

The provisions of FAR 42.7 (Indirect Cost Rates) also apply to fixed-price

contracts if the contractor requests progress payments or its fixed-price contracts

include price adjustment provisions (e.g., incentive contracts). In these cases, the

billing and final indirect rates will be established using the same administrative

procedures as for cost-reimbursement contracts.

6-705 Interim Billings **

6-705.1 Provisional Billing Rates **

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a. The Government allows interim payments, if authorized by the contract, during

contract performance by use of either the SF 1443 (progress payments) for fixed-price

contracts, or by an SF 1034 (public voucher) (“Cost Voucher” in iRAPT) for cost-type

contracts. The contract itself will designate the manner of billing. Reimbursement of

indirect costs in these payments is generally made through billing rates that are

established to approximately equal the expected final indirect cost rates. Therefore, the

billing rates should be as close as possible to the expected final indirect cost rates,

adjusted for anticipated unallowable costs. Contractors billing rates are used for interim

reimbursement purposes until settlement is reached on final indirect cost rates at the

end of the contractor’s fiscal year. Before final indirect cost rates are established, the

billing rates may be prospectively or retroactively revised by mutual agreement, at either

the Government’s or contractor’s request, to prevent substantial overpayment or

underpayment.

b. The established provisional rates are for billing purposes only and contractors

should not use these rates for other applications such as cost proposals or forward

pricing rates.

c. FAR 42.704 provides that the contracting officer or auditor responsible for

determining the final indirect cost rates shall usually also be responsible for determining

the billing rates. When the contracting officer (or cognizant Federal agency official) or

auditor determines that the dollar value of contracts requiring use of billing rates does

not warrant submission of a detailed billing rate proposal, the billing rates may be

established by making appropriate adjustments from the prior year's indirect cost

experience to eliminate unallowable and nonrecurring costs and to reflect new or

changed conditions. Also contractors may voluntarily submit a billing rate proposal to

assist the responsible official in establishing rates.

d. Generally, the contracting officer or auditor establishes provisional billing rates

at the beginning of the contractor fiscal year for contractors with existing contracts.

When a contractor that previously did not have contracts requiring billing rates is

awarded such contracts, rates will be established during the contractors fiscal year. To

simplify interim indirect cost claim computations, billing rates should be calculated using

the least number of decimal places that will properly consider the impact of the rates on

contract costs. The auditor’s rate calculations will be appropriate to the circumstances

regardless of how the contractor submits its rates.

e. Provisional billing rates may require adjustment during the year and after the

end of the contractor’s fiscal year, prior to the contractor’s submission of the final

indirect cost rate proposal. When rates are established by the auditor, the auditor

needs to compare the interim billing rates with the year-end recorded allowable rates

(considering any historical audit exceptions) to determine if the billing rates need to be

adjusted. The auditor should not wait to receive the final indirect cost rate proposal

which is not due until six months after the end of the fiscal year to make these

comparisons. At contractors where DCAA has a resident or suboffice, the comparison

should be done as soon as practicable after the year-end closing. At smaller

contractors where DCAA does not have an in-plant office, the auditor should request

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that the contractor provide copies of the summary cost records showing the year-end

recorded allowable indirect expense rates. These records should be verified during the

next scheduled field visit to that contractor. After the final indirect cost rate proposal has

been received, the guidance contained in 6-707.4 should be followed.

6-705.2 Interim Indirect Cost Billing Adjustment **

a. Upon receipt of the certified final indirect cost rate proposal, FAR 42.704(e)

provides that the Government and the contractor may mutually agree to revise billing

rates to reflect the certified proposed indirect cost rates. The proposed indirect rates

will be adjusted to reflect historically disallowed amounts from prior audits until the

proposal has been audited and settled. The historical decrement will be determined by

either the contracting officer or the auditor responsible for determining final indirect cost

rates. The contractor should be advised to adjust the claimed indirect costs for the

revision in the provisional billing rates. If claimed costs as adjusted to reflect historical

disallowances exceed billed costs, advise the contractor to submit an interim claim for

the difference. If billed costs exceed claimed costs, the contractor must appropriately

adjust the next voucher or remit or otherwise credit the Government for the difference.

b. After the establishment of final indirect cost rates for the period (see 6-708 and

6-709), the contractor may claim reimbursement for amounts due over and above the

interim reimbursements previously obtained.

(1) For contractors who submit their vouchers electronically in WAWF using

the iRAPT electronic cost voucher and attachment, the iRAPT system will give the

contractor the option of submitting a separate iRAPT electronic cost voucher for rate

adjustment or submitting the rate adjustment on the next billing.

(2) For contractors who manually submit hard copy vouchers to DCAA for

approval, the reimbursement claim should be submitted on a separate public voucher

which should not include any other costs or fee. The amount of the adjustment will be

shown on the SF 1035 (continuation sheet for the public voucher) in the "current period"

column, and the "cumulative to date" figures will be adjusted accordingly.

c. After the establishment of final indirect cost rates for the period (see 6-708 and

6-709), the contractor may owe money back to the Government.

(1) For contractors who submit their vouchers electronically in WAWF using

the iRAPT electronic cost voucher and attachment, and the contract is still being billed,

the contractor can only submit a rate adjustment on the next billing since iRAPT does

not allow submission of a negative cost voucher.

(2) If there is no additional billing on the contract, the contractor must use a

manual check submission process.

(3) For contractors who manually submit hard copy cost vouchers to DCAA

for approval, the contractor must use a manual check submission process.

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d. Where the contractor submits a reimbursement voucher that is not consistent

with the established final indirect cost rates, the auditor should follow the procedures in

6-900.

6-705.3 Indirect Cost Billing on Fixed-Price Contracts **

As with cost-type contracts, the established billing rates (whether by submission

of the certified indirect cost rate proposal or final settlement of indirect rates through

negotiation or audit determination) will be used by the contractor in calculating its

progress payments. Progress payments, however, are usually limited to a stated

percentage of total cost. On establishment of the final indirect rates, little additional

effort is required other than ensuring that the total incurred cost to date and the

estimated costs to complete amounts on the next progress payment request have been

properly adjusted for any changes in the rates.

6-706 Cost Certification for Final Indirect Cost

Rates **

6-706.1 Final Indirect Cost Rates **

a. The clause at FAR 52.242-4 requires contractors to certify that all costs

included in a proposal to establish final indirect cost rates are allowable in accordance

with FAR cost principles and agency supplements applicable to the contracts to which

the final indirect cost rates will apply. The certification requirements are applicable for

all solicitations and contracts issued on or after October 1, 1995. The Federal

Acquisition Streamlining Act of 1994 (FASA), Public Law 103-355, Section 2151,

codified the certification requirement at 10 U.S.C. 2324(h) and in 41 U.S.C., Subtitle I,

Division A, Chapter 1. This certificate must be submitted before the proposal will be

accepted by the Government and must be signed by an individual at a level no lower

than a vice president or chief financial officer of the business segment that submits the

proposal. “Signed” as used in this section means a verifiable symbol of an individual,

including electronic symbols (see FAR 2.101, Definitions). A new certificate is required

whenever the contractor changes the proposed rates and submits a revised proposal.

A new certificate is not required if the contractor agrees to lower indirect rates as a

result of our audit of a previously certified proposal. As a result of the certification

process, some contractors have incurred extraordinary costs for screening overhead

costs prior to certifying their proposals (see Selected Areas of Cost Guidebook, Chapter

17, Section 17-2 Costs Related to Extraordinary Reviews of Unsettled Overhead Costs).

b. Prior to October 1, 1995, the certification requirements were contained at

DFARS 242.770-2 (now incorporated into FAR 42.703-2) and were applicable only to

solicitations and contracts issued by DoD contracting agencies. Accordingly, only DoD

contractors are required to certify final indirect rates related to contracts issued prior to

October 1, 1995.

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c. When a contractor does not certify its proposal, FAR 42.703-2(c) provides that

the contracting officer may unilaterally establish the rates. Rates established

unilaterally should be based on audited historical data or other available data as long as

unallowable costs are excluded; and set low enough to ensure that unallowable costs

will not be reimbursed. The auditor's role is to provide rate recommendations which

preclude reimbursement of potentially unallowable costs. In arriving at the rate

recommendations, the auditor may use audited historical data, such as percentage

disallowance factors computed from the results of prior audits, or any other supporting

data obtained from the contractor which show that unallowable costs have been

excluded. The scope of the assignment and the supporting data on which the rate

recommendations are based will have to be determined by the auditor on a case-by-

case basis. In no case should the auditor develop an alternative contractor proposal or

complete an audit of the contractor's incurred cost when the contractor has not

submitted a properly certified proposal. Either action would relieve the contractor of its

contractual requirement to submit a proper proposal that excludes all unallowable cost.

However, at large contractors, as described in 6-706.2 certain audit procedures can be

performed before submission of the certified proposal.

d. In the event a contractor withdraws or indicates it will withdraw its proposal,

consider discontinuing the audit effort. Request the contractor to explain why the

proposal is being withdrawn, and promptly notify the ACO in writing of the situation.

When applicable, advise the ACO that the contractor's proposal was initially submitted

late, the withdrawal will delay the audit and settlement of indirect expense rates, and

that the withdrawal may result in the loss of appropriated funds. You should seek

assistance from the ACO to establish a firm date for the contractor's resubmittal of the

proposal. If the contractor refuses to resubmit a certified proposal in a timely manner,

the FAO should follow the procedures outlined in 6-706.1c. A model pro forma

memorandum addressed to the ACO is shown in Figure 6-7-1. Modify it as appropriate

to suit each situation.

6-706.2 Reserved **

6-706.3 Corporate, Group, or Home Office Expenses **

a. The certification requirement (FAR 42.703-2) is predicated on the idea of a

knowledgeable corporate official accepting individual responsibility for the allowability

and allocability of costs included in indirect cost rate proposals. All corporate indirect

cost submissions used to allocate costs to divisions for establishment of final overhead

rates must be certified at the corporate level. These costs need not be certified again at

the division level, and the divisional certification would only cover indirect costs arising

from that division.

b. If a contractor refuses to certify a proposal made at this level, the FAO should

notify the CFAO, who may decide to unilaterally establish the rates as outlined in 6-

706.1c.

6-707 Audits of Indirect Cost Rates **

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6-707.1 Submission of Indirect Cost Rate Proposal **

a. The contractor is required by FAR 52.216-7 to submit an adequate final

indirect cost rate proposal to the contracting officer and the auditor within the six-month

period after the end of the applicable fiscal year. Effective June 30, 2011, the clause

was updated to add a description of the contents (Schedules A through O) required for

an adequate final indirect cost rate proposal, and added the contents of supplementary

schedules A through O as additional information not required for determination of an

adequate proposal but may be required during the audit process. Variations in the size

of the firm, type of business, accounting systems, and auditor procedures mandate

judgment and flexibility in the requirements for form, format, and contents of the

proposal components. The contracting officer may waive the requirements to submit

some schedules or adjust the timing of the proposal based on a valid request by the

contractor.

b. The submission must include an executed Certificate of Final Indirect Costs

(required per FAR 42.703-2; a copy of the certificate is shown at FAR 52.242-4). This

certificate, signed by no lower than a contractor vice president or chief financial officer,

is required for all final indirect cost rate proposals, except CAS 414 (cost of money)

factors, regardless of whether the rates will be established by auditor determination or

contracting officer negotiation. For multidivisional contractors, the proposal for each

segment is to be submitted to the divisional CFAO and the auditor responsible for

conducting audits of that division, with a copy to the corporate auditor and CFAO. The

submission time limit does not preclude the auditor from receiving elements of incurred

cost data or supplemental information from the contractor as it becomes available

c. Auditors must evaluate a contractor’s incurred cost rate proposal for adequacy

within 60 days after receipt of the incurred cost proposal from the contractor, as

required by the 2018 NDAA enacted on December 12, 2017. The electronic Checklist

for Determining Adequacy of Incurred Cost Proposal, based on FAR 52.216-7

requirements, shall be used for the adequacy evaluation. The auditor must also notify

the contractor in writing within 60 days of receipt of the incurred cost submission as to

whether or not the submission is a qualified (adequate) incurred cost submission. If

there are inadequacies, the auditor should contact the contractor to discuss the

deficiencies. If the auditor and contractor are unable to resolve the proposal’s

inadequacies identified by the auditor, the auditor will elevate the issue to the CFAO to

resolve the inadequacies per FAR 42.705-1(b). A written description of any

inadequacies should be provided to the CFAO and contractor. However, at times

auditors receive incurred cost proposals that are so significantly inadequate that the

auditor should include the CFAO from the beginning in the discussions with the

contractor regarding the deficiencies.

d. Contractors are required to submit an indirect cost rate proposal within the six-

month period following the expiration of its fiscal year in accordance with FAR 52.216-

7(d)(2). If the proposal is more than 12 months overdue, the FAO should coordinate

with the CFAO to determine if the incurred cost proposal has already been closed out

by DCMA unilaterally, or if DCMA plans to unilaterally establish final indirect cost rates

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as authorized in FAR 42.703-2(c ) and FAR 42.705(c)(1). To ensure we update DMIS

appropriately, and to ensure the records for DCMA and DCAA remain consistent, the

FAO should determine if the CFAO granted an extension or any other type of

agreement with the contractor regarding the submission of this certified incurred cost

proposal. If the FAO does not receive notification from DCMA regarding an extension

or other updated information, the FAO should cancel the programmed incurred cost

assignment. If, at a later date, the contractor does submit a certified final indirect cost

rate proposal, contact the CAFO to determine if at that time an audit would need to be

performed and if so, a new assignment would be established.

6-707.2 Obtaining Indirect Cost Rate Proposals **

a. According to the Allowable Cost and Payment Clause, FAR 52.216-7, the

contractor is responsible for submitting an adequate final indirect rate proposal within

the six-month period after the end of its fiscal year to contracting officer (or CFAO) and

the contract auditor. Audit teams should assist the contracting officer by:

(1) Educating the contractor of its contractual requirement to submit a final

indirect rate proposal as part of the audit team’s on-going interaction with the contractor,

and by attending meetings, as necessary, to obtain an adequate proposal;

(2) Referring contractor management to the following resources located on

the DCAA public website:

(a) Help for Small Business, including Information for Contractors Manual

(DCAAM 7641.90), Enclosure 6;

(b) ICE (Incurred Cost Electronically) Model;

(3) Notifying the contractor in writing, when a proposal becomes 30 days

overdue, notwithstanding the contracting officer's written extension (a sample letter is

available on the intranet); and by

(4) Supporting the contracting officer in calculating a unilateral contract cost

decrement based on history, when the contractor does not submit a proposal consistent

with the requirements of FAR 52.216-7 in effect at the time of contract award.

b. Headquarters Policy is responsible for coordinating directly with DCMA, and

other administrative Agencies, to help identify significantly delinquent contractors that

require administrative action. Administrative actions are at the discretion of the

contracting officer, and may include further coordination with the contractor in

cooperation with the audit team, and applying a unilateral contract cost decrement.

Relevant History Exists

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Audit teams should provide the contracting officer with all information that is

relevant to the contractor’s delinquent final indirect cost rate proposal, including billing

deficiencies and incurred cost audit experience, etc. Upon request, audit teams may

offer for the CFAO’s consideration a calculated unilateral contract cost decrement

based on relevant historical questioned costs.

