Contractor Business Systems Series: Part 1 — The Ins and Outs of Government Contractor Accounting System Requirements

Article

June 27, 2024

Contributors: Jeffrey Annessa, Senior Manager, Government Contractor Industry Group | Artan Ivezaj, Manager, Government Contractor Industry Group

Government contractors who serve the Department of Defense (DoD) under Cost Accounting Standards (CAS) covered contracts that contain the DFARS clause 252-242-7005 need to evaluate and maintain key Contractor Business Systems for compliance and adequacy per the Defense Federal Acquisition Regulation Supplement (DFARS) clauses listed below. Per these rules, the DoD will conduct audits or reviews of the adequacy of these systems. If significant system deficiencies are identified and not corrected, the DoD can impose substantial consequences, such as withholding a percentage of payment or deeming a contractor ineligible to submit bids.

There are six contractor business systems:

Accounting System DFARS 252.242-7006
Estimating System DFARS 252-215-7002
Material Management Accounting System (MMAS) DFARS 252-242-7004
Purchasing System DFARS 252-244-7001
Property Management System DFARS 252-245-7002
Earned Value Management Systems (EVMS) DFARS 252-234-7002

The first three of the six contractor systems are audited by the Defense Contract Audit Agency (DCAA). The remaining three are reviewed (not audited) by the Defense Contract Management Agency (DCMA). Per 252.242.7005(d)(2), it is the sole purview of the contracting officer (CO) to determine system adequacy. This means the CO will make determinations regarding system approval or disapproval and the level of deficiencies if deficiencies are identified in a DCAA audit or a DCMA review.

In Part 1 of our series on Contractor Business Systems, we explore the requirements for a government-approved adequate accounting system as outlined in DFARS 252.242-7006 and required by Federal Acquisition Regulation (FAR) 16.301-3 in the award of a cost-reimbursable type contract.

What Are the Requirements for an Adequate Accounting System?

In accordance with the FAR, in order to be deemed responsible, contractors must have an accounting system that is adequate for the contract type contemplated. Thus, the FAR does not contemplate that all contractors must have an accounting system with the same attributes. Despite this, DFARS 252.242-7006 Accounting System Administration, lists 18 attributes a contractor’s accounting system must have in order for the system to be deemed acceptable. DCAA has paraphrased these 18 attributes so that an adequate accounting system should include:

Segregation of direct and indirect costs: The accounting system should segregate direct costs (costs that are directly attributable to a contract) from indirect costs (overhead costs)
Timekeeping system: The system should have a timekeeping system that accurately records employee time and labor charges
Cost accumulation system: The system should have a cost accumulation system that accumulates costs by contract, project or job
Job cost reporting: The system should provide job cost reports that show actual costs compared to budgeted costs
Indirect rate calculations: The system should calculate indirect rates (overhead rates) based on actual expenses incurred
Management control system: The system should have a management control system that ensures compliance with regulations and internal policies
Audit trail: The system should have an audit trail that provides a complete history of all transactions
Financial reporting: The system should be able to produce financial statements in accordance with Generally Accepted Accounting Principles (GAAP)
Internal controls: The system should have adequate internal controls to prevent fraud, waste and abuse
Compliance with regulations: The system should comply with applicable government regulations, such as the Federal Acquisition Regulation (FAR) System and the Cost Accounting Standards (CAS)

Who Is Responsible for Requesting an Accounting System Audit?

The CO will contact DCAA to determine whether the potential contractor has performed government work recently or if there has been a gap in performing on government contracts. If either condition applies, DCAA will be notified that the CO would like an accounting system audit to be performed within a certain time period, which is typically a two-week period.

What Types of DCAA Accounting System Audits Might Be Requested by the Contracting Officer?

There are two types of accounting system audits:

Pre-Award Accounting System
Post-Award Accounting System

Pre-Award Accounting System audits are requested to be performed when a new contractor is being considered or if there has been a prolonged period since the last contract with the Federal government. The pre-award accounting system audit is used to determine whether the contractor’s accounting system can comply with the Standard Form (SF) 1408 or Pre-Award Survey of Prospective Contractor (Accounting System) criteria:

Follows General Accepted Accounting Principles (GAAP)
Segregation of direct versus indirect costs
Identification and accumulation of direct costs by contract
A logical and consistent method of allocating indirect costs
Accumulation of costs under general ledger control
A timekeeping system that identifies labor by intermediate or final cost objective
A labor distribution that charges both direct and indirect labor to the appropriate cost objectives
Interim determination of contract costs through routine posting of books of account
Exclusion of unallowable costs
Identification of costs by CLIN or level required by the contract
Segregation of preproduction costs from production costs
Meets contract clauses concerning limitation of cost and/or limitation of payments
The system can support progress payments
The system records are maintained so they can support follow-on pricing

It should be noted that the 1408 has three options for the auditor to use in reporting on the system’s adequacy for each criterion. They are “yes,” “no” and “na” (not applicable). Although a criterion may not be applicable for the contract type contemplated, DCAA generally will evaluate and report on that criterion anyway.

