It’s been ten years since I first tackled government contract accounting issues associated with joint ventures.  (See “Accounting, Cost and Pricing Issues in Strategic Alliances and Teaming Agreements,” Strategic Alliances and Teaming on Government Contracts: Winning Combinations for the Next Century, American Bar Association, 2000.)  At that time, my co-authors (Jim Check and Jason Aiken) and I asserted that “The structural form and, more importantly, the substance of an alliance arrangement will bear significantly on determining whether costs are allowable and how they are allocated.”

We discussed three primary scenarios—

1. Each alliance member will incur all costs individually and no costs will be incurred by the alliance (the “unpopulated alliance” scenario).

2. The alliance will incur all costs and no alliance member will incur any costs (the “populated alliance” scenario).

3. Each alliance member will incur some costs as an individual entity, while some costs will be incurred by the alliance (the “hybrid alliance” scenario).

In the first scenario above, all costs (including costs of the alliance’s infrastructure such as program management, billing, audit support, etc.) are incurred by an alliance memberand included on that member’s billings to the alliance entity.  The alliance entity is simply a shell without any of its own costs, employees, or control systems.  In the second scenario, the alliance is brought to life by infusing it with working capital, employees, and control systems.  The alliance implements all necessary business systems, including payroll processing, purchasing, property control, etc.  The alliance will develop its own indirect rate structure and calculates is own indirect cost rates, based on the direct and indirect costs it incurs.  In such circumstances, the alliance may require its own Disclosure Statement.  Finally, in the third scenario there are at least two structures involved—that of the alliance entity and those of the alliance members.  Alliance members may operate as both owners and subcontractors, depending on how the work is allocated.

Although there are several different forms of “alliance” (including teaming agreement or Special Business Unit), the most prevalent type is the joint venture.  Joint ventures (JVs) offer the opportunity to present a single, unified face to a customer, to create a separate cost structure and benefit packages, and to utilize the alliance members’ past performance information for purposes of winning a proposal.

The DCAA Contract Audit Manual (CAM) discusses audit issues associated with JVs at 7-1800.  According to the CAM—

A joint venture, proposed and established as a separate business entity, should have its own set of books and supporting documentation sufficient for an audit trail. Transactions should be recorded consistent with the joint venture agreement, and care must be taken to ensure that the joint venture bears its equitable share of the costs.  A joint venture, proposed and established as a separate business entity, should have its own set of books and supporting documentation sufficient for an audit trail. Transactions should be recorded consistent with the joint venture agreement, and care must be taken to ensure that the joint venture bears its equitable share of the costs.

More recently, in its role as adjudicator of bid protests, the GAO has addressed the need for a JV to have an adequate accounting system suitable for cost reimbursement contracts, as well as whether a JV needs to file a CASB Disclosure Statement. 

In PMO Partnership Joint Venture (B401973.3, 1/14/2010), the Department of Transportation (DOT) rejected PMO’s offer because it considered the JV’s indirect cost structure to be “unacceptable.”  In the words of the hired auditor (BMC)—

Indirect cost rates were not projected for the PMO Partnership and used in the cost proposal in accordance with FAR 31.203. Instead the indirect cost rates for each partner were used separately in the cost proposal. A budget should have been developed for the partnership entity and projected indirect rates should have been calculated from the budget and used in the cost proposal. As a result the indirect costs included in the cost proposal are questioned . . .The cost proposal should be for the PMO Partnership Joint Venture Entity and should not list the costs for each partner separately. The PMO Partnership Joint Venture is a separate entity in and of itself and that is how the costs should be presented in the cost proposal. . . .

Because the JV’s indirect structure was found unacceptable (and by the way noncompliant with CAS 401), the entity’s offer was rejected and PMO protested the contracting officer’s decision.  As a preliminary matter, DOT’s argument that the JV had violated CAS 401 was dismissed because the JV was a qualified small business concern, and thus exempt from the requirements of CAS 401.  In addition, GAO noted that the Government had “not explained why the particular overhead rate structure proposed by PMO-JV would lead to an inconsistency in the application of cost accounting practices or a loss of financial control over costs during contract performance.”  Accordingly, the protest was sustained.