Relevant History Does Not Exist

Audit teams should contact Policy for assistance in recommending a unilateral

total cost decrement that the contracting officer may consider as a last resort.

c. To permit proper inter-agency coordination, audit teams must maintain

accurate DMIS information. Audit teams must:

(1) Create timely incurred cost inventory records;

(2) Update the incurred cost proposal status code immediately upon proposal

receipt (i.e., Change from “X” to “P”);

(3) Assess proposal adequacy as soon as practical after proposal receipt, and

revise the incurred cost proposal status code accordingly.

d. When a proposal is significantly delinquent, audit teams should periodically

coordinate with the contracting officer to determine its status and offer necessary

assistance. If, through proper coordination with DCMA, the FAO determines that it is

unlikely that an auditable proposal is forthcoming, the FAO may cancel the assignment

in DMIS.

6-707.3 Request for Audit **

a. Generally, receipt of the contractor’s submission establishes the audit

requirement without need for a specific contracting officer request. If such a request is

received, it should be promptly acknowledged in writing using the format and contents

described in 4-104. If a request is not received, notify the cognizant contracting officer

at the beginning of the audit as discussed in 4-104. The processing of non-DoD agency

requests is discussed in 1-303.

b. Failure to receive a contracting officer request is not a basis to defer indirect

cost audits when such audits are in the best interest of the Government.

6-707.4 Timeliness of Final Indirect Cost Rate Audits **

For incurred cost rate proposals (or resubmissions) received on or after the date

of enactment of the FY 2018 NDAA, December 12, 2017, audits must be completed

within one year of the date of receipt of the qualified (adequate) incurred cost

submission. If there is a significant disparity between billing and actual rates, the

procedures in 6-705.2a should be followed.

6-707.5 Audit Objectives and Procedures **

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a. This section provides the administrative procedures that should be used in

establishing billing and final indirect cost rates. Section 6 of this chapter states the audit

procedures to be considered in the examination of indirect expenses incurred in the

performance of contracts. Chapter 9 sets forth the procedures for the evaluation of

indirect expenses included in price proposals. The procedures and objectives in these

chapters should be applied as appropriate when performing the indirect cost rate audit.

b. The cost principles in FAR Part 31 should be used as the basis for

determining the allowability, allocability, and reasonableness of indirect expenses in

billing/final indirect cost rates whether these rates are negotiated by the contracting

officer or determined by audit. These same cost principles, as appropriate, should be

considered in the evaluation of indirect expenses included in cost proposals used for the

negotiation and award of contracts, or amendments to existing contracts.

6-708 Audit Determined Final Indirect Cost Rates

a. When the FAR provides for audit determination of final indirect cost rates, the

contractor, after the close of its fiscal year, will furnish the contracting officer and auditor

with a copy of its final indirect cost rate proposal for the period (see 6-707.1). The

auditor will perform an audit of all incurred cost rate proposals classified as high risk or

meeting certain high dollar ADV thresholds and issue an incurred cost audit report to

the cognizant CFAO. The low-risk proposals selected for audit during the sampling

process, the auditor will issue a low-risk memorandum (see 6-104.1).

b. During the course of an audit, significant audit findings should be brought to the

attention of, and discussed with, the contractor, and when appropriate with the

cognizant CFAO as soon as possible to expedite the resolution process (see 6-902e).

The discussions are to ensure that the auditor's conclusions are based on a proper

understanding of the facts and to ascertain whether the contractor or CFAO has any

additional information which would support or modify the audit findings. This will enable

resolution of the findings to take place prior to the completion of the audit. If agreement

on an issue cannot be reached, the auditor should issue a DCAA Form 1 (see 6-903).

The issuance of the Form 1 triggers the CFAO’s involvement in the audit determination

process. The contractor should also be requested to prepare a rebuttal for inclusion in

the audit report.

c. Significant system deficiencies, or CAS/FAR noncompliance(s), should be

reported immediately. The auditor should consider whether the circumstances warrant

issuing a Form 1 (see 6-708.1f). If the auditor believes that the billing rate(s) should be

adjusted, an appropriate recommendation (including cost impact calculations) should be

made to the contracting officer. When there are no findings that require an immediate

report or Form 1, individual working paper packages (i.e. activity code 10160), which

are part of the final indirect cost rate audit, may be closed using a "MEMORANDUM

FOR RECORD (MFR)" (see 10-202). See 15-100 for additional comments related to

non-DoD agencies.

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6-708.1 Actions Taken at Completion of the Audit **

a. Upon completion of the audit field work necessary to audit local costs, and

after supervisory approval, the auditor will hold an interim exit conference. At that time,

the auditor will provide the contractor with the results of the audit in writing and seek the

contractor's response. These results will be presented in such a manner that the

contractor will clearly understand the reasons for disapproving any costs, and the basis

for any additional audit recommendations. Since significant audit findings have been

brought to the attention of, and discussed with, the contractor and the contracting officer

during the audit process, a final exit conference should merely be a summary of issues

and resolutions. If unresolved issues exist, the contractor should have already prepared

a rebuttal for the audit report.

b. Upon presentation of the final audit results in written form, the contractor may

be given, if unresolved issues remain, a reasonable amount of additional time to furnish

any new information that may help in resolving open issues. This time should be

minimal since the audit results were provided to and responded by the contractor during

the audit. The time should be predicated upon the number of issues and number of

prior discussions with the contractor, but should generally not exceed 30 days. If the

contractor requests fact-finding sessions, it is acceptable for the auditor to participate in

discussions with the contractor to clarify factual matters. However, the auditor has not

been delegated the authority to "negotiate" final indirect cost rates. The auditor's

responsibility is to determine the final indirect cost rates based on audit of the

contractor's proposal.

c. For multidivisional contractors, the auditor responsible for conducting the audit

is responsible for seeking agreement with that contractor. The corporate audit

directorate (CAD) auditor or the corporate home office auditor (CHOA) is responsible for

seeking agreement with the contractor on corporate home office costs. The CAD

network shall be used to the fullest extent to ensure uniformity and consistency in

arriving at audit recommendations. At a minimum, the divisional auditor shall provide a

copy of the audit results to the CAD prior to discussions with the contractor.

d. If the contractor was given additional time to furnish further information on

unresolved issues, the auditor will have 30 days to thoroughly analyze the contractor's

response, notify the contractor of any changes to the audit exceptions, and issue the

audit report (see 6-708.2). If changes are made, the reasons for all changes will be

thoroughly documented in the working papers. After the audit team has completed

reviewing the additional data and making any necessary changes, a final meeting shall

be scheduled to advise the contractor of any changes to the original audit

recommendations. During this meeting, the audit team should seek the contractor's

agreement on any remaining areas of difference. The CFAO will not ordinarily attend

any of the audit determination meetings with the contractor; however, the auditor should

keep the CFAO informed of developing areas of disagreement which may lead to

issuing a DCAA Form 1.

e. Settlement of the indirect rates should not be delayed because of

noncompliance(s) with CAS identified during the incurred cost audit (or an outstanding

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CAS noncompliance that impacts the incurred cost audit). The audit finding should be

developed within the incurred cost audit and reported through a CAS non-compliance

audit. The incurred cost audit report will include an explanatory note informing the

reader of the nature and status of the noncompliance and that the costs reported in the

exhibit(s) and schedule(s) have not been impacted by the CAS noncompliance, as the

CAS noncompliance and the resulting impact will be processed in accordance with FAR

30.605, Processing Noncompliances.

f. Although the audit report cannot be issued until all required audit work has

been completed, the issuance of a Form 1 should not be delayed until the audit report is

issued. If the contractor does not agree with the disapproved costs, the auditor may

prepare and issue a Form 1 at that point, even though the final report is not due to be

issued until other items are completed. (Also see 6-708.3 and 6-900 for further

comments on issuance of Forms 1.)

g. Should the contractor fail to provide its agreement or rebuttal comments within

the time period allotted (including the 30-day extension, if granted by the auditor), the

audit report shall be issued together with applicable DCAA Forms 1. The working

papers and audit report should state that the contractor did not respond within the

requested timeframe.

6-708.2 Actions Taken When Agreement with Contractor is Reached **

a. If agreement is reached, the auditor will prepare a written rate

agreement/understanding setting forth the final indirect cost rates. This document will

automatically be incorporated into the contracts upon execution, as provided by the

Allowable Cost and Payment clause.

b. Guidelines for the content of the written understanding are contained in FAR

52.216-7(d)(3). The contractor should be given a maximum of 10 days to sign and

return the agreement to the auditor. This is because the final meeting (per above

requirements), and the 10-day period for the contractor to sign the written agreement,

shall be scheduled to allow the audit report to be issued within 60 days from the date

the auditor received the contractor's rebuttal comments. A copy of the signed rate

agreement shall be attached to the annual audit report.

c. Pursuant to FAR 52.216-7(d)(2)(v), effective June 30, 2011, the contractor is

required to update billings on all contracts to reflect the final settled rates and update

the schedule of cumulative direct and indirect costs claimed and billed within 60 days

after rate settlement (Schedule I). The updated Schedule I will be used by the CFAO to

assist in closing out contracts (see 6-1007.3) for contracts awarded after June 30, 2011.

6-708.3 Actions Taken if Agreement with Contractor is Not Reached **

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a. If agreement is not reached, the auditor will issue notices of costs suspended

and/or disapproved (DCAA Form 1 or equivalent non-DoD forms, where applicable).

These notices will detail the items of difference and advise the contractor of its right to:

(1) request, in writing, the cognizant contracting officer to consider whether

the unreimbursed costs should be paid and to discuss his or her findings with the

contractor or

(2) submit a proposal to the CFAO for any disapproved costs. Under this

procedure, the contracting officer does not negotiate final indirect rates, but issues

written determinations or final decisions on specific issues with which the auditor and

the contractor do not agree. Accordingly, it is extremely important that the applicable

DCAA Forms 1 is prepared so the contracting officer is able to obtain a thorough

understanding of the issues involved (see 6-900). The Forms 1 issued shall accompany

the audit report as prescribed in 10-503c and should be cross-referenced. However,

both the Form 1 and the audit report should contain sufficient detailed explanations so

that each can stand alone.

b. If the inclusion of a final determination of CAS noncompliance prevents

agreement on final indirect rates, the audit report should be forwarded to the ACO or

CFAO for resolution, in accordance with FAR 42.705-2(b)(2)(iv).

6-708.4 Reporting Audit Results **

a. Audit teams will issue a low-risk memorandum to the CFAO when an incurred

cost proposal placed in the low-risk universe was not selected for audit during the low-

risk sampling process (see 6-104.5). For incurred cost proposals audited, an audit

report shall be submitted to the CFAO designed to furnish audit information and

recommendations on the allowability of costs and rates for settlement purposes and to

provide support for establishment of final indirect cost rates. Any necessary DCAA

Forms 1 should be attached to the report. Once the report is issued, the contractor may

request CFAO reconsideration or file a claim for the disapproved costs as explained in

6-908.

b. In the case of audit determined indirect rates, or if the audit of the contractor's

proposal discloses insignificant questioned costs, the information normally included in the

explanatory notes for each cost element as described in 10-200 does not need to be

provided, as long as this is agreeable to the contracting officer. Insignificant questioned

costs do not need to be reported if they are not considered expressly unallowable.

c. In the case of contracting officer determined rates, or if the audit resulted in

either significant or expressly unallowable questioned costs, include sufficient indirect

cost and rate data in the explanatory notes for each account/element as described in 10-

200. Details need to provide the reader with an understanding of how the audit results

were achieved (see 6-709.2). Including such data should also enable the negotiator to

prepare the negotiation report and make determination penalty assessment when

required. A qualified audit report may be issued before completion of the assist audits

of the subcontract or intracompany costs if all of the following conditions are met:

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(1) The request for annual incurred cost audits of the subcontract has been

sent (see 6-802.5b) and the report is expected to be received before the planned date

of the final voucher evaluation or final CACWS on the prime contract. The requesting

audit office should have a system to (i) monitor receipt of the subcontract assist audit

reports, (ii) follow-up on those audits not promptly received, (iii) compare subcontractor

costs included in the assist audit report(s) with those included in the upper tier

contractor incurred cost proposals, and (iv) issue any needed supplemental audit

reports, if they will serve a useful purpose.

(2) There are no significant deficiencies in the contractor’s business systems

(DFARS 252.242-7005), that could materially impact the claimed subcontract costs.

(3) The subcontract or intracompany costs do not have a material impact on

the indirect cost allocation bases.

d. A qualified audit report may be issued before completion of assist audits on

corporate or home office costs. The report should show the corporate or home office

costs as being unresolved, and upon receipt of the assist audit reports, a supplemental

audit report should be issued, if requested by the contracting officer and/or if it would

serve a useful purpose. If a supplemental audit report is not issued, the auditor should

coordinate with the contracting officer to provide negotiations support for incorporating

the results of assist audits.

e. When a Schedule of Cumulative Allowable Costs (see 6-711.3) is included in

the incurred cost report, the use of the schedule should be coordinated in advance with

the ACO. The schedule must contain sufficient detail to enable the ACO to close out

contracts without individual contract audit closing statements. The schedule shows the

cumulative allowable costs (inception to date) by contract or subcontract. If not practical

(e.g., if the schedule would be too voluminous), identify the location of the specific records

that contain the allowable costs by contract and subcontract.

f. When appropriate, the DCAA Intranet and the Caseware application software

should be used to expedite the following exhibits:

List of Unsettled Flexibly Priced Contracts

Government Participation in Allocation Bases

Statement of Proposed Rate/Amount and Results of Audit

Unallowable Costs Subject to Penalty (Figures 6-7-2 and 6-7-3)

g. When appropriate, the DCAA Intranet and the Caseware application software

should be used to expedite the following appendixes:

Certificate of Indirect Costs

Rate Agreement Letter (if applicable)

Technical Evaluations

DCAA Forms 1

Assist Audit Reports

Contractor’s Written Response

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Advance Agreements (with effect on covered contracts)

h. Indirect cost rates should not remain open awaiting the resolution of Business

Case Analysis (BCA) cases, technical problems, and other items beyond DCAA's

control, except for allowing the FAR 30.605 noncompliance process to proceed as

described in 6-708.1.e. The report should be issued with appropriate qualifications and

be supplemented, as necessary.

6-708.5 Writing the Audit Report **

a. Prepare the report in the format given in 10-200. It should be addressed to the

contracting officer, and should include the information required by FAR 42.705-2(b)(2).

The extent of detail to be included in the report exhibits and schedules should be

governed by the materiality of the indirect cost pools, the government's participation, and

the amount of questioned costs.

b. Summarize the results of audit in an exhibit format, showing the pool and base

amounts for each indirect rate as proposed by the contractor and as questioned by the

auditor. Include the following categories of costs in the exhibit(s) for each cost pool:

Proposed Indirect Costs (Pool, Base and Rate)

• Voluntary Deletions

• Total Questioned Costs

• Questioned Costs (Concurred)

• Questioned Costs (Nonconcurred) (Attach DCAA Form(s) 1 if rates are

audit determined).

c. Detail the audit results for each indirect cost rate with supporting schedules as

required. Modify the presentation to accommodate complex rate determinations and

negotiation problems. Significant questioned costs for each cost element or account

should be supported by explanatory notes presented in the format discussed in 10-200.

