It was an Employee Morale Gathering, not a Christmas Party!
That time when you have to explain to your client that just because the expense is deductible for tax purposes, doesn’t make it allowable for government contract cost accounting purposes. . . . In other words, there are a lot of government contractors who don’t even know about FAR Part 31 and its cost principles, let alone what those cost principles say and how to apply them.
We probably should be writing about the new proposed DFARS rule dealing with government property, but today it just doesn’t seem as important as writing about the FAR Part 31 cost principles. (Sorry property people, No disrespect intended.) Instead, let’s talk about 31.205-13 and 31.205-14. In our experience, people get those two cost principles confused and that confusion leads to audit findings.
Contractors like the way 31.205-13 reads. It says (in part) “Aggregate costs incurred on activities designed to improve working conditions, employer-employee relations, employee morale, and employee performance (less income generated by these activities) are allowable, subject to the limitations contained in this subsection.”
That seems to say that any expenses incurred for purposes of improving employee morale or improving employee performance are allowable. We’ve seen employers claim expenses of employee barbeques as allowable expenses, citing to this cost principle. (After all, the employees were a lot happier after chowing ribs and brisket, weren’t they?) Similarly, we’ve seen Christmas parties (or as they are called today, “holiday parties”) claimed as being allowable expenses under a similar rationale—even though those parties were quite lavish and included alcohol and entertainment. We’ve seen entire departments head to the bowling alley after work, where somebody submits an expense report claiming allowable employee morale expense. We’ve seen one-on-one supervisor/employee lunches and dinners claimed as being allowable “performance reviews” (which meant they were claimed to be allowable because they were intended to improve employee performance). Quite honestly, we’ve seen it all and most of it was claimed as an allowable expense under this cost principle.
But the cost principle is not as permissive as it may seem as first glance. In contains some restrictions, including—
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“Costs of recreation are unallowable, except for the costs of employees’ participation in company sponsored sports teams or employee organizations designed to improve company loyalty, team work, or physical fitness.”
Thus, those bowling alley “morale improvement” gatherings are clearly unallowable, because bowling is a recreational activity, and the costs of recreation are expressly unallowable. Similarly, those season tickets you handed out to employees are also unallowable, either under the “no gifts” language or under the “no recreation” language.
However, costs of sponsoring employee after-work sports teams are clearly allowable under this cost principle, as are costs of employee gyms/fitness centers. So, in theory, you could sponsor an employee bowling team if you could assert (with a straight face) that it led to improved employee fitness.
Having said all that, we need to now turn our attention to 31.205-14 (“Entertainment Costs”). You need to read the permissive language of 205-13 in conjunction with the language of 205-14 in order to make the right call on cost allowability. The 205-14 cost principle is simple. It states—
Costs of amusement, diversions, social activities, and any directly associated costs such as tickets to shows or sports events, meals, lodging, rentals, transportation, and gratuities are unallowable.
Importantly, the 205-14 cost principle also states “Costs made specifically unallowable under this cost principle are not allowable under any other cost principle.” Thus, the language in the 205-14 cost principle overrides the language in the 205-13 cost principle. (You can thank ICF Kaiser for the additional language. ICF Kaiser is a no-longer-in-existence government contractor whose Christmas parties were legendary and who used the 205-13 cost principle language to justify the allowability of the costs.1)
What this all means is that you can’t make your parties at the local bar allowable by calling them “employee morale activities” under the 205-13 language because all “social activities” are already made expressly unallowable by the 205-14 language. Similarly, you can’t make your year-end program reviews allowable if they are held at a venue whose purpose is entertainment or amusement. We mean: you can try. But your auditors are rightfully going to be extremely skeptical.
How does one successfully navigate this minefield? How does one maximize the cost allowability of legitimate employee gatherings whose primary purpose is to really, honestly, to improve employee morale, communication, and performance?
First, if you are going to hold an employee gathering offsite (no matter where) you need to have an agenda that supports your business purpose. And we’re not talking about a 15 minutes speech by the Division President, followed by a general cry of “the bar is now open!” There needs to be an agenda and it needs to support the concept that the purpose of the meeting is other than entertainment, amusement, or an open bar social activity.
Second, you need to keep an attendee list. The attendee list supports the notion that the offsite meeting was business related. And if the attendees include spouses or significant others, that’s going to be a red flag to the auditors that there was more going on here than a business meeting. Similarly, if the attendees include subcontractors or suppliers, that’s going to be a different red flag.2 Finally, if the attendees include your customers (e.g., government employees), that’s going to be a different red flag—one you really don’t want to wave unless you have really, really, researched government employee ethics rules. The perfect attendee list is filled only with employees (but of course you want the attendee list to be accurate).