Post-Award Accounting System audits can occur once performance has begun on a contract. Additionally, they can occur on a cyclical basis or if there have been issues or potential deficiencies identified in other audits that are related to the accounting system. The intent of the post-award accounting system audit is to test for compliance with DFARS Accounting System criteria and contract requirements, as well as to determine that the accounting system and cost data produced by the system are reliable.

What Does the Government Review in a Pre- or Post-Award Accounting System Audit?

Pre-award and post-award audits both base their audit testing programs on the DFARS Accounting System criteria. One builds upon the other, and the post-award audit is more in-depth.

For the pre-award audit, the government is looking to determine whether the accounting system is capable of handling a flexibly priced contract and if a contractor can sufficiently demonstrate that the system is designed to comply with the DFARS criteria, although not all those criteria may be applicable to the contract in question. The SF 1408 and DCAA Pre-Award Accounting System Adequacy Checklist, which is available on the DCAA website, should be used by contractors new to government contracting to document how their accounting system is designed to meet the SF 1408 criteria. When conducting these types of audits, the government will typically ask a contractor to demonstrate how their system is designed or working effectively. This routinely involves several walkthroughs to gain a detailed understanding of the policies and procedures related to each DFARS criteria, as well as various system demonstrations to validate the system is working as described.

For a post-award audit, the government is looking to determine whether the accounting system currently complies with all DFARS criteria and whether the data provided by the accounting system is reliable for management purposes. The post-award audits will typically require more in-depth walkthroughs and system demonstration of the functional areas that relate to the DFARS criteria. The auditors will perform detailed testing that will typically cover several areas, including billing, timekeeping and labor charging, GL accumulation and reconciliation, unallowable costs, direct versus indirect costs, accumulation of indirect costs, etc.

How Should a Contractor Prepare for an Accounting System Audit?

Make sure the accounting, billing, payroll processing, and management individuals are available and ready to meet with the DCAA auditor. Be prepared to answer all of the questions on the SF 1408, Pre-Award Survey of Prospective Contractor (Accounting System) checklist.
Review your policies and procedures to ensure they are up-to-date and being followed. Having policies associated with your current timekeeping system, accounting policies, direct versus indirect cost accumulation, and unallowable costs is a great start. Be prepared to discuss how your accounting and timekeeping systems work either virtually or in person.
Be prepared to pull reports live when you meet with DCAA such as your chart of accounts, trial balance, balance sheet, aging reports, timesheets, labor distributions, payroll reports and project status reports. DCAA wants to validate the report information is being pulled from the accounting system. Producing those reports live is going to be important so that they can tick and tie various schedules. During live walkthroughs, an auditor may ask to pull up the trial balance that they’ll use to tie out to the previously provided report as part of their original request list.
Complete a dry run-through of the DCAA questionnaire that is typically provided at the onset of an accounting system audit, which outlines the different kinds of cost accounting system practices, timekeeping practices, and general audit questions.
Evaluate your own policies and procedures to identify where there may be gaps against the DFARS criteria. For example, the unallowable cost policy, direct versus indirect costs, or describing your pools and bases for indirect costs.
Review your current practices and start to ask questions internally prior to the DCAA auditor coming in and performing a DCAA pre-award audit or post-award audit.
Ensure your current policies and procedures are consistent with your disclosure statement if fully CAS covered.
Be prepared to provide a listing of internal audits performed and the reports requested, if applicable.
Be aware that DCAA will ask whether management is aware of the presence of fraud or whether the business is subject to ongoing or pending legal investigations or proceedings.

There has been a trend in Indefinite Delivery, Indefinite Quantity (IDIQ) and Governmentwide Acquisition Contracts (GWAC) requests for proposals (RFPs) scoring for DCAA-approved accounting system requirements, although DCAA does not approve such systems and there is no mention of such an approval in the FAR. In some instances, an accounting system review can be done by a third party versus an audit conducted by the government. Going through a third-party review can be used as a best practice to identify where you might need to tune up your policies and can also be leveraged as part of financial statement audits or reviews.

The Accounting Systems requirements for government contractors aren’t going anywhere and, at times, can even start to flow down into non-flexibly priced contract vehicles. As your company scales, you become CAS-covered or win large, fixed-price, or sole-sourced contracts that require you to submit certified cost and pricing data, the accounting system requirements start to trickle in. As your company continues to grow, you should keep the accounting system requirements on your radar and consider lining up your current cost accounting practices with the DFARS requirements. Staying informed about updates to DFARS and consulting with qualified professionals are essential for government contractors in today’s ever-evolving regulatory landscape.

Let Us Be Your Government Contractor Business System Compliance Guide

Cherry Bekaert’s team of seasoned and experienced government contracting consultants are well versed in Contractor Business Systems requirements and complex control environments. We guide contractors in developing and maintaining compliant DFARS business systems, performing systems assessments, providing audit support, and preparing contractors for audits or reviews by DCAA, DCMA, or other cognizant agencies. If you have any questions specific to your situation, we are available to discuss them with you.

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