The auditor can briefly describe the reasons for the questioned costs in those instances

when the contractor concurs. When advance agreements or special provisions governing

specific contracts are in effect, reference the appendix in the explanatory notes

associated with the applicable costs.

d. If necessary include an exhibit listing all government cost-reimbursement, and

flexibly priced contracts and subcontracts performed during the fiscal period, excluding

contracts that were removed from the audit scope. Indicate those contracts and

subcontracts with advance agreements or governed by special provisions. Contracts that

contain, or should have contained the FAR or DFARS “Penalties for Unallowable Costs”

clause must be identified through a footnote (contracts where the penalty clause has

been inadvertently omitted should be separately identified). Request the contractor to

furnish the necessary information subject to your selective verification. Group the

contracts by military departments or other government agencies concerned. Identify

prime contracts and subcontracts by number, and reference subcontracts to the prime

contractor and prime contract number. (Note: If a properly completed CACWS, which

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meets all of the requirements of the Exhibit of Unsettled Flexibly Priced Contracts, is

attached to the report, a separate exhibit does not need to be included.)

e. Use appendixes as applicable to provide information and comments. Include an

affirmative statement when a DCAA Form 1 or equivalent non-DoD forms is including in

the report, that the ACO was advised of the areas of disagreement that led to their

issuance.

(1) If the audit report covers audit-determined rates, and the contractor agrees

with the audit findings, enclose a copy of the completed indirect cost rate agreement

required by FAR 42.705-2(b)(2)(iii) in the appendix section of the audit report. In addition,

include a specific reference to the attached indirect cost rate agreement in the narrative

body of the exhibit.

(2) If the contractor's submission applies to contracts that contain, or should

have contained the FAR or DFARS penalty clause, and the audit identified questioned

costs, include a schedule identifying all questioned costs which are potentially expressly

unallowable (see Figure 6-7-2). For corporate home office expenses, the schedule should

also include the allocable share of potentially expressly unallowable costs for each

division (see Figure 6-7-3). These should be included in the appendixes of the report.

6-709 Establishment of Final Indirect Cost Rates

by Contracting Officer Determination **

a. Where FAR provides for contracting officer-determined final indirect cost rates

(other than predetermined rates), the contractor, after the close of its fiscal year, will

furnish the contracting officer and auditor with a copy of its final indirect cost rate

proposal for the period (see 6-707.1). The auditor will perform an audit of the incurred

cost proposal classified as high risk and those low-risk proposals selected for auditing

during the sampling process (see 6-104.1) and will issue an advisory incurred cost audit

report to the cognizant contracting officer for use in the rate negotiations.

b. During the course of an audit, significant audit findings should be brought to the

attention of, and discussed with, the contractor, and, where appropriate, with the

principal cognizant CFAO and Corporate Audit Directorate (CAD), as soon as possible

so as to expedite the resolution process (see 6-902e). The discussions are to ensure

that the auditor's conclusions are based on a proper understanding of the facts and to

ascertain whether the contractor/CFAO/CAD have any additional information which

would support or modify the audit findings.

c. Significant system deficiencies, or CAS/FAR noncompliances, should be reported

immediately. When a Form 1 is appropriate, it should be issued immediately in

accordance with procedures in 6-900. If the auditor believes that the billing rate(s)

should be adjusted, an appropriate recommendation (including cost impact calculations)

should be made to the contracting officer. The contracting officer should immediately

forward these findings to the contractor with a request to respond within 30 days

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(generally, one 30-day extension may be granted). When there are no findings which

require an immediate report or Form 1, individual working paper packages, which are

part of the final indirect rate audit, may be closed using a "MEMORANDUM FOR

RECORD (MFR)" (See 10-202). See 15-100 for additional comments related to non-

DoD agencies.

6-709.1 Actions Taken at Completion of the Audit **

a. Upon completion of the audit field work necessary to audit local costs, and

after supervisory approval, the auditor will hold an exit conference. The contracting

officer will be given an advance briefing on the audit findings and invited to attend the

exit conference with the contractor. The auditor will provide the contractor with a written

summary of the audit results at the exit conference. The summary must clearly state

the reasons for questioning costs, if any, and the basis for any additional audit

recommendations.

b. The contracting officer should request the contractor to respond to all findings

within 30 days (one 30 day extension may be granted). Contracting officer concurrence

is not a precondition to holding the exit conference. However, the contracting officer

should understand the findings and participate in the resolution process.

c. Should the contractor fail to provide its agreement or rebuttal comments within

the time period allotted (including the 30-day extension if granted by the contracting

officer), the auditor will promptly issue the audit report. The working papers and audit

report should state that the contractor did not respond within the requested timeframe.

6-709.2 Reporting Audit Results **

a. Upon receipt of the contractor's rebuttal, the auditor will have 30 days to

consider and respond to the contractor’s rebuttal and to issue the final audit report. In

order to provide the ACO as much assistance as possible in deciding open issues, the

auditor should logically and fairly address the contractor's rebuttal to the audit position.

If the auditor is unable to present a strong, logical defense to the contractor's rebuttal,

the auditor should consider withdrawing the finding. Each open issue in which there is

not concurrence should be presented in the audit report in the following format:

(1) A clear, concise description of the audit finding must be provided.

(2) The contractor's rebuttal should be summarized immediately following the

description of the audit finding and attached in its entirety as an enclosure to the audit

report.

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(3) The auditor's rejoinder to the contractor's rebuttal should defend the audit

position in light of the contractor's comments and fully explain in logical terms why the

contractor's argument is flawed or otherwise inappropriate. If the auditor has modified

the finding as a result of considering the contractor's comments, this fact should be

disclosed.

b. When a CAS noncompliance is found during the incurred cost audit or there is

an outstanding CAS noncompliance that could impact the incurred cost audit, the costs

of the report should not be impacted for the CAS noncompliance. The audit report will

include an explanatory note informing the reader of the nature and status of the

noncompliance and that the costs reported in the exhibit(s) and schedule(s) have not

been impacted by the CAS noncompliance, as the CAS noncompliance and the

resulting impact will be processed in accordance with FAR 30.605. When the CAS

noncompliance could impact the allowability of the costs on non CAS-covered contracts,

the audit report will inform the reader that the CAS noncompliance needs to be

considered when determining the final indirect rates.

c. When assist audits are required, the requesting auditor will coordinate with the

assist auditor when establishing due date requirements. The assist auditor should

make every effort to complete the audit within the time frame established. Should the

requesting auditor encounter protracted delays in obtaining assist audit results and is

unable to reach a resolution, the situation should be elevated to the region or CAD for

resolution.

(1) A qualified audit report may be issued before completion of assist audits

on corporate or home office costs. The report should show the corporate or home office

costs as being unresolved, and upon receipt of the assist audit reports, a supplemental

audit report should be issued, if requested by the contracting officer and/or if it would

serve a useful purpose.

(2) A qualified audit report may also be issued before completion of the assist

audits of the subcontract or intracompany costs if all of the following conditions are met:

(i) The request for annual incurred cost audits of the subcontract has been

sent (see 6-802.5b) and the report is expected to be received before the planned date

of the final voucher evaluation or final CACWS on the prime contract. The requesting

audit office should have a system to (i) monitor receipt of subcontract assist audit

reports, (ii) follow-up on those audits not promptly received, (iii) compare subcontractor

costs included in the assist audit report with those included in the upper tier contractor

incurred cost proposal, and (iv) issue any needed supplemental audit reports, if they will

serve a useful purpose.

(ii) There are no significant deficiencies in the contractor’s business

systems (DFARS 252.242-7005), that could materially impact the claimed subcontract

costs.

(iii) The subcontract or intracompany costs do not have a material impact

Page 186 of 227

on the indirect cost allocation bases.

d. After the audit report is issued, the contracting officer will attempt to reach a

settlement with the contractor as promptly as possible. The auditor should be invited to

attend all meetings between the contracting officer and contractor during which open

items are formally discussed.

6-710 Indirect Costs Advance Agreements **

a. The contracting officer may enter into advance agreements with the contractor

concerning the allowability of special cost elements, ceilings for IR&D/B&P, etc. The

auditor shall abide by properly executed advance agreements that are in effect for the

fiscal year when determining final rates. Should the auditor find that an advance

agreement is not in the best interest of the Government, the auditor will follow

established procedures for recommending to the contracting officer, in writing, that the

advance agreement be rescinded. Any steps taken to recommend rescinding the

advance agreement will be thoroughly documented in the working papers.

b. A recommendation to rescind the advance agreement should not unduly delay

issuing the audit report. If the CFAO does not provide a timely response, the auditor will

proceed with the formal exit conference and present the audit results to the contractor.

The audit recommendations will incorporate the terms of the advance agreement and

the results will indicate that the auditor relied on the terms of the advance agreement.

The circumstances involving the advance agreement, including the auditor's actions

with respect to the advance agreement, shall be included in the audit report.

6-711 Expediting Settlement of Indirect Cost

Rates **

6-711.1 Expediting Settlement of Indirect Costs Rates on Completed

Contracts **

a. The final period of performance under a contract is generally less than a full

fiscal year, and some contracts, task order, or delivery order will in fact, be completed

early in the year. The indirect cost rate determination for the contractor's fiscal year in

which a contract, task order, or delivery order is physically completed may not occur for

a considerable period of time thereafter, since the contractor's indirect cost proposal

may not be submitted up until six months after the end of its fiscal year. It is

recognized, therefore, that in many cases the expeditious settlement of direct and

indirect costs and the prompt close out of physically completed contracts have

considerable administrative advantage to both the Government and the contractor.

b. Accordingly, FAR 42.708 provides for quick-closeout procedures. These

procedures allow the contracting officer to negotiate a settlement of direct and indirect

costs for a specific contract, task order, or delivery order to be closed, in advance of the

determination of final direct and indirect rates if the requirements specified in FAR

42.708 are met. Use of the quick-closeout procedures will be binding on that contract,

Page 187 of 227

task order, or delivery order and no adjustment will be made to other contracts, task

orders, or delivery orders for the over- or under recovery of costs that may result from

the agreement. Likewise, using the quick-closeout procedures will not be considered as

a precedent when establishing final indirect rates for other contracts, task orders, or

delivery orders. The contracting officer will perform a risk assessment to determine

whether the use of the quick closeout procedures is appropriate. (See 6-1010 for

further information on the use of quick closeout procedures.)

6-711.2 Expediting Settlement of Indirect Cost Rates on Terminated

Contracts **

As discussed in 12-407, settlement of a terminated contract may be unduly

delayed if settlement is held until final indirect rates are established. Accordingly, FAR

49.303-4 permits negotiation or use of the billing rates as final rates to expedite closing

a terminated contract. Aside from ensuring that allocated indirect costs to the

terminated contract are reasonable (12-304.15), the other main concern when using this

closeout procedure is to ensure that the subsequent final rate proposal is consistent

with the amounts used to closeout the terminated contract (e.g., items included as

settlement expenses which would normally be part of indirect costs, like salaries related

to preparing the settlement proposal, are eliminated from the proposed indirect cost

pools).

6-711.3 Cumulative Allowable Cost Worksheet (CACWS) **

a. The Cumulative Allowable Cost Worksheet (CACWS) is a summary schedule

of cumulative allowable contractor costs for each open flexibly priced contract through

the last contractor fiscal year for which indirect cost rates have been settled. The

CACWS is used to assist the CFAO (generally the ACO) to approve final vouchers to

close contracts without requiring further assistance from DCAA. The worksheet notes

which contracts are physically complete, provides the status of requested assist audits,

and contains other key information needed for closing contracts. It is recommended

that an electronic CACWS or comparable summary report should be prepared by the

contractor as part of their incurred cost rate proposal. CACWS are not required for an

adequate certified incurred cost rate proposal; however, should be encouraged because

of the benefits and efficiencies gained in closing contracts timely. Cumulative costs are

necessary to assure that the cumulative amounts billed do not exceed total ceiling cost

on the contract and/or the current contract minimum funding levels. Information to

compile the CACWS is obtained from Scheduled H, I, J, K and O from the certified

incurred cost rate proposal. These schedules are required for an adequate incurred

cost rate proposal in accordance with FAR 52.216-7(d)(2)(iii). Effective June 30, 2011,

the Allowable Cost and Payment clause added a requirement for contractors to update

the Schedule I, Cumulative Direct and Indirect Costs Claimed and Billed, to reflect

settled rates and cumulative costs within 60 days after settlement of final indirect cost

rates (FAR 52.216-7(d)(2)(v)). This was considered necessary to enhance the contract

closeout process. Contracting officers can use this updated Schedule I in lieu of a

contract audit closing worksheet to assist in closing out contracts once they have

verified the accuracy of the data on the updated schedule.

Page 188 of 227

b. Generally, the CFAO can generate or update existing CACWS using data from

incurred cost audit reports, low risk memoranda, Schedules H, I,J,K, and O of the

certified incurred cost proposals, settled direct and indirect costs, and rate agreement

letters. For contracts awarded after June 30, 2011, the CFAO should obtain the

contractor’s updated Schedule I, Cumulative Direct and Indirect Costs Claimed and

Billed to reflect settled costs. For older contracts where complexities exist and the

contractor does not have a CACWS, the CFAO may request DCAA to provide advisory

services on the contract/task order to compile existing factual direct and indirect costs

information (based upon settlement/audit determined agreements) for the CFAO to use

in the closeout process, see 6-1007.3b. No additional examination is being performed.

c. If completion/final vouchers and the accompanying closing documents are

received by the FAO, they should be forwarded to the CFAO for review and approval,

see 6-1007.1, Receipt-Completion/Final Vouchers. Additional final voucher support

should be performed only upon receipt of specific CFAO request as described in 6-

1007.3.

Page 189 of 227

Figure 6-7-1 – Memorandum for The Administrative Contracting Officer **

[Date]

MEMORANDUM FOR THE ADMINISTRATIVE CONTRACTING OFFICER,

[insert the cognizant ACO organization]

Attention:Mr./Ms. [insert name]

Subject:Contractor Withdrawal of Final Indirect Expense Rate

Proposal for FY 20XX, [insert the contractor name]

We are in the process of auditing [or plan to audit] the [insert the contractor

name]'s final indirect expense rate proposal for FY 20XX. On [month/day 20XX] the

contractor notified our office that the submission for FY 20XX is being withdrawn.

[Describe the reasons for contractor withdrawal; e.g.,. We understand the contractor's

withdrawal is due to recent stories in the press regarding possible changes to the

current law on penalties for unallowable costs.] As you know the FY 20XX claim was

already submitted [insert # of months] months late based on contract requirements.

We are concerned that the contractor's withdrawal of the final indirect expense

rate proposal(s) is unduly delaying the settlement of rates and could have adverse

funding consequences. If contracts cannot be closed before cancellation of the

appropriations, any subsequent payments would have to be made with current year

funds.

Your assistance is requested to establish a firm date for the contractor's

resubmittal of the proposal(s). This will enable us to plan to have the necessary audit

staffing in place to complete the audit(s) as expeditiously as possible. If the contractor

is not responsive, we would encourage consideration of the available remedies

including unilaterally established rates (FAR 42.703-2).

We appreciate your continued support of our joint objective to establish final

rates and close out contracts in a timely manner. If you would like to discuss this matter

further, please contact Mr./Ms. [insert name], Supervisory Auditor, at [insert the

telephone number] at your convenience.

John A. Smith

FAO Manager

Page 190 of 227

Figure 6-7-2 - Schedule of Potential Expressly Unallowable Costs **

SCHEDULE OF POTENITAL EXPRESSLY UNALLOWABLE COSTS

Period __________ Through __________

Amount Subject to FAR 42.709

Questioned

Costs

Level One

Penalty

Level Two

Penalty

Reference

Cost Element

Engineering Overhead:

Consultants

$150,000

$100,000

SEE NOTE

Depreciation

100,000

BELOW***

Pension

100,000

Relocation

100,000

50,000

Legal Fees

80,000

40,000

Professional Actv.