Similarly, in McKissack+Delcan JV II (B401973.2, 1/13/2010) the JV’s offer to DOT was rejected because the JV member maintaining the accounting records (Delcan) would utilize Canadian GAAP instead of US GAAP.  Moreover, “The proposal submitted to the Government does not show that the joint venture is an independent entity. An independent joint venture for Government contracting purposes would have employees committed from each company and the indirect rate structure would be unique to the joint venture. . . . In addition, the indirect rate structure proposed is Delcan's; the proposal should contain an indirect rate structure specific to McKissack & Delcan Joint Venture II.”  However, as the protest evolved the Government abandoned its initial position(s) and ended-up with the same arguments it used with respect to PMO, namely that the JV’s “accounting system is inadequate because MD-JV's failure to submit a unique indirect rate for the joint venture violates CAS 401.”  As with PMO, the protest was sustained.

In both protests above, DCAA failed to appreciate that a JV need not be “populated” and might simply consist of the costs of its members.  On the other hand, companies wishing to enter into a JV or other strategic alliance should be mindful of the blind spot(s) in DCAA’s audit approach, and take care to link proposed indirect costs to the form and substance of the alliance entity they have chosen.

Finally, in Northrop Grumman/Textron (B400837, 2/17/2009) the two companies protested award of the Joint Light Tactical Vehicle (JLTV) contract to the GTV Joint Venture (a JV between General Dynamics Land Systems and AM General) because (among other things) GTV failed to submit a CASB Disclosure Statement for the JV.  GAO noted that “GTV’s proposal indicated that 100 percent of the contract costs would be accounted for by subcontracts with the two joint venture members, apportioned between them equally.  GTV indicated in its proposal that a CAS disclosure statement had previously been submitted, and specifically cited in this regard disclosure statements submitted by AM General and GDLS.” 

GAO relied on the DCAA audit guidance that states—

The need for a joint venture CAS Disclosure Statement depends upon the characteristics of the venture itself. The determination must be made on a case-by-case basis. Where the joint venture is the entity actually performing the contract, has the responsibility for profit and/or producing a product or service, and has certain characteristics of ownership or control, a Disclosure Statement should be required. Where the venture merely unites the efforts of two contractors performing separate and distinct portions of the contract with little or no technical interface, separate joint venture disclosure may not be required.

Because “GTV’s proposal in fact incorporated CAS disclosure statements applicable to the contemplated contract effort” the protest was denied.

To sum up, there are undeniable attractions to forming a joint venture or similar alliance to pursue government business.  But doing so presents difficulties—not the least of which is ensuring alignment between the form/structure of the alliance and its cost structure, and navigating the submission of CASB Disclosure Statements.  Based on recent GAO decisions, auditors will not be sensitized to the possible forms of the alliance, and may misevaluate what is presented, unless pains are taken to clearly show how proposed costs are consistent with how costs will be accumulated and billed after contract award.

We’ve posted about this before but you need to hear it again.  The next big war between nation states probably won’t be fought using tanks and planes; it will probably be fought in cyberspace.  The war could be over before a single shot is fired, with the winner being the first to shut down the other side’s electrical and information grids.  The soldiers of the next war are in training now.  And the United States is way behind other nations in training and equipping its cybersoldiers.

In this article, we told you about French Rafale fighters being grounded because the Conflicker worm invaded the French Navy’s mission planning system via an infected thumb drive, and we reported that the British Ministry of Defense and its aircraft carrier HMS Ark Royal were similarly attacked by computer viruses.  In response to pervasive cyber threats, in June 2009 the Pentagon established USCYBERCOM as a subordinate unified command under the U.S. Strategic Command.

"My own view is that the only way to counteract both criminal and espionage activity online is to be proactive. If the US is taking a formal approach to this, then that has to be a good thing. The Chinese are viewed as the source of a great many attacks on western infrastructure and just recently, the US electrical grid. If that is determined to be an organized attack, I would want to go and take down the source of those attacks." – Lt. Gen. Keith Alexander, nominated USCYBERCOM Commander, May 2009 (quoted here)

In another article, we told you about the U.S. Cyber Challenge, where children as young as high-school age are invited to participate in “contests” (that look an awful like training exercises) in which their nascent skills in cyber attack and defense are “nurtured and developed”.  Those participants who stand out from the rest will be offered grants, scholarships, advanced training, and/or full-time employment, in order to become full-fledged “cyber-security practitioners, researchers, and warriors.”  We noted that the impetus for this effort was the fact that the U.S. had belatedly recognized how far behind China it had fallen in this area.