If you have “red flag” attendees, you will want to develop a ratio of the unallowable attendees to total attendees, so that a pro rata share of otherwise allowable costs can be moved to unallowable.
With respect to the costs of the meeting, you will want to segregate “entertainment” and other unallowable costs from costs such as food and non-alcoholic beverages, which are allowable. The DJ? Unallowable. The open bar? Unallowable. Et cetera. The facility rental and general wait service will more than likely be allowable, but watch gratuities for the bartenders, which of course are unallowable.
Finally, watch the communications. If your employee email and check requests call the gathering a “Christmas Party” or “Holiday Party” then you’ve shot yourself in the foot and you may as well not worry about all the analysis discussed above. You’ve declared your purpose—and it’s an unallowable purpose. All costs are now unallowable as well. If you really believe that the purpose of your employee gathering is in line with what the 205-13 cost principle says is allowable—and not what the 205-14 cost principle says is unallowable—then make sure all your communications reflect that purpose. Don’t permit people to be lazy with respect to describing the gathering.
One more thing: timekeeping. If you are going to claim the employee gathering as an allowable meeting, then it’s business-related and you are going to have timekeeping issues. You can’t say on one hand the gathering is an employee morale/performance improvement event while on the other hand saying people are attending on their own time. That might work with your exempt employees, but you are running a big risk with respect to your non-exempt and hourly employees. And what about expense reports for local mileage and parking?
The point is, you had better think this through. It might be easier and cheaper to call a gathering a voluntary party and write all expenses off to unallowable, as opposed to trying to claim a percentage of the expenses as allowable costs while having to deal with the timekeeping and directly associated travel expense aspects.
Now let’s talk about reasonableness. There’s another cost principle (31.201-2) that requires a cost to be reasonable in amount in order for it to be allowable. There’s yet another cost principle (31.201-3) that discusses how to determine if a cost is or is not reasonable in amount. You can do all the math in the world to identify what you believe to be allowable costs, but if the auditors believe the costs to be unreasonable you will have to justify why they are reasonable—and the burden of proof will be on you, the contractor. Government employees are going to have a hard time with a party at the Ritz Carlton or the Four Seasons hotel as being reasonable in amount. They are going to have a hard time with lobster and prime rib being viewed as reasonable meals at employee offsite meetings. Think about the concept of reasonableness before you decide to start claiming costs as being allowable.
But if you’ve done your homework and are ready to support your costs through government audit, there’s no reason you shouldn’t claim reasonable bona fide expenses that are intended to improve employee morale and/or performance as being allowable.
Accounting Fraud is Easy … Until You’re Caught
We have worked with AbilityOne not-for-profit (NFP) entities before. We have a lot of respect for their mission, which is to provide jobs and other vocational opportunities for individuals with disabilities. We need more entities like them.
Which makes it difficult to write about how lax internal controls at one AbilityOne NFP allowed an accounting manager to embezzle $1.3 million. That’s $1.3 million that could have gone to the programs that enable people with disabilities to find meaningful work. Instead that money was used to support the lifestyle of REGGIOUS SANCHESTER BELL, age 30, who embezzled the money over a period of about four years and used it to pay for personal expenses at such places as Best Buy ($95,000), Louis Vuitton ($22,000), Dillard’s ($21,000), and various other establishments.
There’s a DoJ press release to tell us that Bell pleaded guilty to one count of federal program theft and two counts of federal income tax evasion. The press release tells us that the maximum penalty for federal program theft is 10 years in prison and a $250,000 fine. The maximum penalty for tax evasion is five years in prison and a $100,000 fine.
The press release relates the following story:
According to information presented by the government at today’s hearing, Bell went to work for Phoenix in 2008 in its accounting department. He worked in accounts payable, accounts receivable and fixed assets management. [Phoenix is the AbilityOne entity; it receives about $20 million annually in contract revenue for providing Redstone Arsenal with custodial support.] As it did with other staff members, Phoenix provided Bell a credit card to use for business expenses only. Bell, however, began using his Phoenix credit card for personal expenses in at least 2009, and continued to do so until he was caught in the summer of 2013, according to his plea. [In addition to running up thousands of dollars of personal charges on his own corporate credit card] Bell also had Phoenix issue a credit card in a fictitious name with a fictitious Social Security number, which he also used for personal expenses.