80,000

Travel

75,000

20,000

Insurance

25,000

Entertainment

25,000

Totals

735,000

515,000

25,000

Participation of Contracts Subject to Penalty Clause

Total

Subject to

Penalty

Not Subject

to Penalty

Allocation Base

$40,000,000

$8,000,000

$32,000,000

Percent of Base

100%

20.0%

80.0%

Questioned Costs Subject to Level One

Penalty ($515,000 X 20%)

103,000

Questioned Costs Subject to Level Two

Penalty ($25,000 X 20%)

5,000

***NOTE: INCLUDE REFERENCES TO NOTES IN THE EXHIBIT CONTAINING THE

POTENTIAL EXPRESSLY UNALLOWABLE INFORMATION.

Page 191 of 227

Figure 6-7-3 - Schedule of Home Office Expense that are Potentially Expressly

Unallowable Costs **

HOME OFFICE EXPENSE

SCHEDULE OF POTENTIAL EXPRESSLY UNALLOWABLE COSTS

Period __________ Through __________

Amount Potentially Subject to FAR 42.709

Questioned

Costs

Level One

Penalty

Level Two

Penalty

Reference

Consultants

$500,000

$300,000

See Note

Lobbying

150,000

Below***

Advertising

100,000

Public Relations

100,000

Relocation

80,000

40,000

Travel

50,000

20,000

Totals

$980,000

$710,000

Allocation to Divisions

Division

Allocable

Amount

Missile

60.0%

$426,000

Submarine

20.0%

142,000

Service Co.

10.0%

71,000

Research

10.0%

71,000

Total

100.0%

$710,000

***NOTE: INCLUDE REFERENCES TO NOTES IN THE EXHIBIT CONTAINING

THE POTENIALLY EXPRESSLY UNALLOWABLE INFORMATION.

6-800 Section 8 - Assist Audits of Incurred Costs **

6-801 Introduction **

This section presents audit policy for the performance of assist audits of incurred

costs on subcontracts, inter-organizational, transfers, corporate/home office expenses,

and offsite locations. For purposes of this section, assist audits refer to the situation

where a contract auditor at one location is furnished assistance by a contract auditor at

another location.

6-802 Subcontract or Inter-Organizational

Transfer Incurred Costs **

6-802.1 Definitions **

Page 192 of 227

a. For the purpose of this section, the term "subcontract" means an auditable

subcontract, purchase order, or other form of agreement under which materials or

services are to be furnished on a flexibly priced basis to a prime contractor under a

flexibly priced contract subject to DCAA audit. Flexibly priced contracts include all cost-

type, fixed-price-incentive, and fixed-price-redeterminable contracts, orders issued

under indefinite delivery contracts where final payment is based on actual costs

incurred, and portions of time-and-material and labor-hour contracts. Firm fixed priced

subcontracts are auditable for allocability, allowability, and reasonableness by the prime

auditor but would not be audited by the subcontract auditor.

b. The terms "prime contractor" and "subcontractor" as used in this section also

relate to a higher-tier subcontractor and the next lower-tier subcontractor, respectively.

c. The term “inter-organizational transfer” means work products or services

performed at a contractor's segment or division and charged to another segment or

division of the same company/entity. These transfers can occur for different reasons

but often occur as a result of the normal business relationships that exist between the

divisions of the same company/entity. (See FAR 31.205-26(e), FAR 44.303(e), and

DFARS 252.244-7001(c)).

6-802.2 Basic Responsibilities **

a. The prime contractor is responsible for managing its subcontract. The

Allowable Cost and Payment clause (FAR 52.216-7) makes the prime contractor

responsible for billing costs to the Government that are in accordance with FAR 31.2.

To accomplish this responsibility, the prime contractor should have adequate internal

controls to identify and notify the Government of auditable type subcontracts and inter-

organizational transfer under auditable type Government contracts, and to assure that

subcontract/inter-organizational transfer costs are allowable, allocable, and reasonable.

Per FAR 52.216-7(d)(5), the prime contractor is responsible for settling subcontractor

amounts and rates included in the completion invoice or voucher and providing a status

of subcontractor audits to the contracting officer upon request.

Page 193 of 227

b. DFARS 252.244-7001, Contractor Purchasing System Administration,

identifies the requirements of an adequate purchasing system. Among the

requirements is that the contractor’s system should be able to, and does, notify the

Government of awards (DFARS 252.244-7001(c)(16)). The contractor's notification to

the Government of awards of subcontracts and inter-organizational transfer should be

made as soon as practicable after award, and as part of the prime contractor’s annual

incurred cost proposal (FAR 52.244-2). The listing of subcontracts and inter-

organizational transfers awarded to companies for which the contractor is the prime or

upper-tier contractor should include the prime contract number, subcontract/ inter-

organizational transfer contract number, subcontract/inter-organizational transfer

amount claimed during the fiscal year, subcontract/inter-organizational transfer award

type (CPFF, T&M, etc.), subcontractor/inter-organizational transfer name and address,

and point of contact information. (FAR 52.216-7 (d)(2)(iii)(J)).

c. The contractor's internal control system over subcontracts and inter-

organizational transfers should include FAR 52.215-2, which is a mandatory flow down

clause, into the subcontract/inter-organizational transfers. FAR 52.215-2 provides the

Government or prime contractor the right to examine and audit all subcontract records

supporting the costs proposed or anticipated to be incurred directly or indirectly on the

subcontract. The Allowable Cost and Payment Clause, FAR 52.216-7 provides that the

contractor shall submit an adequate final indirect cost rate proposal to the Contracting

Officer and auditor as well as a completion invoice or voucher to reflect the settled

amounts and rates. FAR 52.216-7 is not a mandatory flow down clause to

subcontracts. However, if the prime contractor has not included FAR 52.216-7 in its

cost-type subcontracts, it should be prepared to demonstrate how it determines the

subcontract costs to be allowable, allocable and reasonable.

d. DCAA policy is to examine, based on risk during a contractor’s fiscal year,

auditable subcontracts and inter-organizational transfers issued by the contractor under

auditable Government contracts and subcontracts, and to request or perform assist

audits of incurred costs whenever such audits are of potential benefit to the Government

and necessary to assure adequate and effective audit coverage of a contractor's

operations or cost representations

e. Under certain conditions, it is desirable that DCAA perform the audit of the

subcontractor. Examples of these conditions include:

(1) Subcontract dollar value is significant to the prime contract dollar value,

(2) Subcontractor objects, for competitive reasons, to an upper-tier contractor

auditing its records,

(3) DCAA currently performs audit work at the subcontractor's location or can

perform the audit more economically or efficiently,

(4) Contractor or subcontractor are related parties; i.e., one has a substantial

financial interest in, or control over the other.

Page 194 of 227

f. An assist audit may be requested by the ACO or initiated by the DCAA prime

contract auditor. Communication between the DCAA prime FAO and the DCAA

subcontract FAO should occur when making a determination on whether the

Government should examine a subcontractor's records.

g. The Government's interest and good auditing practice require that assist audits

of incurred costs be accomplished primarily while the contract is physically being

performed.

h. Requests for assist audits of incurred costs will be processed through audit

channels (6-802.5) and documented in the FAO control system to provide visibility of

assist audits in process.

i. Results of subcontract assist audits should be incorporated into the prime

contractor audit report. Questioned costs not concurred to by the subcontractor are

generally reported in a DCAA Form 1 at the prime contractor level (unless the prime

contractor concurs to the questioned costs).

6-802.3 Preparation of Subcontractors' Cost Proposal **

In many cases, subcontractors also have prime contracts that contain the

Allowable Cost and Payment clause (FAR 52.216-7). A subcontractor generally submits

its costs on commercial invoices directly to the prime contractor. In cases where DCAA

will perform the audit, the auditor cognizant of the subcontractor will arrange with the

subcontractor to make available copies of invoices submitted to the prime contractor.

The auditor will document their understanding of the subcontractor’s billing procedures,

including the contractors process for updating billings to reflect actual indirect cost rates

(post year-end).

6-802.4 Prime Contractor Audits of Costs Proposed by Subcontractors **

Generally, when the DCAA prime contract auditor requests an assist audit of

subcontract costs, the prime contractor should be advised of these assist audit plans so

that duplicative audits can be avoided. On those subcontracts where the prime

contractor performs the audit, the DCAA auditor shall request and review the prime

contractor's audit working papers to ascertain whether the scope and extent of audit

was sufficient to establish the validity of the subcontractor's proposals, and that

appropriate deductions were made in the prime contractor's proposals to the

Government for unallowable subcontract costs. If the DCAA auditor considers the

audit to be deficient or inconclusive and believes there is a need for further evaluation

of subcontract costs, the prime auditor should discuss the matter with both the

contractor and the ACO to determine if a Government audit is necessary.

6-802.5 DCAA Audit of Subcontractor’s Proposed Costs **

Page 195 of 227

a. The prime DCAA auditors will initiate timely requests for assist audits of

subcontract incurred costs. The need for assist audits should be assessed on an

annual basis. Based on assessed risks, there may be years where an assist audit is not

necessary. The DCAA auditor cognizant of the subcontractor has a mutual

responsibility to assure concurrent and coordinated audit effort. Both prime and

subcontract auditors should maintain adequate controls for identifying auditable

subcontracts, tracking subcontracts, and monitoring the status of subcontracts.

b. The need for assist audits should be assessed on an annual basis and should

be requested only where significant risk has been identified in the prime contractor’s

incurred cost proposal. Prior to issuing the request for assist audit, the prime auditor

should communicate with subcontract auditors in part to explain the risk factors that

resulted in the request for assist audit. Matters of discussion would include, as an

example, audit history, prior issues, eligibility for the low risk sampling pool, reliability of

the indirect rates/budgets, etc. The amount of detail included with assist audit requests

will vary according to the respective audit offices involved, but should normally include a

copy of the subcontract or agreement; a listing of subcontractor billings included in the

prime proposal; and a contractor identified point of contact for the subcontractor, to

include physical and electronic mailing addresses and phone number. A pro forma

assist audit request is provided as Figure 6-8-1. The prime auditor should communicate

to the subcontractor auditor any special prime contract terms (e.g., ceiling rates, or

specific unallowable costs) that should be considered in the audit of the subcontract.

The subcontract auditor should promptly acknowledge the request for assist audit. Any

potential access to records problem at the subcontractor location should be elevated

quickly to the prime auditor and the ACO (1-504.)

c. Some flexibly priced contracts, such as price redeterminable and incentive

types require the submission of price adjustment proposals. Requests for audits of

these proposals should be processed under the field pricing support procedures of FAR

15.404-2.

d. The prime and subcontract auditor should coordinate planned audit effort. The

subcontract auditor should discuss the plans with the subcontract ACO, where

applicable, to assure coverage in specific areas of mutual interest. Depending on the

materiality of the subcontract, the scope of effort needed to cover the risk of the

subcontract cost, and the depth and documentation of the prime contractor’s oversight

of its subcontractors, the assist audit request can range from a full scope audit to cost

verification of indirect expense rates and direct costs. The requesting auditor will also

coordinate these matters with the ACO at his/her location.

e. Low risk should be taken into careful consideration when planning the assist

audits and reporting the results. When low risk memos are received, the prime audit

report should include an explanatory note of the circumstances and reference the

appendix which should include a list of low risk memos received.

Page 196 of 227

f. The subcontract auditor will arrange for necessary technical assistance with the

subcontract ACO. Guidance on requesting and evaluating technical assistance is in

Appendix B.

g. In most circumstances, questioned indirect costs based on the assist audit will

be recovered through the annual billing rate adjustment after the subcontractor’s

settlement of final rates for the year under audit. The subcontract should submit

adjustment vouchers to reflect the impact of the questioned costs to the prime

contractor on a timely basis. The prime contractor should verify that the adjustments

were made and the vouchers are correct.

h. When agreement on the questioned costs cannot be reached with the

subcontractor, the subcontract auditor should advise the prime contract auditor of a

suspension or disapproval of a subcontractor cost. Upon receipt of advice of a

suspension or a disapproval of a subcontract cost, the prime auditor will immediately

discuss the matter with the prime contractor's designated representative. The purpose

of this discussion is to alert the prime contractor to the need for reaching an agreement

with the subcontractor regarding disapproval or suspension of the questioned costs, or

recoupment thereof if already paid. Depending on the results of the communication and

relevant supplemental audit procedures, the prime contract auditor may also need to

prepare a DCAA Form 1 to effect the necessary deduction from the prime contractor's

interim vouchers.

i. Prime contract auditors should be alert for subcontractor assist audits results

that could affect progress payments.

j. Since the Government has no contractual relationship with subcontractors, it is

not bound by any agreement between prime and subcontractors as to payment or

disposition of any subcontract costs determined to be unallowable by the DCAA auditor.

Therefore, the cognizant auditor will disapprove any such amounts that may be included

in the prime contractor's claims under flexibly priced contracts, regardless of the prime

contractor's disposition thereof with the subcontractor.

6-802.6 Release of Subcontractor Data to a Higher-Tier Contractor **

When a DCAA subcontract assist audit is contemplated, the higher-tier contractor

normally will have made satisfactory arrangements for its unrestricted access to the

subcontract audit results so that it will be able to fulfill its responsibilities for settling any

audit exceptions. In rare cases, this may be impracticable. The following procedures

are required to protect subcontractor data when special circumstances warrant such

protection.

Page 197 of 227

a. Before beginning a subcontract audit, determine whether the subcontractor will

have any restrictions or reservations on release of the resulting audit report(s) to the

higher-tier contractor. A significant reservation exists if the subcontractor desires to

withhold its decision on release of an audit report pending review of the audit results or

report contents. If the subcontractor does not assure unrestricted report release at the

outset, refer the matter to the requesting higher-tier contract auditor. The latter will

reassess the assist audit request, consulting with the higher-tier contractor and/or ACO

as appropriate.

b. In most cases, the higher-tier contractor should be able to remove the

subcontractor's objections to unrestricted release of the audit results. This may be

necessary to avoid Government suspensions or disapprovals of subcontract costs billed

by the higher-tier contractor. If the prime contractor's diligent efforts are unsuccessful,

request the ACO to advise whether the subcontract costs should be audited by the

Government, even though some or all of the audit report information may have to be

kept within Government channels.

c. There may be rare cases when the higher-tier contract auditor and ACO

decide that an audit should proceed without the subcontractor's advance concurrence

on report release of the subcontractor’s data. In such cases, the subcontract auditor

should attempt during the exit conference to obtain the subcontractor's concurrence in

unrestricted release of the report to the higher-tier contractor. If this fails, the

subcontract auditor should modify the Restrictions section of the audit report per 10-

210.4. If practicable, obtain the subcontractor's written statement as to what information

may be released, and provide this to the report addressee either as a report appendix or

by separate correspondence.

d. At subcontractor locations where recurring cost audits are made on

subcontracts issued by the same higher-tier contractor, try to expedite the process by

developing a working arrangement for unrestricted audit report release. The

subcontractor's representative should document the arrangement, with a copy to the

auditor.

