Are You Ready for a DCAA Accounting System Audit?
Every government contractor prefers to be in the low-risk pool for being audited-but contractors who have been awarded a cost-reimbursable contract have a 100% chance of being audited by the Defense Contract Audit Agency (DCAA). Company size and its determination of adequacy along with risk also play a big factor: large government contractors that exceed $250 million in auditable dollar volume (ADV) will be audited without question, whereas contractors below that threshold may not be. In either case, the Government reviews the completeness and accuracy of your Incurred Cost Submission when determining if your firm should be audited. Therefore, Government contractors should know what guidance the DCAA is following regarding selecting incurred cost submission (ICS) for audit to best prepare their incurred costs and decrease their risk.
The Current Landscape: What the DCAA Looks For
To begin their review, the DCAA uses an adequacy checklist and performs a risk assessment. The DCAA checklist of final direct and indirect incurred costs ensures compliance with the contractual agreements under Federal Acquisition Regulation (FAR). It includes approximately 50 questions, covering general and administrative expenses, overhead expenses, and more to ensure contractors are readily prepared for an audit.
The DCAA also considers the operating history of the company. For example, have there been past incidents within the company that would raise a red flag? Are there any risks related to the company's operations and internal controls? What were the results of previous audits? The DCAA considers each of these questions and others before making their final determination.
Tips for Government Contractors
Government contractors should keep in mind that if it's the first time they've submitted a cost-type proposal, their DCAA audit risk may be higher. It would be wise to invest in making sure that the submission is in good shape. Further, if the DCAA has determined a contractor to be low-risk in the past, that doesn't necessarily mean the contractor remains low-risk even under perfect conditions, after 2 or 3 years, contractors will likely be subject to an audit again.
Because of the DCAA's risk-based approach, the level of scrutiny is much tighter and stricter than it's been in the past, meaning submissions have little to no room for error. When reviewing their checklists in ICS submissions, contractors must remember all the schedules and information are interrelated. If one schedule is neglected, it's almost guaranteed to pop up somewhere else. Pay close attention to Schedules H, I, and K, use proof totals, and be sure to check your math!
Before submitting an ICS, government contractors should take advantage of the adequacy checklist posted on the DCAA website-especially smaller contractors because they tend to have smaller accounting departments dedicated to assessing their risk for audit. This checklist is readily available for contractors to self-check their ICS. If contractors experience significant issues using the checklist, they can work with an outside party to assist them.
Do you know what the government is looking for when it comes to the accounting system of its contractors? What policies and internal controls do you need to put in place to be ready for an audit?
While you can study the SF 1408 Pre-Award Survey to understand its criteria, it can be difficult to figure out what evidence is necessary to demonstrate that your business satisfies DCAA audit requirements. That's why we have come up with a practical DCAA compliance checklist of the internal controls and accounting information you should provide, along with an explanation of what this information is and why it's needed. We'll also touch on common compliance issues relevant to the pre-award audit.
Broadly, DCAA will want to examine four main areas: the way your accounts are set up, the flow of transactions in your accounting system, and the computations derived from it.
DCAA Compliance Area: Internal Financial Controls
Checklist #1: Delegation of Authority
You have written procedures for who has the authority to approve transactions, and you can demonstrate that these procedures are being followed.
Checklist #2: Recording Transactions
Develop written policies and procedures for how transactions flow and how they are recorded in the General Ledger.
Checklist #3: Closing Accounting Period
Develop written policies and procedures for closing the accounting period on a regular basis (monthly)
DCAA Compliance Area: The Way Your Accounts are Set Up
Having your accounts correctly set up is the cornerstone of DCAA audit compliance because it allows direct costs, indirect costs, and unallowable costs to be separated easily.
Checklist #4: Chart of Accounts
Your Chart of Accounts (COA) should demonstrate to the auditor how the accounts are structured to provide the ability to separate costs that are direct, indirect, and unallowable, and the COA should demonstrate the further breakdown of indirect costs into cost pools, such as fringe, overhead (OH) and general and administration (G&A) expenses. Your accounting system should provide a report that generates the COA, which is essentially a list of general ledger accounts in which financial transactions are posted.
Depending on the size and complexity of your business, you could use a simple cost pool indirect structure, consisting of a single fringe, OH, and G&A pool, or a more complicated structure consisting of multiple fringe, OH, and G&A pools. You may also create cost pools for accumulating indirect costs in cost centers that will allow the cost to be allocated to specific contracts.
DCAA will also examine your Chart of Accounts to make sure you're following Generally Accepted Accounting Principles (GAAP). Having accounts like Accounts Payable, Accounts Receivable, Prepaid Expenses, and Unearned Revenue will show that you're accounting for cost and revenue on an accrual basis.