More recently, media outlets carried reports of China’s apparent involvement in a sophisticated attack on Google, in which “the e-mail accounts of several Chinese human rights activists had been compromised.”  This Reuters article discusses China’s Hong Ke (Red Visitors) and quotes a blogger as saying, “China may not be where the U.S. is militarily, but it clearly has invested a lot of brainpower in developing capabilities that can offset the U.S. advantage in force-on-force conflict.”

The foregoing is but a bit of background to the discussion of the Comprehensive National Cyber Security Initiative, the Department of Homeland Security’s National Cyber Security Center, and DARPA’s National Cyber Range.  It is in these arenas that the United States is developing its offensive and defensive doctrines for fighting the next war.

The Comprehensive National Cyber Security Initiative (CNCI) dates back to 2008, when then-President George W. Bush issued National Security Presidential Directive 54 to improve how the Federal government protects sensitive information from hackers and nation states trying to break into agency networks.  Much of the details surrounding CNCI are classified, but reports indicate that its multi-year budget may be as much as $40 billion. 

Apparently, the Department of Homeland Security (DHS) is the lead CNCI agency.  Reports assert that DHS uses an automated system known as Einstein to collect security information, such as notifications of intrusions via sensors deployed in agencies’ networks, and reporting that information to the U.S. Computer Emergency Readiness Team (US-CERT).  In addition, one article reported that “Defense and intelligence agencies were assigned an operational role, particularly for computer systems and networks deemed more sensitive to national security. Those agencies were expected to focus on counterterrorism efforts.”

The National Cyber Security Center (NCSC) is tasked with protecting the Federal government’s communication networks from domestic and foreign threats.  After a rough start in which the NCSC head quit over allegations of undue influence by the National Security Agency (NSA), the NCSC has lowered its profile under the direction of long-time Microsoft Executive Phil Reitinger.  In a rare interview posted on Govinfosecurity.com, Mr. Reitinger let drop some tidbits about the NCSC.  He said, “I was talking before about the National Cybersecurity Division, which is part of cybersecurity communications. The National Cybersecurity Center is an even smaller group that will be growing form perhaps somewhere in the neighborhood of five people to perhaps 25 by the end of the year, so it is going to be much more than doubling but it is a smaller group of people.” 

Finally, let’s discuss DARPA’s National Cyber Range (NCR).  According to the DARPA press release:  “The goal of the NCR program is to revolutionize the state of the art of the Nation’s cyber testing technology, and develop a computer systems test bed on which cyber scenarios can be evaluated simultaneously to provide a comprehensive, qualitative and quantitative assessment of the security of information and automated control systems that are under development.”  DARPA’s vision for the NCR is to “simulate the entire internet, allowing soldiers to drill in virtual simulations ranging from a small scale computer virus to a World War III-sized conflict,” according to this article.  Northrop Grumman won the Phase I concept design work, but contracts for Phase II efforts, which include building and evaluating “prototype ranges and their corresponding technology,” were awarded to John Hopkins University-Applied Physics Laboratory and to Lockheed Martin.

While Aviation Week & Space Technology magazine is excited about the Next Generation Jammer (NGJ), focusing on new techniques in Electronic Attack and Electronic Warfare, the real future of warfare is already taking shape behind computer screens and in large-scale testbeds and laboratories.  For example, the January 18, 2010 edition of AW&ST describes that the future of electronic attack weapons as including “a magazine filled with electron pulses, information scrambling data streams and invasive algorithms.”  That may well be true, but if the planes that carry the NGJ and its science fiction weapons can’t take off because the military command and control structure has been hacked from abroad, or if the mission planning and guidance maps have been altered via undetected intrusion, then those weapons will avail us very little.  Instead, AW&ST might want to think about getting excited about cyber.