6-803 Inter-Organizational Transfer Billings **

As used in this section, inter-organizational transfer billings are invoices (or credit

memorandums) for work or services performed at a contractor's segment or division and

charged to flexibly priced contracts at another segment or division. For purposes of this

section, the auditor at the segment or division billed for services is referred to as the

prime auditor and the auditor at the location where the work is performed is referred to

as the lower-tier auditor. Auditors should gain an understanding of the contractor’s

practices related to cost incurred between divisions.

6-803.1 General Information **

a. A contractor may use more than one of its segment or divisions to perform

required work or services. It may issue inter-organizational transfer work orders,

purchase orders, or requisitions for the services or work to be performed. Where

Page 198 of 227

segments or divisions involved are separate entities for accounting purposes, the

contractor generally will use inter-organizational transfer billings or invoices to bill costs

or charges applicable to the work or services performed. Except as provided in FAR

31.205-26(e), the allowable costs for such work or services will be the actual costs of

the performing organizational unit (6-313).

b. The provisions of this section are not applicable to monthly or periodic billings

which cover solely estimated indirect expense allocations, such as distributions of home

office expenses to various benefiting segments. Ordinarily, the contractor will adjust

these allocations to actual at its fiscal year end. The cognizant auditor will review

charges of this nature as part of the normal overhead audit at the benefiting segments

through the assist audit procedures (6-804).

6-803.2 Audit Procedures **

a. The prime auditor will initiate requests for assist audits of inter-organizational

transfer plant billings pursuant to the criteria stated in 6-314 and should normally include

copies of the related work orders, purchase orders, or subcontracts and billing

documents to help the lower-tier auditor identify the costs to be audited. However, the

lower-tier auditor has a mutual responsibility to assure concurrent and coordinated audit

effort similar to that envisioned in subcontract audits (6-802). The prime auditor should

initiate timely identification of auditable inter-organizational transfer work authorizations

and information related to the anticipated volume of auditable work for sound audit

planning and performance of the assist audits.

b. The lower-tier auditor should coordinate planned audit effort with the prime

auditor and the lower-tier ACO to assure coverage in specific areas of mutual interest.

Based on this coordination, the lower-tier auditor will furnish the prime auditor with the

anticipated issuance date of the assist audit report. The prime auditor will also

coordinate these matters with the ACO at his or her location.

c. The lower-tier auditor will arrange for necessary technical assistance with the

lower-tier ACO. Guidance on technical assistance is in Appendix B.

6-803.3 Audit Reports **

a. The lower-tier auditor will issue timely audit reports, prepared under the

general requirements of Chapter 10, to the prime auditor according to the reporting

schedule. The report will cover the acceptability of the total transferred costs, together

with specific comments on the indirect expense rates. When circumstances warrant,

the lower-tier auditor should issue a special report to advise the prime auditor on a

timely basis of newly noted matters which affect the allowability or allocability of inter-

organizational transfer costs.

Page 199 of 227

b. Comments on indirect expense rates should indicate whether or not final rates

have been established. If final indirect expense rates have not been established, the

lower-tier auditor will provide comments regarding proposed billing rates and the effect

of questioned costs on the billing rates. The lower-tier auditor will coordinate with a

prime auditor and issue a supplemental audit report needed at the prime level.

c. The lower-tier auditor will also provide comments on any transferred costs not

covered by an inter-organizational transfer work order.

d. The lower-tier auditor will explain all suspended or disapproved costs in

sufficient detail to enable the prime auditor to prepare necessary DCAA Form 1s.

6-804 Corporate, Home Office and Service Center

Audits **

The contractor's home or group office comprises the general corporate or divisional

headquarters responsible for the management of business carried out at various

segments, branches, divisions, or subsidiaries of the organization.

a. The home office is responsible for the overall administration and management of

the operations performed under its general guidance and incurs expenses that are

allocable to the operations carried out at the various segments, branches, divisions, or

subsidiaries.

b. Some home or group office services may not be of a general nature but are

performed for a particular segment or division. Under such conditions, the associated

costs may be directly charged to the segment or division. Treat these transactions as

inter-organizational transfers covered by the audit procedures outlined for inter-

organizational transactions (6-314).

6-804.1 Audit Responsibility **

a. The home office auditor is responsible for the audit of all corporate or home

office expenses distributed to the various segments of the corporation irrespective of

how such expenses may be charged to the segments.

b. There is, however, a significant corollary responsibility placed on lower-tier

auditors. They must develop sufficient information and necessary visibility to permit

effective evaluation by the home office auditor. Segment auditors, in cooperation with

the home office auditors, may identify overlapping or duplicative effort between the

home office and operating entities. Accordingly, take appropriate measures to assure

that effective coordination is accomplished among the home office auditor, the segment

auditor, and the CAD network, if applicable.

c. The audit scope will depend to a large extent on the overall value and

percentage of Government contracts the contractor is performing and the amount of

home office expenses allocated and assigned to Government contracts.

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d. The corporate auditor should resolve audit problems, such as inequitable

allocation methods or corporate policies, as soon as possible to prevent undue delays

of overhead audits at the various segments.

6-804.2 Audit Procedures **

a. Guidance in Chapters 4 and 6 are applicable to the audit of home office

expenses. In reviewing home office expense pools, pay particular attention to the

expense types which may not be applicable to the business as a whole, such as those

applicable only to a particular group of products, group of segments, or only to those

products sold through certain channels or to certain customers.

b. The corporate auditor should review accounts not included in the expense pool

for the possibility that they are applicable to Government contracts. These accounts

include other (or miscellaneous) income and expense accounts, reserves for

contingencies, surplus, and others. (6-500.)

c. The corporate auditor should review tax returns, corporate minutes, reports

filed with regulatory bodies (such as SEC filings), and financial statements for their

impact on the contractor's organization, operations, and proposed costs. (3-2S1, 3-

2S2). The results of this review should be coordinated with, and written confirmation

provided to, cognizant lower-tier auditors.

6-804.3 Cost Accounting Standards (CAS) **

Cost Accounting Standard 403 (Allocation of Home Office Expenses to

Segments) is particularly important in reviewing the allocability of home or group office

expenses. The need for assuring compliance imposes special requirements on both the

home office auditor and lower-tier auditors, and close coordination and interface

between these auditors is essential. All auditors involved in the review and analysis of

home or group office expenses will observe the specific guidance contained in 8-403.

6-804.4 Audit Reports **

a. The prime/upper-tier auditor normally should issue audit reports annually, but

also report significant findings when discovered. The narrative section of the report

should contain summary comments on unsatisfactory contractor policies and

procedures affecting contract costs at the segment level to alert those auditors to

conditions that may require special emphasis.

b. Audit reports should provide sufficient detail and information for the segment

level auditors to identify and evaluate cost allocations considering the circumstances or

specific provisions of their contracts.

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c. Reports distributed to segment or division level auditors should not divulge

"contractor confidential" information which the contractor itself does not release to the

segment or division level. A factor representing the percentage of questioned or

disapproved allocated home or group office expenses may be all that is required at the

segment or division level.

6-805 Offsite Locations (including overseas

locations) Using One Audit Approach **

The contractor may maintain books and records at locations different from the site of

physical work performance. In this instance, DCAA’s One Agency Approach can be

used. One FAO (requesting/prime office) incorporates audit procedures performed by

another FAO (assisting/offsite office) into its working papers without a traditional assist

audit. When an audit covers multiple locations within the same contractor organization,

(e.g., offsite locations) where the assist portion of the audit is material to the requesting

(prime) office’s submission or system being evaluated, the One Agency Approach is

recommended. See 4-1005.1. For purposes of this section, auditors at locations where

contractors' books and records are maintained are referred to as prime auditors and

those where the work is physically performed as offsite auditors. Both prime and offsite

auditors are responsible for maintaining timely effective communication.

6-805.1 Audit Responsibility **

a. The prime auditor retains responsibility for the audit of the primary accounting

records and approval of costs under Government contracts. The prime auditor will

coordinate the overall plan or program, including assist audit requests, with the offsite

auditor to assure proper integration of audit efforts at the respective locations. For

example, an assist labor floorcheck request may include a listing of current employees

at the offsite location, the name, title, and telephone number of the offsite contractor

representative, a listing of contractor project numbers active at the offsite location, a

cross-reference to active Government contract numbers and types, a copy of a current

payroll distribution, and DMIS contractor DUNS ID and Cage Code for the offsite auditor

to use when setting up the assignment. It is especially important that the prime auditor

notify the offsite auditor of special provisions or sensitive areas concerning contract

performance. The offsite auditor has a corollary responsibility to apprise the prime

auditor of any auditable work or additional areas of audit coverage at the offsite location

which have not otherwise been identified.

b. The offsite auditor will time-phase general areas of audit coverage at the

offsite location to coincide with the prime location's overall plan. The offsite auditor

should initiate physical observations and coordination with offsite contract administration

officials.

c. The prime and offsite auditors should discuss any unresolved problems

between them through regional or CAD channels. (6-806.)

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6-806 Differences of Opinion between DCAA

Offices **

In the exchange of information and ideas in the performance of assist audits, it is

possible that significant differences of opinion on administrative procedures or technical

accounting matters may develop. Auditors encountering such differences in performing

audit assignments will forward the information to their respective regional or CAD

offices. If the directors of the respective organizations cannot resolve the differences, or

if the differences are resolved, but the matters involved would be of interest to

Headquarters, either or both regional/CAD directors will forward promptly to

Headquarters, Attention PSP, a report containing sufficient details regarding the

differences involved including, where appropriate, the conclusions reached.

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Figure 6-8-1 - Pro Forma Assist Audit Request **

[Date]

MEMORANDUM FOR FAO MANAGER, [insert the cognizant FAO name]

Prime Contractor Assignment Number:

SUBJECT: Assist Audit Request for Prime Contractors FY ______

As discussed with Supervisory Auditor (NAME) on (DATE), we request that you

audit (Describe Scope) (Include discussion details with Supervisory Auditor (i.e. no

history of indirect questioned costs; etc.)) In order to assist you, we have included the

following documents (copies of the related work orders, purchase orders, or

subcontracts and billing documents, etc.).

Enclosed are copies of subcontract(s)/inter-organizational transfer awarded by

[contractor name] to the subcontractor under your audit cognizance. We are also

providing the [contractor name] identified point of contact for [subcontractor name],

along with its physical and electronic mailing address and phone number to assist you

in coordinating with the identified subcontractor.

Prime

Contract

Number

Contract

Type

Subcontract

Number

Period of

Performance

FY xx Costs

Recorded at

Prime

DUNS

Code

CAGE

Code

In addition, we request that you inform our office if either of the following

conditions occurs during subcontract performance:

● Incurred cost audits disclose significant questioned costs. If so, please

provide the amount applicable to the subcontract so we can prevent the prime

contractor from over billing the Government.

● The subcontractor no longer has an adequate accounting system.

Please provide an acknowledgement of this request within 5 business days to

our FAO mailbox DCAA[email protected], ATTN: Name of Supervisor.

If you have any questions pertaining to this memorandum, please contact Mr/Ms

[Insert name], Supervisory Auditor, at [insert the telephone number] at your

convenience.

John A. Smith

FAO Manager

Enclosures: a/s

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6-900 Section 9 - Notices of Cost Suspensions and Disapprovals

under Cost-Reimbursement Contracts **

6-901 Introduction **

This section states the audit guidance and procedures to be followed for effecting

suspensions and disapprovals of costs under cost reimbursement contracts and the

issuance of DCAA Form 1, Notice of Costs Suspended and/or Disapproved under Cost

Reimbursement Contracts.

6-902 General Guidance for Suspensions and

Disapprovals of Cost **

a. In general, an item of cost, either direct or indirect, which lacks adequate

explanation or documentary support for definitive audit approval or disapproval, should

be suspended until the required data are received and a determination made as to the

allowability of the item. Suspensions may also be used to:

(1) Reduce the fixed-fee when the interim amount claimed for payment is in

excess of the amount authorized by the contract.

(2) Establish the necessary withholding reserves required by the contract terms

when the contractor fails to do so.

(3) Provide for the correct amount of current reimbursements of costs in

accordance with contract billing requirements (e.g., suspend costs that are otherwise

allowable but which have not met the contract billing requirements).

b. Costs claimed by the contractor for which audit action has been completed, and

which are not considered allowable, will be disapproved. Disapproved cost may

comprise any of the following:

(1) Items specifically limited or excluded by FAR Part 31 or other terms of the

contract.

(2) Items which, although not specifically unallowable under (1) above, are

determined, in accordance with FAR Part 31, to be unreasonable in amount, contrary to

generally accepted accounting principles, or not properly allocable to the contract in

accordance with the relative benefit received or other equitable relationship.

(3) Items disapproved at the direction of the contracting officer (DFARS

242.803(b)(ii)(B)).

c. Costs which the auditor determines should be suspended or disapproved should

be discussed with the contractor to ensure that the auditor's conclusion is based upon a

proper understanding of the facts and to inform the contractor of the auditor's

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determination. If the contractor agrees that the costs in question should be suspended

or disapproved, one of the following actions will be taken:

(1) Where the costs have not yet been submitted on a reimbursement voucher,

arrangements will be made to ensure exclusion of the costs from any future

reimbursement claims. The auditor shall maintain a record of improper contract costs

which the contractor has agreed to deduct or exclude from its claims on public

vouchers.

(2) Where the costs have already been included in provisionally approved

reimbursement vouchers, the auditor may issue a DCAA Form 1, or as an alternative

the contractor may deduct the amount on the next voucher submitted. For indirect

costs, this may be accomplished by the contractor making the appropriate reduction to

the billing rates.

d. The issuance of a DCAA Form 1 should not be delayed until the auditor is

prepared to issue an audit report if the cost to be disapproved has been reimbursed

through interim billings. If an audit finding has been presented to the contractor and the

contractor does not agree with the questioned costs, the auditor may prepare and issue

a DCAA Form 1 even though the audit report will not be issued until other portions of

the audit are completed.

e. The auditor is responsible for keeping the ACO advised of issues related to

indirect costs and the PCO advised of issues related to direct costs which have the

potential for becoming the subject of a DCAA Form 1. This will permit the auditor to

ascertain whether the ACO or PCO has any additional data which would either support

or modify the audit findings. The auditor may also refer the matter to the regional office

for guidance, particularly in those cases where the ACO or PCO indicates non-

concurrence with the proposed audit action. The regional office, in turn, may consider it

desirable to consult Headquarters before reaching a decision. The consultations and

discussions held with the ACO or PCO and higher level audit personnel should be

expedited so that audit action can be completed on a timely basis. The issuance of a

DCAA Form 1 triggers the ACO and PCO's involvement in the audit determination

process (6-708).

f. If the contractor does not agree that the costs in question should be suspended or

disapproved, and the auditor has taken the action prescribed in e. above, the auditor will

issue a DCAA Form 1 (6-903) to effect suspensions and disapprovals of costs or fees

claimed for payment on contractors' reimbursement vouchers.

g. Occasionally a contractor may under bill and wait until the final indirect rates are

settled before billing the Government. Where such an under billing has occurred and

the auditor and the contractor do not agree on the allowability of the amounts contained

in the contractor's claim, the auditor should still issue a DCAA Form 1. The amount of

questioned costs with which the contractor did not agree will be shown in the

designated block on the DCAA Form 1. A statement shall be included in the Description

of Item and Reason for Action section on the DCAA Form 1 explaining that no action is

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necessary to recoup the questioned amount as the contractor has not been reimbursed

for it. The following statement is suggested and may be modified and/or expanded to

suit particular circumstances:

The purpose of the DCAA Form 1 is to initiate ACO/PCO action in rendering a

final decision on the questioned costs associated with the issue described herein with

which the contractor does not agree. At the present time, no action is required to

recoup the questioned amount as the interim billing rate used by the contractor during

FY 20XX was low enough to preclude reimbursement of the questioned costs on an

interim basis. However, should the contractor bill these costs before this issue is

resolved, the DCAA Form 1 will be attached to the request for payment for the purpose

of disapproving the costs.

h. A DCAA Form 1 should be issued even though there will be no future billings

under a contract. Auditors should reference the contract and the amount of the

disapproved dollars in the designated blocks on the DCAA Form 1. A statement shall

be included in the Description of Item and Reason for Action section on the DCAA Form

1 describing the reason for the DCAA Form 1 and a statement explaining that:

(1) ACO/PCO action is necessary to recoup the disapproved costs because there

are no future billings under the contract to which to apply the DCAA Form 1, and

(2) the ACO/PCO should issue the demand for payment as part of the final

decision, if a final decision is required (FAR 32.604 and FAR 32.605(a)).