DCAA Compliance Area: The Flow of Transaction
From a DCAA point of view, the following reports are useful for tracking how transactions flow through your accounting system to ensure they're recorded accurately and reconcile with other systems like timekeeping and billing.
Checklist #5: Trial Balance
The Reports functionality in the accounting system allows you to print a Summary Trial Balance or a working trial balance. The former summarizes the debits and credit balances on each of your accounts, the latter contains more details like the opening balance, transactions, transfers, and closing balance.
Checklist #6: General Ledger Detail
Similarly, a general ledger detailed report provides beginning balances, transactions, and ending balances for each account over a specific period.
DCAA Compliance Area: Computations
In addition, DCAA will check your processes for allocating revenue and costs to projects, as well as the way you make indirect rate calculations. For more on rates see our blog: Basics of Indirect Rates - How to Calculate Them.
Checklist #7: Profit & Loss by Contract and/or Project
A key requirement highlighted in the pre-award survey is the accounting system's ability to accumulate costs by contract and/or project. Therefore, a Profit and Loss by contract and/or project report that agrees with the standard Profit and Loss (P&L) gives confidence that this can be done accurately.
Checklist #8: Labor Distribution Report
Labor distribution describes the process of allocating labor costs, including both direct and indirect costs, to the total time recorded on timesheets.
To run labor distribution in an accounting system, you'll need to ensure employee details, compensation data, and payroll items are set up in the system. There should be a payroll item for every kind of labor you have, including things like paid time off and holidays. You should also double-check that account mappings are correct so that labor costs are posted to the right general ledger accounts.
It's a good idea to separate cost categories so that you have direct labor for government contracts, direct labor for commercial contracts, overhead for government contracts, and overhead for commercial contracts.
What DCAA wants to see is that labor costs are fairly distributed among customers-both government and commercial-and that no one is favorably treated by receiving a cost subsidy.
Checklist #9: Contract Backlog Report
The accounting system should generate a Contract Backlog Report allowing you to see the percentage of work completed and the remaining cost to complete each contract and/or project in your backlog. It tells you how much money is left on a contract, whether there could be a potential contract overrun, and if there are corrective actions required as a result.
Issues relating to revenue recognition or unbilled accounts receivables can sometimes arise. Revenue recognition could differ depending on the type of contract: Time and Materials (T&M), Cost-Plus-Fixed-Fee (CPFF), or Firm-Fixed-Price (FFP). But generally, billed amounts should be based on the accounting principle of matching contract revenue with the cost associated with earning that revenue.
In terms of unbilled receivables, you may have unbilled accounts receivable amounts for numerous reasons, including rate variances where the actual indirect rate is greater or less than provisional or target rates.
Checklist #10: Indirect Rate Calculations
QuickBooks cannot perform rate calculations, but you don't need a system-generated figure to be compliant. You can achieve DCAA audit compliance if you show a template on an external spreadsheet that you have used in the past to correctly calculate your indirect rates.
When it comes to wrap rates, you'll have to justify the basis of your calculations. FAR requires that you show trends and budgetary data to establish the reasonableness of proposed rates to be evaluated. These can be based on reasonable sales forecasts and costs, but smaller firms with limited budgetary data can use historical data to calculate out-year rates.
Checklist #11: Monthly/Period Close Checklist
The final item on our DCAA compliance checklist is more about providing the auditor with information about the processes you have in place to check for errors in your books and ensure the true financial position of your business is disclosed each month.
The month-end or period-close process essentially involves recording transactions, verifying, and adjusting account balances, performing reconciliations and printing, as well as monitoring, relevant reports. Done effectively, these processes should highlight potential mistakes in your accounting system and other financial or business issues.
Learn More About DCAA Compliance
Achieving DCAA audit compliance takes time, effort, and specialist knowledge. Apart from understanding relevant regulations, you'll also need to structure your chart of accounts to configure your accounting system correctly. If you're unsure about your company's accounting system and data, Mike Bodgon, CPA, VP of Accounting Services, can help with years of industry experience, our experts are well-positioned to identify and resolve potential DCAA compliance issues before an audit begins.
Learn More About AtWork Systems
AtWork Systems' OneLynk platform, provides an integrated suite of tools you'll need to address the accounting and project management requirements for managing government grants and contracts. The GovCon industry's most modern ERP system, OneLynk, was built from the ground up to support project accounting and the ICE Model. OneLynk provides information that contractors need to prepare accurate and timely job cost reports as well as the incurred cost submissions. The integrated project and general ledger generate the list of required schedules for the ICS using data directly from the accounting system. Both the general ledger and project ledger have been optimized to support the project accounting and the ICS submission.
Additional Reads on the Top:
A more complete explanation of the pre-award survey SF 1408 can be found at What is the SF 1408.
A more complete explanation of the incurred cost submission can be found at What is the Incurred Cost Submission.