Bell deleted unauthorized purchases from the credit card monthly statements and manipulated Phoenix’s account ledgers so that they would balance with the bank’s spreadsheet that showed what Phoenix owed for its staff credit cards, according to the plea.
Bell also established an accounting firm, called Bell-Pete Associates. Although Phoenix never did any business with the firm, Bell invoiced Phoenix for $58,133 in accounting services in 2011, and for $235,740 in 2012, according to his plea. Bell did not report the fraudulent income to the IRS, resulting in an underpayment of taxes of $15,132 in 2011, and $66,636 in 2012.
So what do we learn from this sad story?
We learn that Mr. Bell was able to approve fraudulent invoices. He created a fictitious company and paid that company nearly a quarter million dollars in one year but apparently nobody noticed. We learn that Mr. Bell had the ability to delete certain purchases from credit card monthly statements and he had the ability to “manipulate” Phoenix’s general ledger so nobody would notice the manipulations. Apparently he had the full run of the accounting department with minimal oversight. The (apparent) lack of segregation of duties coupled with (apparent) lax oversight coupled with (apparently) a lack of basic anti-fraud activities allowed him to embezzle more than a million dollars in roughly four years.
What might a company do that wants to avoid a fate similar to that which Phoenix experienced?
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Split roles; don’t give one person too much authority. For example, don’t let the person who cuts the checks also approve invoices for payment. Another example: don’t give people the ability to manipulate the general ledger. Make sure your accounting software keeps a record of who made every entry. Review the records periodically to ensure that each person is staying within their “swim lane” of authority.
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Rotate people. Make sure everybody takes a vacation each year. During a person’s vacation, review areas in the ledger for which they are responsible.
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Every quarter run a report to review your largest vendors—the 20% that make up 80% of your A/P activity. Then run another report to review your smallest vendors—the 80% that make up 20% of your A/P activity. Make sure you know exactly what goods/services every one of those vendors provided.
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Review check runs thoroughly. Select a sample and do an independent match of supplier invoice and purchase order and payment. Identify who approved the invoice for payment; make sure it isn’t your A/P accountant. Select a sample of approved invoices and call the approvers to make sure they actually approved the invoice.
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Have copies of corporate credit card statements sent to supervisors and managers; have them review the monthly transactions for propriety. Yes, some employees will use their corporate cards for personal expenses. Ensure they pay for their personal expenses and counsel them. Take away the cards of repeat offenders.
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Do not have the company pay the credit card bills; ensure each employee is responsible for paying off their own cards each month. Yes, some employees will run up balances that aren’t cleared timely. Counsel them and help them to pay off their balances through submitting expense reports. Take away the cards of those employees who can’t manage them.
The above list of tasks is not burdensome. Not really. Not if you are looking to keep your money.
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Risk Management in M&A Activities
Apogee Consulting, Inc. has done some M&A stuff before. We’ve participated in due diligence activities, we’ve briefed lawyers and investment firms on results, and we’ve participated in post-merger integration activities (including contract novations, business system integration, and post-award indirect rate structuring). All of which is to say: while we don’t claim to be M&A experts, we’ve done enough to have some insight into what can go wrong.
Rule #1: Due diligence findings are rarely enough, by themselves, to affect the deal. If enough people want the deal to happen then it’s going to happen regardless of the due diligence efforts. (This situation tends to happen when one or more corporate officers have “do a successful deal” in their annual performance plans, and their incentive comp is riding on the deal getting done.) Conversely, if enough people don’t want the deal to happen then it’s not going to happen regardless of the due diligence efforts. (We’re thinking here of Lockheed Martin’s proposed merger with Titan Corp., which cratered because Titan couldn’t clear itself fast enough from its FCPA problems. Lockheed Martin walked and eventually L-3 acquired the company but there’s a reason you don’t hear much about the former Titan Corp. anymore.1)
Rule #2: There is never enough time or money to perform the due diligence you would like to perform. Instead, you perform the due diligence that’s budgeted and your results are in line with what is being paid for. You can never identify all the risks. You can never verify all the contract ETCs and you can never look at all the purchasing files and you can never examine all the accounting transactions. You simply have to do the best job you can, while hoping the attorneys have structured an escrow or some similar protection into the deal.