If the ACO/PCO issues a demand for payment and the contractor does not make

payment within 30 days, the ACO/PCO may authorize DCAA to disapprove the costs

under another contract with future billings. The courts have ruled that the Government

has a common-law right to offset contract debts against payments due the contractor

under other contracts. The following statement is suggested and may be modified

and/or expanded to suit particular circumstances:

The purpose of this DCAA Form 1 is to initiate ACO/PCO action in rendering a final

decision on the disapproved costs associated with the issue described herein with

which the contractor does not agree. Currently, there are no future billings under

Contract No. [Complete applicable contract number]. The ACO, therefore, should take

immediate action to recoup the disapproved cost, i.e., issue a final decision and a

demand for payment (see FAR Subpart 32.6). If the contractor does not make payment

within 30 days following the issuance of the demand for payment, the ACO should

coordinate with DCAA when initiating procedures to recoup the disapproved amount

through an intercontractual offset.

i. A DCAA Form 1 can be issued to affect a cost suspension or disallowance on one

delivery order in order to recover an overpayment under another delivery order on the

same contract if it is funded by the same appropriation.

j. When the auditor cognizant of a home office determines that certain amounts

should be suspended or disapproved, he/she is responsible for:

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(1) discussing the costs with the appropriate home office representatives;

(2) consulting with the CACO, if appropriate;

(3) preparing computations to show the allocation of the suspended/disapproved

costs to each receiving entity; and

(4) advising the auditor cognizant of the receiving entity as to the description of

the cost element to be suspended or disapproved, the amount allocable to the entity,

and the reasons for the action.

A copy of this advisory notice should also be sent to the cognizant CACO and the

contractor's home office representative. The auditor cognizant of the entity receiving

the costs to be suspended or disapproved should prepare a regular or blanket DCAA

Form 1, as appropriate, listing all affected contracts, and showing the computations to

the contract level.

k. When the auditor cognizant of a subcontractor determines that certain

amounts should be suspended or disapproved, he/she is responsible for immediately

notifying the prime contract auditor of the suspension or disapproval (see 6-802.5g.)

l. For special administrative procedures to be followed in processing suspensions

and disapprovals related to non-DoD contracts refer to 15-103.

m. Should it be necessary, a previously issued DCAA Form 1, including those

issued at the direction of the ACO/PCO, may be rescinded by the auditor.

6-903 Types of DCAA Form 1 **

Suspensions and disapprovals affecting DoD contracts, and contracts of non-DoD

organizations where the auditor has been granted the authority (15-103), will be

accomplished by means of one of the following types of DCAA Form 1.

6-903.1 Regular **

Where the cost element to be suspended or disapproved is applicable to only

one contract, a regular DCAA Form 1 will be prepared and issued as prescribed in

6-904.

6-903.2 Blanket **

Where the cost element to be suspended or disapproved is applicable to more

than one contract, a blanket DCAA Form 1 will be prepared and issued as prescribed in

6-904. The blanket DCAA Form 1 will contain a description of the issue involved and

will list all affected contracts, showing the computation to the contract level. Although all

affected contracts are listed on the blanket DCAA Form 1, the auditor may elect to

process the DCAA Form 1 against interim billings for only those contracts containing the

major portion of the costs to be suspended or disapproved when the amounts on the

remaining contracts are relatively immaterial. Once the issue is settled, the other

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contracts should be adjusted as necessary. Final voucher evaluations should reflect

reductions for all outstanding DCAA Form 1 suspensions and disapprovals applicable to

the contract even though the Form 1 has not been previously processed against interim

billings under the contract due to materiality considerations.

6-904 DCAA Form 1 Preparation **

The auditor is the authorized representative of the contracting officer for the purpose

of issuing a DCAA Form 1. The auditor should prepare a separate DCAA Form 1 for

each major issue. This procedure facilitates tracking the status of the issue should the

contractor appeal the DCAA Form 1.

All DCAA field offices (except Field Detachment) are required to generate and

submit all new Notices of Contract Costs suspended and/or disapproved (i.e. DCAA

Form 1’s) using the automated process eTOOL. Please note that if the eTOOL system

is not available, manual versions for the Form 1 are acceptable.

a. There are four DCAA user roles at the FAO level: DCAA Auditor, DCAA Supervisor,

DCAA FAO Reviewer, and DCAA Regional Reviewer. Each user role will need

to gain access to eTOOL through EWAM.

b. Once the auditor has access they will log into eTOOL and follow the instructions

presented below:

(1) Click on the Form 1 to access the Form 1 eTOOL application.

(2) Click on My Workload.

(3) Click on Create Form 1 on the right hand side of the screen.

(4) To initially create a new Form 1, there are three required fields.

(i) Type of Form 1: There are two types of Form 1’s to choose from in the

drop down menu: DCAA form 1 and NASA Form 456.

(ii) Kind of Form 1: There are two types of Form 1’s to choose from in the

drop down menu: Regular and Blanket (see 6-903).

(iii) Category of Form 1: There are two categories of Form 1’s to choose

from in the drop down menu: Notice of Disapproved Cost or Notice

of Suspended Costs.

(5) Once these required fields are complete, click on the Create button at the bottom of

the screen. A screen will be loaded to input the details of the Form 1 you are

entering into the system. There are red asterisks identifying the required fields.

These fields include Supervisor, FAO Reviewer, DCMA ACO Name, Contract

Number, CAGE, DUNS, Contractor Name, Address, Disbursing Office Name,

Item No, and Amount of Cost Disapproved/Suspended Dollars.

6-905 Acknowledgement and Distribution of

DCAA Forms 1 **

a. The auditor should obtain the contractor's acknowledgment of receipt of the DCAA

Form 1. Where the auditor personally presents the DCAA Form 1 to the contractor,

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he/she should obtain the required acknowledgment, provide the contractor an

acknowledged copy, and retain the original in the audit file. Where the DCAA Form 1 is

mailed to the contractor, rather than personally presented, it should be sent by certified

mail, return receipt requested, and the contractor shall be advised to forward the

acknowledged original of the DCAA Form 1 to the auditor. This procedure shall be used

in any case where the contractor refuses to acknowledge receipt of the DCAA Form 1.

b. Immediately upon receipt, the auditor should attach the scanned Contractor

signed Form 1 to the record in eTOOL.

c. Also see 15-103 for distribution requirements pertaining to non-DoD agencies.

6-906 Deductions on Public Vouchers for

Suspensions and Disapprovals **

a. If it appears that the full immediate deduction of a cost suspension or disapproval

might seriously impair the contractor's ability to continue contract performance, the

auditor should consult with the contracting officer concerning the Government's possible

use of FAR 32.607 procedures regarding deferred payments of contract debts.

b. When effecting a DCAA Form 1 deduction to a cost voucher, the auditor will need

to determine the billing process used by the contractor on the impacted contract(s). The

acquisition regulations clearly establish electronic billings as the preferred method;

however auditors may encounter traditional hardcopy SF 1034/SF 1035 billings in

addition to electronic billings in iRAPT.

(1) When processing a paper based billing, insert in the differences block of the

public voucher, SF 1034, the total amount suspended and/or disapproved as shown on

the DCAA Form 1, and the net amount provisionally recommended for approval, as

follows:

DCAA Form 1

Net Amount Approved $

(2) When processing an electronic billing through iRAPT, complete the following

process:

(a) Under the auditor actions section, select the Recommend Cost

Suspension or Disallowance action box.

(i) If the contract is administered by Defense Contract Management

Agency (DCMA), a single input box titled Disallowed will be displayed. Enter the DCAA

Form 1 disallowed or suspended cost amount in the Disallowed box. If there are

multiple DCAA Forms 1 containing both suspended and disallowed costs, enter the sum

of all items in the Disallowed input box.

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(ii) If the contract is not administered by DCMA, two input boxes will be

displayed, one for the Suspended amount and one for the Disallowed amount. Enter

the appropriate amount in each individual box.

(b) Attach the DCAA Form 1 document(s) electronic billing within the

Miscellaneous Information tab.

total of all adjustments in the Approver Information comments section of the electronic

voucher within the Miscellaneous Information tab. An example comment may read:

"Suspended cost total $5,000 and Disapproved cost total

$5,000. The total reduction to voucher is $10,000. The detailed

explanation for each reduction is provided for in the attached DCAA

Form(s) 1."

(d) Electronically sign and submit voucher.

c. Ensure that the DCAA Form 1 amount is shown as an offset to cumulative billings

in the "Contract Reserves and Adjustments" section of the SF 1035 (or equivalent)

attached to the next public voucher (see DCAAM 7641.90).

d. If the amount of the deduction is more than the amount of the public voucher, the

auditor shall apply the installment method of deductions to this and subsequent public

vouchers against the contract(s) involved until the amount is fully liquidated against the

contractor's claims. Public vouchers with zero amounts must be forwarded to the

disbursing office for appropriate action.

e. Auditors may disapprove costs submitted for payment no matter what cost

elements are currently being billed. FAR 52.216-7(g), Allowable Cost and Payment,

allows adjustments to be made against current billings for any prior overpayments.

6-907 Follow-up Action on Suspensions and

Disapprovals **

a. It is expected that within a reasonable time after issuance of a suspension, the

contractor will submit the required explanations, documentation, data, or justification in

support of the suspended costs. At that time, the auditor will complete the evaluation

and determine the allowability of the items involved. Auditors will make all reasonable

efforts to obtain the additional information required for an audit determination as

promptly as possible. When such efforts are not successful, the auditor, after the lapse

of a reasonable period of time, may process a DCAA Form 1 to effect the disapproval of

the suspended item. If the contractor disagrees with this determination, it may elect to

assert a claim with the contracting officer pursuant to the "Disputes" clause of the

contract(s).

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b. If a reimbursement voucher contains a resubmission of items of cost or fee that

were previously suspended by DCAA Form 1, the contractor will show each such item

as a separate line item on its SF 1035 (or equivalent) in the current period column of the

section entitled "Contract Reserves and Adjustments" (see DCAAM 7641.90). A final

audit determination on all suspended items will be made by the auditor prior to or at the

time the completion voucher under the contract or subcontract is processed and the

contract closing statement is issued.

6-908 Contractor's Request for Reconsideration

or Claims of Disapproved Costs **

a. Following the issuance of a DCAA Form 1, the contractor may:

(1) request the cognizant ACO in writing to consider whether the unreimbursed

costs should be paid and to discuss the findings with the contractor; and/or

(2) submit to the ACO a claim for disapproved costs in accordance with FAR 33.2

(Disputes and Appeals).

Arrangements should be made for ACOs to notify the auditor promptly of any claims

they may receive. The ACO will normally make a written determination as promptly as

practicable on contractor written requests for reconsideration, but when a formal claim is

filed, the ACO should make a final decision within 60 days. If a contractor disagrees

with the ACO’s final decision regarding a claim, the contractor may appeal the decision

to the ASBCA or the Court of Federal Claims.

b. Written determinations or final decisions may sometimes involve complex issues

and significant dollar amounts. Moreover, they may have an impact far wider than the

particular transaction at issue. Generally, the ACO will seek legal counsel and advice

from others, including the auditor. In these cases, the auditor shall cooperate with the

ACO by furnishing any additional information and audit explanations necessary to

permit him or her to reach a conclusion. In the event the ACO does not sustain the

contract auditor's cost disapproval, DoD Instruction 7640.02, Policy for Follow-up on

Contract Audit Reports, requires the ACO to comply with the documentation and review

procedures prescribed by his/her DoD component prior to final disposition of the

disapproved cost (see 15-603). In this connection, DCMA procedures are stated in

DCMA Instruction 128.

c. When a claim of disapproved costs is decided, in whole or in part, in the

contractor's favor, the ACO may advise the contractor to resubmit on its next public

voucher the amount determined acceptable by the ACO. The amount of the

resubmission shall be shown as a separate item in the section on the SF 1035 heading

"Contract Reserves and Adjustments" (see DCAAM 7641.90). The ACO's decision

sustaining the contractor's claim will be retained in the audit file with the auditor's copy

of the resubmission voucher as supporting documentation.

Figure 6-9-1 – See DCAA Form 1 **

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Page 213 of 227

6-1000 Section 10 - Responsibilities for Processing and Approval of

Interim and Completion/Final Cost-Reimbursement Vouchers **

6-1001 Introduction **

This section provides information on the responsibilities for the processing and

approval of the contractor's interim and completion reimbursement vouchers. Additional

guidance on terminated cost-type contracts and processing of non-DoD reimbursement

vouchers is contained in 12-400 and 15-100, respectively.

6-1002 General **

a. Contractors submit reimbursement vouchers or invoices (herein referred to as

vouchers) to obtain interim and final payment under cost-reimbursement, time-and-

materials and labor-hour contracts and the cost-reimbursement portions of fixed price

contracts. A cost-reimbursement type contract provides for payment to the contractor of

the allowable costs incurred in performing the work or services prescribed in the

contract. This type of contract specifies an estimate of total cost for the purposes of:

(1) obligating funds, and

(2) establishing a cost ceiling, which the contractor may not exceed except at its

own risk without the approval of the contracting officer.

b. The contract may also provide for the payment to the contractor of a fixed fee, or

a target fee subject to subsequent incentive adjustment dependent upon prescribed

contract performance or cost factors. Conversely, a cost-sharing contract may limit

reimbursement to the contractor to an agreed portion of the total allowable costs, and

provide for the remaining portion to be absorbed by the contractor in consideration of

expected compensating benefits. A time-and-materials contract provides for acquiring

supplies or services on the basis of:

(1) direct labor hours at specified fixed hourly rates that include wages, indirect

expenses, and profit; and

(2) materials at cost, including material handling and/or general and

administrative (G&A) costs, if appropriate.

A labor-hour contract is a variant of the time-and-materials contract, differing in that

the contractor does not supply materials. The various types of contracts described

above are hereafter referred to as cost-reimbursement type contracts for purposes of

this section and are more fully explained in FAR Subparts 16.3, 16.4, and 16.6, and

applicable FAR supplements.

c. A fixed price contract obligates the contractor to complete physical

performance of the contract at the stipulated price(s). The failure to complete

performance subjects the contractor to possible Government termination for default.

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Under a cost-reimbursement type contract, although the contractor is expected to use

its best efforts to complete performance, the contractor is not obligated to continue

performance under the contract if it involves the incurrence of costs in excess of the

estimated total cost stated in the contract.

