November 28, 2017

2018 NDAA Analysis: New Mandate to Use Private Accounting Firms to Audit Incurred Cost Submissions

Holland & Knight Government Contracts Blog
Terry L. Elling

This is the fourth blog post in a series of blogs analyzing the current draft of the 2018 National Defense Authorization Act (NDAA) as agreed-to by House and Senate negotiators on November 8, 2017. Stay tuned for additional blog posts covering additional topics in the near future from Holland & Knight’s Government Contracts Team.

The conference version of the 2018 NDAA (H.R. 2810) contains a potentially significant change in the Department of Defense’s approach to audit of Government Contractors’ Incurred Cost Submissions and Final Indirect Rate Proposals. If passed, the Section 803 of the NDAA would amend 10 U.S.C. Chapter 137 to include a new Section 2313a, “Performance of Incurred Cost Audits.”

Government contractors that hold flexibly-priced contracts are required to submit a detailed statement of their incurred direct and indirect costs, and proposed final indirect rates within six months of the end of each fiscal year. These submissions, which must be certified, are then audited by the Defense Contract Audit Agency (DCAA). Any costs questioned by DCAA are then negotiated between the cognizant Contracting Officer and the Contractor. If a negotiated resolution cannot be achieved, the Contracting Officer issues a Final Decision which the Contractor may challenge in either the U.S. Court of Federal Claims or a Board of Contract Appeals. Unfortunately, due to years building a backlog, DCAA often does not initiate these audits until several years after they are submitted. DCAA also has the ability to postpone the audit if the auditor deems the submission not to meet the regulatory criteria for an “acceptable” incurred cost submission. This often results in protracted delays of many years before DCAA completes its audit, and further delay in the resolution of the Contractor’s allowable costs and final rates in the event the audit report questions material amounts of direct or indirect costs. Accordingly, it can take many years for the Contractor to submit its final invoices under the affected contracts, which can result in either a payment to the concerned Government agencies (in the event the Contractor’s final direct costs and indirect cost rates turn out to be less than the rates the Government agreed to during the course of contract performance) or final payments to the Contractor (in the event its final direct costs and indirect cost rates turn out to be greater than those invoiced during contract performance).

In an effort to deal with the long-existing backlog of audits, the conference version of the NDAA directs DoD, and DCAA in particular, to implement a program to engage qualified private accounting firms to conduct audits of Contractor incurred cost submissions. The purpose is to eliminate the current backlog by October 1, 2020. The NDAA also includes specific timelines for DoD to establish criteria for audits to be performed by qualified private auditors, a requirement that DCAA itself receive an unqualified peer review audit before it issues any incurred cost submission audits, and a provision re-affirming Contracting Officers’ authority to resolve disputes relating to questioned costs.

Some of the more significant provisions in Section 803 are summarized below. It is important to keep in mind that these changes are not yet effective; the conference version of the NDAA has not yet been enacted into law, and, even after passage, DoD and DCAA will have to take the actions required under the NDAA in a timely fashion, and regulations may have to be drafted to implement the provision.

Requirements to Eliminate Audit Backlog Through Selection and Ongoing Use of Qualified Private Auditors

  •  If enacted, Section 2313a(a) will, among other things require DoD and DCAA to eliminate the present incurred cost audit backlog by October 1, 2020 and to ensure that all audits are completed within one year of a “qualified incurred cost submission.” A qualified submission is one that comports with DoD’s requirements for a complete submission (presumably, consistent with the current FAR 52.216-7 requirement for a complete submission).
  • The NDAA will also require DCAA to notify a Contractor within 60 days of receipt of an incurred cost submission in the event the submission does not meet the criteria for a “qualified” submission. The NDAA also mandates that in the event an audit is not completed within one year of receipt of a qualified submission, the audit shall be deemed to be complete and no further audit work may be conducted. This should be a welcome change for Contractors who presently may not be informed for many months (or years) that DCAA does not deem their submission to be adequate for audit purposes.
  • The NDAA also sets standards for “qualified private auditors,” and requires that they be free of conflicts of interests and subject to strict nondisclosure requirements with respect to the financial and other contractor data they will have access to (and subjects private auditors to criminal sanctions in the event of an unauthorized disclosure).
  • The conference NDAA then requires that DoD ensure the ongoing, appropriate, mix of DCAA and qualified private auditors in order to ensure the elimination of any backlog going forward.

Timeline for Selection of Qualified Private Auditors

  • If passed, the NDAA will require DoD to submit a plan for the selection of qualified private auditors not later than October 1, 2018. The plan must include a description of the audits that DoD deems appropriate for performance by private auditors (including the total number and dollar value of such audits), a projection of the number of incurred cost audits anticipated to be performed by private auditors for 2019-2025 to ensure that DoD eliminates the audit backlog, and all other elements of an acquisition plan under the FAR.
  • DoD will then be required not later than April 1, 2019, to award contracts or task orders to two or more qualified private auditors.

Requirements for DCAA Unqualified Peer Review Audit and Affirmation of Contracting Officer Authority

  • Effective October 1, 2022 DCAA must possess and unqualified peer review audit in order to be authorized to issue incurred cost audits. Although DCAA currently possesses an unqualified peer review audit, this has been an issue in the past. If this measure is retained in the final NDAA, it should provide DCAA with a strong incentive to maintain a “clean audit” of its own.
    • The conference version of the NDAA also contains a provision that confirms that the cognizant Contracting Officer has the authority to resolve all issues relating to the resolution of questioned costs under an audit report. Although such a provision would seem unnecessary given Contracting Officers’ broad authority to resolve cost and cost accounting standards issues, many Contractors and practitioners have encountered COs who are reluctant to compromise costs questioned by DCAA without the Auditors’ agreement. This provision may expedite reasonable compromises of questioned costs.

It remains to be seen whether the foregoing and other provisions in Section 803 of the Conference Committee version of the NDAA will pass. The draft, however, reflects the frustration that Congress, Government Contractors, and Government Contracting Agencies have had over the past decade or more with the timely audit and resolution of incurred cost submissions.

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