So if Rule #1 and Rule #2 are correct, then why bother? That’s a good question. The best answer we’ve been able to come up with is that due diligence efforts often uncover risks that need to be mitigated post-merger. In addition—and this may be the more important reason—the time to start post-merger integration planning is on Day 1 of the due diligence effort. Key questions, such as “Will the acquired entity be left as a stand-alone or will it be fully integrated?” can be addressed during due diligence. The merging of business systems can be addressed. Potential issues with security clearances and government property and any backlog of contracts (and subcontracts) awaiting closure can be addressed. The meting-out of billed and unbilled receivables can be addressed. Reserves for litigation can be addressed. In sum, there’s a whole host of issues – most of which really don’t impact whether the deal happens or craters – that can be discussed during the due diligence process.
Even so, certain risks are going to escape scrutiny. Either they are too hidden to surface, or they do surface but are minimized or ignored during the rush to consummate the deal. Example: somebody looks at the target’s timekeeping system and writes a report saying it’s weak and there could be mischarging going on. That report doesn’t identify any specific mischarging (because there’s no time and/or budget for such an investigation), but it does identify a specific risk. That report is buried in the avalanche of due diligence data and forgotten. Until two years later (well after the merger) when members of the Defense Criminal Investigative Service and the Army Criminal Investigation Division show up at one site and allegations of multiple millions’ worth of time mischarging are dropped on the heads of the integrated entity, seemingly out of nowhere.2
Today we are going to address two somewhat hidden risks.
The first risk is what happens to proposals in the pipeline as of the date of the merger/acquisition/ divestiture. Do those proposals continue under the name of the entity that started them, or do they get submitted under the name of the post-merger entity? And how will the government view the post-merger entity?
In a very recent bid protest decision, the GAO found that the US Army Corps of Engineers had reasonably excluded a proposal submitted by Lockheed Martin Integrated Systems (LMIS) because it was about to merge with Leidos (the spin-off that used to be a part of SAIC). It was appropriate for the awarding agency to conclude “that it could not determine the realism of the protester’s costs and identified other risks associated with the anticipated transaction.” The Source Selection Advisory Council concluded that—
It is unknown, and unknowable, what impacts the new LM-Leidos corporate structure will have on future performance, whether past performance is still a predictor of future performance of offerors, and how small business will be utilized. Therefore, there are potential risks associated with the delivery of the technical capabilities proposed. Based on the above, LMIS’s proposal should therefore not be considered for award.
Similarly, the merger between Engility Corp. and TASC created uncertainty in the mind of the contracting officer and Engility was found to be non-responsible because its facility security clearances were in the name of TASC. (See this protest.) In this case, Engilty’s bid protest was upheld, because there was evidence that Engility had submitted the required paperwork, and updated its CAGE Codes. Thus, the nonresponsibility determination was unreasonable. Note, however, that Engility had to file a bid protest to overcome its exclusion from the shortlist.
To sum up, the impact of the proposed merger/acquisition/divestiture on proposals in the pipeline must be addressed during the due diligence phase. This activity includes running indirect rate simulations, figuring out novations, updating CAGE Codes, and making sure facility and personnel clearances are handled well in advance of the actual effective date of the activity. Also the CAS implications must be considered if one entity is less than fully CAS-covered. (Note: If you don’t know whether you are going to run the post-merger entity as one integrated entity or two stand-alone entities, this is going to be a challenge.)
Now on to the second risk. It’s a bit more subtle and, frankly, we don’t see any practical mitigation strategies at the practitioner level. But let’s talk about it anyway.
It’s about insider trading.
When two publicly traded entities are in discussions regarding a potential merger, acquisition, or divestiture, it’s obvious that there is some money to be made. The company about to be acquired is going to be acquired at a premium from the current share price; that’s a given. If you knew about the transaction in advance you could buy up shares of the entity to be acquired, and then sell them at a handsome profit a short time later when the deal took place.
Now, we’re sure your people would never stoop so low. They are obviously of the highest integrity to start with, plus they signed a special NDA in connection with the due diligence activities, plus they know there’s a downside to being caught. But suppose, just suppose, that they thought they were smarter than you. Suppose they thought they had figured out a fool-proof way to pass on insider information and to hide the proceeds from the use of that insider information. If that’s the case, then maybe they are like this former Global Vice President for SAP, who was just indicted (along with two others) in a “scheme to commit insider trading and money laundering that allegedly resulted in hundreds of thousands of dollars in profits.”
According to the (obligatory) DoJ press release—
The indictment charges all defendants with one count of conspiracy to commit wire fraud and securities fraud, one count of conspiracy to commit money laundering and one count of conspiracy to structure currency transactions involving a financial institution for the purpose of evading the reporting requirements. In addition, Salis is charged with four counts of wire fraud and five counts of securities fraud; Douglas Miller is charged with six counts of wire fraud, five counts of securities fraud and one count of making false statements; and Edward Miller is charged with one count of wire fraud, one count of securities fraud, one count of witness harassment and one count of obstruction of justice.