6-1003 Responsibility for Recommendation of

Approval of Interim Public Vouchers **

a. The authority and responsibility for recommendation for approval of interim public

vouchers under cost-reimbursement type contracts are set forth in Department of

Defense Directive No. 5105.36, subject: Defense Contract Audit Agency (see 1-1S1) as

implemented in FAR 42.803(b), DFARS 242.803(b) and other applicable supplements.

b. Under cost-reimbursement contracts, the cost-reimbursement portion of fixed

price contracts, letter contracts that provide for reimbursement of costs, time-materials

contracts, and labor-hour contracts, the contract auditor is the authorized representative

of the contracting officer to:

(1) receive reimbursement vouchers, interim rate adjustment vouchers, and final

rate adjustment vouchers directly from contractors,

(2) recommend approval for payment of vouchers found acceptable,

(3) reject vouchers found not acceptable for payment, and

(4) suspend payment of questionable costs (see 6-905).

When required (i.e., paper vouchers), the auditor will assure the vouchers that are

found acceptable for payment are forwarded to the cognizant disbursing officer for

payment.

c. If the evaluation of a voucher raises a question regarding the allowability of a cost

under the contract terms, the auditor, after informal discussion with the contractor and

the Contracting Officer, will issue a DCAA Form 1, "Notice of Contract Costs Suspended

and/or Disapproved". Guidance on the preparation and submission of DCAA Form 1 is

contained in 6-900. The Form 1 will be submitted simultaneously to the contractor and

the disbursing officer, with a copy to the cognizant contracting officer, for deduction from

current payments with respect to costs claimed but not considered reimbursable. If the

contractor disagrees with the deduction, it may (1) submit a written request to the

cognizant contracting officer to consider whether the unreimbursed costs should be

paid, (2) file a claim under the Disputes clause, or (3) do both. The contracting officer

may issue or direct the auditor to issue a Form 1 for any cost that he or she believes

should be suspended or disapproved.

d. The auditor will approve separate fee vouchers and fee portions of vouchers for

provisional payment in accordance with the contract schedule and any instructions from

the administrative contracting officer (ACO).

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e. Completion vouchers will be forwarded to the ACO for approval as prescribed in

6-1007.1b.

f. The purpose of the approval of interim public vouchers (i.e., pre-payment

assessment) is to determine if the voucher was prepared in accordance with contract

terms and provisions and to pursue adjustments as needed for any

overbillings/overpayments. Guidance pertaining to the pre-payment assessment is

provided in 6-1005.

6-1004 Contractor Preparation and Submission

of Claims for Reimbursement **

a. The requirements for preparing cost reimbursement vouchers are included in

each cost-reimbursement, T&M/LH contract, by the clause(s) FAR 52.216-7, Allowable

Cost and Payment and/or FAR 52.232-7. For commercial T&M/LH contracts, FAR

52.212-4, Alternate I should be included in the contract. The acceptability of costs billed

under a commercial TM/LH contract is determined based on the terms and conditions of

the contract and is not subject to the provisions in FAR Part 31.2 or Cost Accounting

Standards (CAS).

b. Under DFARS 242.803, for commercial Time and Material/Labor Hour (T&M/LH)

and cost reimbursement contracts, DCAA has the sole authority for verifying claimed

costs and approving interim requests. The Contractor should claim costs for those

items that are within the requirements of the contract. In order to facilitate the review of

contract requirements, a contract brief should be completed to ensure claimed costs are

in compliance with contract terms.

c. If the contract is a T&M contract, the clause at FAR 52.216-7 applies in

conjunction with the clause at FAR 52.232-7, but only to the portion of the contract that

provides for reimbursement of materials (as defined in the clause at FAR 52.232-7) at

actual cost. Further, the clause at FAR 52.216-7 does not apply to labor-hour contracts.

d. Cost-reimbursement and commercial T&M/LH contracts provide that the

contractor may submit periodic claims for reimbursement of costs and fee on

Government public voucher forms SF 1034 and SF 1035 or their equivalent. Detailed

information concerning the preparation, submission and processing of these forms is

presented in DCAAP 7641.90 (Audit Process Overview – Information for Contractors).

This pamphlet is available on the DCAA’s public web site.

e. Audit offices receiving requests from contractors for public voucher forms will

advise contractors that they may be obtained from the appropriate ACO or via online

from the General Services Administration Forms Library.

f. DFARS 252.232-7003(a) requires the use of Wide Area Workflow (WAWF) for

contract payment requests and processing. All Department of Defense vouchers should

be submitted through WAWF unless they meet the exceptions described in DFARS

232-7002(a).

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g. Contractors' interim reimbursement claims will be selected for assessment using

sampling methodologies for provisional payment and sent to the disbursing office after a

pre-payment review. Interim vouchers not selected for pre-payment assessment will be

sent directly to the disbursing office. These interim payments are provisional in nature

and are subject to retroactive adjustment upon the determination of the allowability of

costs claimed. The allowable cost and payment clause at FAR 52.216-7 contained in

each cost-reimbursement type contract states in part: "At any time or times before final

payment, the Contracting Officer may have the Contractor's invoices or vouchers and

statements of cost audited. Any payment may be:

(1) reduced by amounts found by the Contracting Officer not to constitute

allowable costs or

(2) adjusted for prior overpayments or underpayments."

A similar clause is contained in T&M/LH (FAR 52.232-7). For DoD commercial

T&M/LH contracts, FAR 52.212-4, Alternate I contains an access to records clause

requiring access to contractor support for the amounts billed to ensure compliance with

contract terms.

h. Upon completion of the contract, the contractor is required to submit a voucher

designated as "completion voucher" together with such other documents as are

prescribed by the contract. Approval and payment by the Government of the

contractor's completion vouchers constitutes complete and final payment to the

contractor, except for any items reserved by qualification of the contractor's Release of

Claims. Detailed instructions relative to submission and processing of these documents

are included in DCAAP 7641.90 and 6-1007.

6-1005 Selection, Assessment, and

Recommendation for Approval of Interim

Public Vouchers (Pre-payment Assessment)

a. Contractors will submit vouchers for payment either in paper format or

electronically through WAWF. Contractors are generally dependent upon prompt

receipt of interim payments under cost-reimbursement type contracts to maintain a

satisfactory financial position. Therefore, as an objective, selected interim vouchers will

be assessed and either:

(1) recommended for approval for payment and forwarded to the disbursing

officer or

(2) returned to the contractor for correction as quickly as possible, but no later

than five working days after receipt. The auditor’s review of the interim public voucher

does not constitute an audit. Rather, it is an assessment of the voucher to verify that

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the amounts claimed are not in excess of which is properly due the contractor in

accordance with the terms of the contract prior to approval of provisional payment.

Payments on interim public vouchers under cost-reimbursement service contracts are

subject to the interest payment provisions as implemented in the Office of Management

and Budget’s regulations (5 CFR Part 1315), if they are paid more than 30 days after

receipt of a proper invoice. Therefore, FAOs should process and send the

recommendation for the approval of interim vouchers to disbursing offices for payments

as soon as possible. FAOs must also annotate (date-stamp) all paper vouchers with

the date the interim vouchers were received by the FAO. The Government disbursing

office will use the FAO annotation date, if necessary, to determine the start of the 30-

day period used to compute the interest penalty. FAOs should expedite reviews of

interim vouchers to assist Government disbursing offices in minimizing the necessity of

paying the interest penalty on interim vouchers submitted under cost-reimbursement

service contracts.

b. In accordance with DFARS 242.803(b), sampling methodologies are used to

select specific vouchers for review. WAWF will route vouchers to the auditor for review

and recommendation for approval on an automated risk-based voucher selection

process. WAWF is designed to route to the auditor, high risk vouchers and a sample of

all remaining vouchers. High risk vouchers routed to DCAA will include all first vouchers

for contract/delivery order/task order. The remaining vouchers will be routed to DCAA

using sampling methodologies and adjusted based on a data analytics approach.

Special procedures for processing cost-reimbursement vouchers for non-DoD agencies

are contained in 15-103.

The Cost Voucher Administrator (CVA) (i.e., the existing Group Administrators

(GAM) has the authority to change the dollar parameter and percent parameter for a

particular CAGE code or contract/delivery order/task order at the request of the

cognizant FAO if the specific contractor risk does not support the Agency level default

parameters. The FAO request for parameter change must be approved by the

cognizant FAO manager and Regional or Corporate Audit Director and should be

submitted to the CVA. If parameters of a contractor or contract/delivery order/task order

under the cognizance of more than one FAO need to be changed, the CVA and FAOs

must coordinate with all impacted FAOs.

c. All vouchers selected based on sampling methodologies should be routed to the

contract auditor for recommendation for approval. At a minimum, FAOs should perform

the assessment steps below on each voucher routed to the approver. The reviewer will

use the Public Voucher Assessment Tool to document the completion of these steps

and the final decision to accept or reject the voucher.

d. Interim public vouchers, not submitted electronically, shall be recommended for

provisional approval by authorized auditors by signing the voucher in the space

provided. As illustrated in DCAAP 7641.90, the signature, printed name, mailing

address, and telephone number of the approving auditor should be typed on the

voucher by the contractor. For applicable signature authorization policy, see DCAAI

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5600.1. For vouchers submitted through WAWF, the Cost Voucher Approvers will

recommend provisional approval of the voucher by electronically signing the document.

e. After DCAA recommends provisional approval, interim public vouchers shall be

forwarded to the disbursing officer for payment and subsequent distribution, as

annotated on the vouchers. In WAWF, vouchers are electronically routed to the

disbursing office after DCAA recommends provisional approval. Amounts that are

recommended for provisional approval on public vouchers are subject to the audit of the

contractor's records prior to the final settlement under the contract.

f. In the event the contractor's public voucher contains an error, it should be returned

to the contractor with a written explanation regarding the error(s) that was found. In

WAWF, a voucher is returned to the contractor by (i) selecting “Reject to Initiator” in the

approval section of the voucher and (ii) typing the reason for the rejection in the

“Comment” field on the “Misc. Info” tab. The reasoning in the Public Voucher

Assessment Tool (step 15) for rejecting the voucher should be what is included in the

comment field. The auditor can also use the DCAA Form 1 (see 6-905) to correct

errors in public vouchers which involve downward adjustments with which the contractor

is in disagreement.

g. By arrangements made with disbursing officers, public vouchers to be returned to

contractors for correction will be transmitted to the contractor via the cognizant auditor.

Returned public vouchers should be reviewed to determine the reason for rejection to

assure that any systemic problems are corrected or if not corrected are used to adjust

control risk and substantive testing.

6-1006 Processing Completion/Final Vouchers **

This section provides guidance on the final voucher process for completed or

terminated cost-reimbursement type contracts and subcontracts (see 6-706.1 for

additional comments on final rates). The auditor should also review the guidance on

assist audits for other contract auditors in 6-802 regarding completion/final vouchers on

subcontracts.

6-1006.1 Receipt-Completion/Final Vouchers **

a. The final voucher is routed directly to the Cognizant Federal Agency Official

(CFAO), usually the Administrative Contracting Officer (ACO), for approval via the

WAWF. DFARS 242.803(b)(ii)(A) provides that the administrative contracting officer

approves all completion/final vouchers and sends them to the disbursing officer. DCAA

has view only access to the final voucher and no action can be taken.

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b. FAR 52.216-7(d)(5) and FAR 42.705(b) specifies that the contractor must

submit a completion voucher within 120 days (or longer period if approved in writing by

the Contracting Officer) after settlement of the final annual indirect cost rates for all

years of the physically complete contract/order. The completion/final voucher is the last

voucher submitted on a contract or task/delivery order and represents the total claim

against the Government. A separate completion/final voucher will be submitted for each

individual project or task/delivery order for which a separate series of public (interim)

vouchers has been submitted. Additionally, FAR 52.216-7(d)(6)(i) and 42.705(c) states

if the contractor fails to submit a completion voucher within the time specified, the

contracting officer may determine the amounts due to the contractor under contract and

record this determination in a unilateral modification to the contract.

c. For terminated contracts, the contractor will submit the completion voucher to

the termination contracting officer (TCO) rather than to the ACO.

6-1006.2 Timeliness of CFAO Review and Approval-Completion/Final

Vouchers **

a. The time period for the CFAO to close a contract is based upon both the type

of contract and the date of physical completion. As indicated in FAR 4.804-1(a)(3) and

applicable supplements, the CFAO has 36 months from date of physical completion to

close out cost reimbursable contracts requiring settlement of indirect rates. Prior to

administrative closeout of the contract, the CFAO must verify that all identified

administrative closeout procedures as detailed in FAR 4.804-5 have been completed

within the FAR specified time standard. This includes the final voucher approval

process. If the contract is not closed within the time standard, then it is considered

overage.

b. FAR 52.216-7, Allowable Cost and Payment clause was updated, effective

June 30, 2011, to enhance the contract closeout process (FAR 52.216-7(d)(2)(v)). In

addition to adding a description of the contents required for an adequate final indirect

cost rate proposal (Schedules A through O), the clause added language requiring the

contractor to update billings on all contracts to reflect the final settled rates and update

the schedule of cumulative direct and indirect costs claimed and billed within 60 days

after rate settlement.

(1) Per FAR 52.216-7(d)(2)(v) contracts awarded after June 30, 2011*

required contractors to update schedule I within 60 days of settlement of the final annual

indirect cost rates.

(2) For contracts awarded prior June 30, 2011 contractors are not required to

update the schedule I.

c. Consideration should be given to those circumstances under which it is

permissible to close out a physically completed contract. Even though the indirect cost

rates may not have been negotiated or settled by audit determination for the period

covering the final stage of contract performance, the contract may be closed using the

quick-closeout procedures described in 6-1010.

Page 220 of 227

d. In those cases where final assist audit reports on interplant billings or cost

reimbursable type subcontracts have not been issued, the auditor should contact the

assist auditor stressing the urgency of final audit action. The auditor should also

coordinate with the CFAO regarding the status of the assist audits.

6-1006.3 Additional DCAA Final Voucher Support **

Usually, the CFAO should have sufficient data to approve final vouchers to close

contracts without requiring further assistance from DCAA. The CFAO can generate or

update existing cumulative allowable cost worksheet (CACWS) using data from incurred

cost audit reports, low risk memos, Schedules H, K & J (if applicable), I and O of the

certified incurred cost proposals, settled direct and indirect costs, and rate agreement

letters. For contracts awarded after June 30, 2011, the CFAO should obtain the

contractor’s updated Cumulative Direct and Indirect Costs Claimed and Billed (Schedule

I) to reflect settled rates and cumulative costs required per the FAR allowable cost and

payment clause. This schedule is used in lieu of a CACWS to assist in closing out

contracts once the accuracy of the data is verified by the CFAO. For older contracts

that do not have the revised allowable cost and payment clause, the CFAO should

determine whether:

(1) applicable data is available to assist in their review and approval of the

final voucher (e.g. prior year CACWS, incurred cost audit reports or rate agreement

letters for contract period of performance, detailed Schedule H and I from the incurred

cost proposal, etc.),

(2) an inaccurate final voucher should be rejected and returned to the

contractor for correction, or

(3) additional DCAA assistance is needed.

The types of additional DCAA final voucher support are as follows:

a. If DCAA work products are not in CFAO files –Upon receipt of specific CFAO

request for specific information previously provided, the field audit office should resend

the requested data to CFAO that could not be located in the CFAO files (e.g. copies of

incurred cost audit reports, low risk memos, signed rate agreement letters for the fiscal

years of the contract, certified final incurred cost proposals, or prior year CACWS).

