Continuing a trend started in late 2008, DCAA audit guidance issued August 4, 2009 spells trouble for Government contractors.  The guidance warns DCAA auditors of contractors that are "inappropriately charging" costs associated with ineligible dependents and/or spouses to the Government.  The audit guidance directs that auditors should question costs associated with ineligible dependents in both forward pricing rate proposals and annual incurred cost submissions.  Ineligible dependents/spouses include those that are (1) too old to receive benefits, (2) divorced or deceased, or (3) covered by another plan but did not notify the contractor of that fact.  Auditors will be developing tests to assure that only spouses and dependents that are eligible for benefits in accordance with the contractor's policies are receiving benefits.

The guidance notes that some contractors offer employees "grace periods" in which to report status changes, and directs that _all_ costs associated with ineligible dependents should be questioned, even if incurred during grace periods that are otherwise consistent with company policy.  Contractors that offer employees such grace periods must calculate the "cost impacts" associated with their practice "even if the contractor will not seek restitution from the [ineligible] employees."  Where contractors refuse to calculate those impacts, DCAA auditors are directed to "develop a reasonable estimate" of the unallowable health benefit costs and "suspend the costs until the contractor provides a cost impact and/or an audit is complete."

Moreover, the audit guidance asserts that costs associated with ineligible spouses/dependents are not only unallowable, they are expressly unallowable, and thus subject to the penalty provisions of FAR 42.709.  Court decisions on this matter tend to favor a contractor, basically saying that penalties should not be imposed where there are reasonable differences of opinion about the allowability of certain costs.(Ref. _General Dynamics Corp._, ASBCA No. 49372, June 2002.)  That being said, it is far from clear that inclusion of costs associated with patently ineligible dependents in claimed health care expenses results from a matter of judgment or opinion.  (The "grace period" issue may be subject to more judgment.)  In any case, who wants to litigate the issue?

There are other troubling aspects of the audit guidance:

-- DCAA auditors are advised that many contractors use third-party plan administrators.  When auditing health plan costs, auditors are directed that the contractor must provide "the same level of access to the third party service provider records that he or she would receive from contractor maintained records."  Auditors are reminded to initiate "access to records" procedures should a contractor deny them access to the third party's records.  Previous DCAA audit guidance imposes a course of action that can lead to suspended costs, for an unresolved "access to records" issue.  (Ref. MRD 08-PAS-042(R) dated 12/19/2008.)

-- DCAA auditors "should verify that contractors have adequate procedures to ensure payment of insurance premiums or claims are only being made related to employees and their eligible dependents."  A contractor's failure to have adequate procedures in this area will treated as "an internal control deficiency in the contractor's accounting system and a CAS 405 noncompliance, if applicable."  Further, inclusion of costs related to ineligible dependents/spouses in cost estimates may be teated as inadequacies in the contractor's estimating system.  Previous DCAA audit guidance (MRD 08-PAS-403(R), dated 12/19/2008) directs that a single control objective failure should lead to a recommendation o system inadequacy.  An inadequate estimating system is a nuisance, but an inadequate accounting system can prevent a contractor from receiving any cost-reimbursement contract.  (Ref. FAR 16.301-3(a)(1).)  Accordingly, a threat to the adequacy of a contractor's accounting system internal controls must be taken very seriously.

Finally (as if the above was not sufficient to cause worry), the audit guidance reminds DCAA auditors that the cognizant Administrative Contracting Officer (ACO) should be "notified of any potential risks related to ineligible dependent care costs in prior fiscal years" so as to "ensure that active negotiations of open incurred cost years are put on hold until any necessary adjustments are made."  In other words, an audit finding in a current year can affect the finalization of prior years' indirect cost rates, which could delay final contract close-outs and submission of final invoices.

Given the foregoing, contractors should immediately review their procedures associated with verifying dependent eligibility and shore them up as appropriate.  To the extent costs associated with ineligible dependents/spouses are identified, they should be treated as unallowable costs.  Contractors should also consider consulting with legal counsel to determine their position regarding DCAA access to the records of any third party service providers.  In cases where it is decided to grant access to those records, it may be necessary to renegotiate or even amend existing service agreements.

See the troubling audit guidance here.

Government Executive (www.govexec.com) reported on August 6, 2009 that it had obtained an internal DCAA memoranda discussing the findings of the upcoming second GAO report--and (unsurprisingly) the GAO has found fault with DCAA's audits.  In July 2008, a similar GAO report was highly critical of DCAA's audits in its Western Region.  The 2008 report created a firestorm of controversy, including a denunciation of DCAA on the Senate floor, Congressional hearings, and a report from the independent Defense Business Board containing recommendations for reforms to "DCAA's culture, structure, and business practices."  According to the GovExec.com article, the DCAA memoranda state that GAO reviewers looked at 37 audit reports issued between 2004 and 2006, and every single report failed to comply with some aspect of Generally Accepted Government Auditing Standards (GAGAS).

The article reports that "GAO focuses much of its attention on a lack of quantitative testing," and that the report will find that "auditors failed to review a sufficient amount of transactional data such as payroll records, vendor receipts and system invoices."  The article notes, however, that GAO may have failed to link these alleged audit failures to any monetary harm suffered by the DOD.  The article quotes a source asking, "'What did GAO find that the DCAA missed? ... The answer is, there is no answer.  They did not explain how the additional testing would have affected the results.'"

According to the internal DCAA memoranda, GAO will recommend that DCAA should be more independent from other DOD agencies "with greater power similar to that of an inspector general."  It is not clear that giving DCAA more independence and/or subpoena power will result in higher-quality audits.  To the contrary, the Government Executive article quotes an unnamed California DCAA auditor as saying, "The audits DCAA [are] issuing now are untimely and poor in quality. ... The metrics still control the audit risk, despite the better judgment of the senior auditors that do all the real heavy work at DCAA."

Although the final GAO report has yet to be issued, if the GovExec.com report is accurate, DCAA could be in for another rough time.  After the 2008 GAO report, DCAA implemented "reforms" that resulted in a loss of auditor discretion, harsh audit approaches, a proliferation of "flash" audit reports, and a bias toward disapproval of contractor internal control systems.  Consequently, DOD contractors should be alert for future changes to audit guidance that impact how they do business with the Department of Defense.

The GovExec.com article is here.