According to allegations in the indictment, while Salis was employed as a SAP global vice president, he obtained material, non-public information about SAP’s acquisition of Concur, which he disclosed to Douglas Miller in violation of a duty of confidentiality. Douglas Miller, Edward Miller and others then allegedly purchased securities in Concur based on this information for the purposes of profiting from these transactions and returning a portion of the profits to Salis. Following the acquisition, the indictment alleges that Douglas Miller and Edward Miller sold the securities and Douglas Miller made approximately $119,000 and Edward Miller made approximately $149,000. Other traders who allegedly used the information profited a total of approximately $237,000. In order to conceal the nature of the proceeds, the Millers allegedly used cash, money orders and checks to transfer some of their trading profits to Salis. In total, Salis allegedly received nearly $90,000 from his co-conspirators.
Note that nobody has pleaded guilty to those allegations and that people are presumed to be innocent until convicted. Nonetheless, the indictment reminds us all that people will bend their ethics for money, and that confidential information related to a potential merger, acquisition, or divestiture can be perceived to be a path to some easy ill-gotten loot. You probably need to remind your people involved in such confidential deals that, if they decide to sell-out for some cash, they will be caught and prosecuted to the full extent of the law.
We have lots to write about M&A activities but let's start with this one. We trust you enjoyed it!
It was Only a False Statement
When we do our “Welcome to Contract Compliance” training we always spend some time covering the major statutes of which a government contractor needs to be aware. First and foremost is the False Statements Act (18 United States Code § 1001). We’ve written about it on this blog several times. For example, see this article in which we wrote—
We are not lawyers but our understanding of the statute’s requirements can be summed up in one sentence: you cannot lie to government personnel and you cannot create false or fictitious documents, or you will get fined and very likely go to jail. … Our blog has been rife with stories about deceit, lies, false certifications, false representations, and the like – most of which had some dire consequences for those who were found to have been engaging in such duplicitous activities.
Don’t be those people.
Let us reiterate: When you deal with government auditors and government contracting officers and government contracting officer representatives, you must not lie. You must not intentionally mislead. You must not create false, fictitious or misleading documents. If you do, it will be very bad news for you and your company.
Are we clear?
Good.
Now you are ready to read about Andy Persaud of North Potomac, Maryland. At 44 years of age, Andy’s life is pretty much in ruins.
Persaud was indicted in October 2015 and charged with three counts of false statements to the Government and three counts of wire fraud. On February 23, 2016, Persaud pled guilty to one count of making false statements. As a result of his plea deal, Persaud was sentenced to 21 months of incarceration and was ordered to pay $1.2 million.
What did Andy do to merit such a harsh sentence?
According to this Department of Justice press release—
Persaud was the President … of Persaud Companies, Inc., a Virginia and Maryland based construction company that entered into a $4.4 million contract in 2011 to renovate several warehouses at the Naval Support Activity (NSA) facility in Mechanicsburg [Pennsylvania]. Persaud hired approximately 17 sub-contractors to work on the project which began in May of 2012.
In June and July of 2012, Persaud submitted invoices to the Navy for progress payments. In the documents, Persaud attached signed certifications verifying that all of his subcontractors had been paid for their work. Relying on the verity of Persaud’s representations, the Navy paid Persaud $1,206,470 between June and August 2012.
However, by September 2012, most of the subcontractors had walked off the job site and the Navy terminated Persaud’s contract after it learned, contrary to Persaud’s certifications, that none of the subcontractors had received payment for their work on the project.
Fortunately for the subcontractors, Persaud had been required to obtain a bond before starting work, and so the bonding company covered their losses. But Persaud was still on the hook for the false statements contained in his progress payments requests. In our view he was lucky to get off without any allegations of violations of the False Claims Act. Nonetheless, his one agreed-to one count violation of the False Statements Act was sufficient to pretty much destroy him.
And let us note that many Federal contractors incorrectly think a firm, fixed-price (FFP) contract is low risk with respect to audits of costs incurred. Indeed, a FFP contract may be lower risk; but if you are getting contract financing payments (such as requests for progress payments based on costs incurred) then you actually have a relatively high risk contract that requires active monitoring of costs and implementation of controls to ensure that only actual costs made allowable by the contract’s payment clause are being billed.
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