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b. Final Voucher Other Than Audit Services –Upon receipt of specific CFAO

request when the contractor does not have a CACWS and there are complexities that

exist (e.g., the contractor has had multiple reorganizations, or there are complex rate

structures), the auditor may perform an advisory service under activity code 15400. The

service will consolidate the direct and indirect costs (based upon previous audit results

and/or contracting officer negotiations) on the contract/task order for the CFAO to use in

closing out the contract/task order. No additional examination is being performed.

Note: If the contract was awarded after June 30, 2011, the CFAO should obtain the

updated cumulative costs and billings by contract/subcontract from the contractor as

required by the revised allowable cost and payment clause instead of requesting this

advisory service.

c. Final Voucher Services – Upon receipt of specific CFAO request in cases

where there are identified risks or concerns on specific contracts (e.g. direct costs, or

level of effort hours) not previously examined, in other audits, the auditor can perform

effort under activity code 17900 at time of final voucher. However, if the reason the

CFAO is asking for support is because DCAA issued a disclaimer of opinion, the CFAO

should contact DCAA to discuss the circumstances that led to the disclaimer to

determine whether the conditions still exist, (i.e., can an examination or agreed upon-

procedures now be done?).

6-1006.4 Supplemental Requirements for Maryland Procurement Office

Contract Closeouts **

The Maryland Procurement Office (MPO) has engaged the services of a private

firm, Chenega Applied Solutions, Inc., Anchorage, AK, to affect the closeout and

physical retirement of MPO contracts. Responses to inquiries from this private firm for

contractor information needed to support MPO’s closeout effort must be submitted in

writing to MPO by e-mail at contract_cl[email protected]. MPO will make the

determination of what material can be released outside of the Government. In order to

minimize the risk of disclosure of contractor proprietary data to anyone outside of MPO,

no potentially privileged information will be furnished orally. This prohibition includes

information such as settled rates, which may appear to be in the public domain.

6-1007 Quick-Closeout Procedures **

a. The final fiscal year of the period of performance under a contract is generally less

than a full fiscal year. The direct and indirect costs incurred on an individual contract,

task order, or delivery order in the last fiscal year of its performance may be relatively

small in amount, particularly if the contract, task order, or delivery order is physically

completed early in the year. In such cases it is generally mutually advantageous to the

Government and the contractor to close such contracts, task orders, or delivery orders

as soon as possible without waiting until after the end of the fiscal year and the

subsequent final determination or negotiation of the indirect expense rates for the entire

period.

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b. FAR 42.708 provides quick-closeout procedures which allow the contracting

officer to negotiate a settlement of direct and indirect costs for a specific contract, task

order, or delivery order, to be closed in advance of the determination of final direct and

indirect costs under specified circumstances. The provision for quick-closeout

procedures can be applied not only to the final fiscal year of a contract, task order, or

delivery order but also to all other open fiscal years with unsettled direct and indirect

costs if the criteria contained in FAR 42.708 are met.

c. To enhance the contract closeout process, FAR 42.708 was revised effective

June 30, 2011. DFARS Class Deviation2019-O0009 dated May 2, 2019, subsequently

increased the threshold for use of Quick Closeout Procedures. The revised procedures

require that the contracting officer negotiate the settlement of direct and indirect costs

for a specific contract, task order, or delivery order to be closed, in advance of the

determination of the final direct and indirect costs if the criteria in FAR 42.708 are met.

The FAR 42.708 criteria for applying quick-closeout procedures are:

(1) the contract, task order, or delivery order is physically complete;

(2) the total unsettled direct and indirect cost allocable to that contract, task

order, or delivery order is relatively insignificant. The cost is considered relatively

insignificant when the total unsettled direct and indirect cost to be allocated to any one

contract, task order, or delivery order does not exceed $2 million (see Class Deviation

2019-O0009 Quick Closeout Procedure Threshold dated May 3, 2019).

(3) The contracting officer performs a risk assessment and determines that the

use of the quick-closeout procedures is appropriate. The risk assessment should

include:

• consideration of the contractor’s accounting, estimating, and purchasing

systems;

• other concerns of the cognizant contract auditors; and

• any other pertinent information, such as documented history of Federal

Government approved indirect cost rate agreements, changes to

contractor’s rate structure, volatility of rate fluctuations during affected

periods, mergers or acquisitions, special contract provisions limiting

contractor’s recovery of otherwise allowable indirect costs under cost

reimbursement or time and material contracts; and

(4) Agreement can be reached on a reasonable estimate of allocable dollars.

DCMA is further authorized to deviate from FAR 42.708(a)(2) and negotiate

settlement of direct and indirect costs for a specific contract, task order, or delivery

order to be closed in advance of the determination of final direct costs and indirect rates

regardless of the dollar value of percent of unsettled direct or indirect costs allocable to

the contract (see Class Deviation 2019-O0009 Quick Closeout Procedure Threshold

dated May 3, 2019).

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d. Effective February 1998, FAR 42.703-1(c) was revised to make it clear that quick-

closeout procedures could be used to establish the final price of fixed-price incentive,

fixed-price redeterminable, and like contracts and awards that:

• require the settlement of indirect costs before final contract prices are

established; and

• meet the criteria in FAR 42.708 for use of quick-closeout procedures.

e. Although a written request for an evaluation is not required when the contracting

officer exercises quick-closeout procedures, the auditor should provide comments

regarding any contract, task order, or delivery order being considered for quick-closeout

if the auditor has specific concerns related to the criteria in c. above (e.g. the 10 percent

ceiling is being approached). The rates recommended should be representative of

conditions during the final fiscal year of contract, task order, or delivery order

performance. Some alternative rate sources are:

(1) the final indirect cost rates agreed upon for the immediately preceding fiscal

year;

(2) the provisional billing rates for the current fiscal year; or

(3) estimated rates for the final fiscal year of contract, task order, or delivery

order performance based on the contractor's actual data adjusted for any historical

disallowances found in prior years’ certified final incurred cost proposals.

f. Because of the small amount of contract costs involved, the use of the quick-

closeout procedures should result in only an insignificant difference in the amount of

direct and indirect costs applied to the contract, task order, or delivery order for the

closeout period as compared with the amount which would be applied if the contract,

task order, or delivery order was closed after the final indirect cost rates were

established. In addition, the chargeback of gains or losses to other contracts is not in

compliance with generally accepted accounting principles. Consequently, except for

terminated contracts discussed in 12-407, no adjustment to compensate for any such

difference should be made in computing the periodic indirect cost rates to be applied to

other contracts performed during the period.

g. For additional information on contract closeout and quick closeout, see also the

Department of Defense Contract Closeout Guidebook.

6-1008 Distribution of Public Vouchers **

After provisional approval, interim public vouchers shall be forwarded to the

disbursing officer for payment and subsequent distribution, as annotated on the

vouchers. In WAWF, the interim voucher is electronically routed to the disbursing office

after provisional approval by the supervisory auditor.

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6-10S1 Supplement - Billing System Examination Considerations for

Contract Types **

1. General Considerations

a. Government contracts may arise from negotiation or from formal

advertising. Contracts resulting from formal advertising must be either firm-fixed-price

(FFP) or fixed-price contracts with economic adjustment and interim payments to the

contractor, if any, are not based on cost. Audits of contractor billing systems ordinarily

do not address policies and procedures for billings on commercial and formally

advertised Government contracts.

b. Negotiated contracts are grouped into two broad categories: fixed price

contracts and cost reimbursement contracts. Fixed price contracts may be firm-fixed-

price, fixed-price with economic adjustment or fixed price with incentive provisions.

Fixed price contracts may be eligible for progress payments, which are invoiced on SF

1443, "Contractor's Request for Progress Payment”. Progress payments under fixed

price contracts are limited to a predetermined percentage (the "progress payment

percentage" specified in the progress payment clause) of the total contract price and do

not include profit. Firm-fixed-price level of effort (FFP/LOE) contracts are classified as

fixed price, but the data submitted on billings under such contracts closely resembles

that submitted on time-and-materials (T&M) contracts in that profit is included in the

direct labor billing rates.

c. Cost-type contracts include cost sharing, cost reimbursement and cost plus

fixed fee, award fee or incentive fee contracts. Interim payment requests under cost-

type contracts are submitted on SF 1034, "Public Voucher for Purchases and Services

Other Than Personal" and SF 1035, the continuation sheet. Fee may be billed with cost

or may be separately vouchered according to the contract terms, and includes a

percentage of the fee up to a predetermined limit. T&M and labor hour contracts are

also invoiced on SF 1034 and SF 1035, but profit is included in the price of a labor hour.

Contract types are discussed in detail in FAR Part 16. Standard forms are illustrated in

FAR Part 53. For contractors utilizing Wide Area Workflow for the submission of interim

payment requests on cost-type, T&M and labor hour contracts, the “Cost Voucher” is

the equivalent of the SF 1034. Data equivalent to the SF 1035 must be included in a

separate electronic file and attached to the cost voucher in WAWF.

2. Special Considerations - Fixed Price Contracts

a. It is important to review the contract clauses affecting the contractor's right

to receive interim payments based on cost. A fixed price contract may require first

article approval (FAR 52.209-3 or FAR 52.209-4) before the contract is eligible for

progress payments. Progress payments must be liquidated against deliveries or other

billable milestones under the contract before any amounts other than progress

payments may be paid (FAR 52.232-16(b)). The progress payment and liquidation

rates are specified on the SF 1443 in items 6a and 6b respectively.

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b. The following example will illustrate the computation of allowable interim

payments under a fixed price contract which is not in an overrun status. Assume that

the contract requires the delivery of 5 widgets over a two-year period at a unit price of

$10,000; a total contract value of $50,000 (5 x $10,000); that the liquidation rate is 80%

and the progress payment rate is 80%. The contractor invoices the widgets as they are

delivered. There is no standard form for invoicing deliveries. If at the time the first

article is delivered the contractor has incurred $12,000 of eligible progress payment

costs and invoiced them on SF 1443s, it will have received $9,600 (80% x $12,000) of

unliquidated progress payments. The Government liquidates $8,000 (80% x $10,000)

of this against the first article, leaving an unliquidated balance of $1,600. The contractor

will bill the Government and receive a payment of $2,000 ($10,000 - $8,000).

c. The contractor is required to report an estimate to complete on SF 1443,

item 12b. The instructions to SF 1443 require that this estimate shall be made not less

frequently than every six months. FAR 32.503-6(g) requires that if the estimated costs

are likely to exceed the contract price, the contracting officer shall calculate a loss ratio

factor and adjust future progress payments to exclude the element of loss. Audit steps

for evaluation of the contractor's estimate to complete and a matrix for computation of

the loss ratio factor appear in the standard audit program for progress payment audits.

d. In addition to verifying that billed costs include only amounts properly

recorded and, where required, paid in accordance with an approved cost accounting

system, a billing system survey at a location having significant progress payment

billings must include a review of the policies, procedures and controls for:

(1) Identifying requisite billing data (progress payment and liquidation

percentages, first article approval, billing frequency, etc.).

(2) Assuring compliance with contractual billing conditions.

(3) Preparing and updating estimates to complete.

(4) Timely computation of loss ratio and progress payment reduction when

appropriate.

3. Special Considerations - Flexible Fixed Price and Fixed Price-Level of Effort

Contracts

As with FFP contracts, progress payments under fixed price incentive (FPI)

contracts are made in accordance with FAR 52.232-16. From an interim billing

standpoint, FPI contracts differ from FFP only in the profit computation. Additionally, the

FPI contract billings and financing payments are monitored on a quarterly basis with the

“Quarterly Limitation on Payment Statement” which may be subject to a DCAA audit or

advisory service depending on risk and customer requirements. In an FFP/LOE

contract, the deliverable product is the labor hour. Accordingly, such contracts rarely

provide for progress payments based on cost. In reviewing billing systems at contractor

locations having a significant volume of FFP/LOE work, treat these contracts as if they

were T&M.

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4. Special Considerations - Cost-type Contracts

a. Because the Government assumes a higher percentage of risk under cost

reimbursement type contracts and because such contracts may contain any number of

special provisions affecting billings (ceiling rates, unallowable or unallocable cost

elements, key personnel, fee billing and retention, etc.), the accounting and billing

system requirements for such contracts are more stringent than for FFP and FPI

contracts. Cost-type contracts permit inclusion in the periodic billing of all allowable and

allocable paid costs and certain recorded but unpaid costs which do not exceed the

contract ceiling or funding limitation, reduced by the contractor's percentage in the case

of a cost-sharing contract; and such costs are provisionally reimbursed in full, subject to

subsequent audit. Fee billings may be vouchered with cost or separately, depending on

the contract terms which frequently provide for a fee retention pending contract

completion and closeout.

b. In addition to verifying that billed costs include only amounts properly

recorded and, where required, paid in accordance with an approved cost accounting

system, a billing system survey at a location having significant cost-reimbursable work

must include a review of the policies, procedures and controls for:

(1) Identifying requisite billing data (type of fee, billing procedures,

including required supplemental data, frequency etc.).

(2) Assuring that appropriate controls for briefing contracts and adhering

to contract provisions and contract ceilings are in place and functional.

(3) Monitoring progress under the contract to provide the data required by

FAR 52.232-20b (the Limitation of Cost clause).

(4) Promptly adjusting indirect billing rates for revised budgetary data.

(5) Where applicable, promptly adjusting prior billings to reflect final rates

and direct cost disallowances.

(6) Including DCAA Form 1 suspensions on subsequent vouchers as an

offset to cumulative billed cost.

5. Special Considerations - T&M and Labor Hours Contracts

a. T&M and labor hours contract costs are vouchered on an SF 1034 (“Cost

Voucher” in WAWF) and SF 1035 (or equivalent data submitted in WAWF). They are a

mixed contract type, since labor is billed at price and other direct costs (ODCs) are

billed at cost. T&M and labor hour contracts provide for billing direct labor hours at

predetermined category rates which include all applicable burden and profit, and bill

ODCs (and direct materials on T&M contracts) at cost plus applicable burden. These

contracts permit billings up to a stated percentage of the contract value, and may or

may not require that each invoice be adjusted to the limitation percentage.

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b. T&M and labor hour contracts contain an inherent risk so high that they

may be used only after the contracting officer executes a determination that no other

contract type is suitable. Nevertheless, at many locations this least favored contract

type constitutes a substantial percentage of the workload. A billing system audit is not

the best place to identify and correct control weaknesses which arise under this contract

type. Refer to 6-204.

c. It is quite common for the contract to specify labor categories which do not

coincide with the contractor's established labor classifications. Ideally, the contract itself

will specify the required skills and experience for each billable labor category. When

this is not the case, the contractor's proposed classifications determine the propriety of

employee classifications to contract categories by operation of the Order of Precedence

clause (FAR 52.215-8). The contractor's labor distribution system should input incurred

labor hours by contract category to the billing system, and the controls preventing

misclassification of employees should be reviewed as a part of the labor controls. If

these controls do not exist, or have not been evaluated, they must be evaluated as a

part of the billing system audit.

d. In addition to review of the controls affecting cost-reimbursable billings,

review of a billing system which processes a significant volume of T&M, labor hour, or

FFP/LOE contracts must verify that controls are in place which assure: that billings

include only actual labor hours per the labor distribution; that each billed hour is

assigned to its proper category; and that categories are billed at the correct contractual

rate.