New Rules on Compensation Allowability Add Complexity, Decrease Recovery
On June 26, 2013, the Federal Acquisition Regulation Cost Principle on the allowability of compensation costs (31.205-6) was revised. It was revised via an interim rule. Concurrently, the FAR Council also published a proposed rule that would revise it even more. And what’s worse, the Cost Principle revision in the interim rule is to be applied retroactively to costs incurred (or allocated) to contracts awarded in CY 2012—and the revision was published literally less than a week before contractors’ CY 2012 annual proposals to establish final billing rates were due. And what’s even worse than that is that the proposed rule would also apply retroactively as well—but to a different time period.
What’s a good contractor to do?
Let’s first discuss the interim rule, which is complicated enough all by itself. The rule became effective on June 26, 2013—literally four calendar days before contractors with a 12/31/2012 fiscal year-end would have been required to finalize and submit their annual proposals to establish final billing rates (aka, “incurred cost submissions”). Does the interim rule apply to costs incurred in those contractors’ fiscal 2012? Yes, it does. Perhaps. It applies to some contracts, but not to others.
Did we mention this rule was complex?
Let’s clarify the rule’s requirements:
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For DOD, NASA and Coast Guard contracts awarded after December 31, 2011, the current executive compensation cap is to be applied to all contractor employees, not just the Top Five most highly compensated executives at each segment.
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For contracts awarded by other Executive Branch agencies, the current executive compensation cap is to be applied only to the Top Five most highly compensated executives at each segment.
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The Allowable Cost and Payment Clause (52.216-7) has been modified and now provides a link to a good history of the compensation benchmark. Here is that link.
The timing of the publication was unfortunate, to say the least. We would assert that there would be no way that a contractor of more than medium size could actually implement the rule in the timeframe provided. And notice that the rule was retroactive, applying to contract costs incurred prior to its publication.
The interim rule, as published, requires contractors with contracts from multiple agencies to establish at least three sets of indirect cost rates to be applied to their 2012 contract costs. The first set is for contracts awarded prior to 12/31/2011. The new rule does not apply to those contracts, regardless of awarding agency. The second set is for DOD/NASA/Coast Guard contracts awarded after 12/31/2011, to which the compensation ceiling is to be applied to labor costs directly charged to those contracts. (There is some question in our minds as to whether the ceiling should be—or could be—applied to indirect labor that is allocated to such contracts, especially G&A labor.) The third set of rates is for contracts awarded after 12/31/2011 by Executive Branch agencies other than DOD, NASA, or the Coast Guard. Those rates will default back to the old rule.
And contractors needed to figure this out in four calendar days, most of which were weekend days.
In reality, we suspect most contractors will ignore the new rule’s 2012 application requirements and apply it to their FY 2013 costs. They will argue—with much support and legal precedent—that the rule is retroactive as written, and that the only cost allowability rules with which they need to comply are the ones that were in effect at the time the contract was executed. We suspect they’ll point out that an attempt to retroactively enforce cost allowability rules is, technically, a breach of contract.
The FAR Councils acknowledged as much, writing—
There are challenges with respect to the retroactive application of section 803 (i.e., to the application of section 803 to contracts awarded before the enactment of section 803). The implementation of section 803 is similar to the implementation of section 808 of the National Defense Authorization Act for Fiscal Year 1998 (Pub. L. 105-85, November 18, 1997), which imposed a cap on Government contractor's allowable costs of “senior executive” compensation. Section 808, like section 803, retroactively applied to contracts that already existed on the date of its enactment; both statutes contain text which applied the statute to contracts awarded before, on, or after the date of enactment of the underlying act. In litigation on the application of section 808 to contracts awarded before the date of the enactment of the statute, the courts held that section 808 breached contracts awarded before the statutory date of enactment (General Dynamics Corp. v. U.S., 47 Fed. Cl. 514 (2000); and ATK Launch Systems, Inc., ASBCA 55395, 2009-1 BCA ¶ 34118 (2009)).
We further suspect that, regardless of the merits of that line of argument, DCAA won’t buy it. The audit agency’s reaction may take the form of a rejection (inadequacy) or it may take the form of additional questioned costs. Consequently, contractors need to prepare for DCAA’s reaction and plan their next steps.
Now, on to the proposed rule.
The proposed rule addresses the retroactive application of the compensation caps to DOD/NASA/Coast Guard contracts awarded before December 31, 2011. Labor costs incurred after January 1, 2012 on those contracts would be subject to the compensation ceiling. Thus, the retroactive implementation of the compensation ceiling would be extended back even further than the interim rule would have it be.
We don’t know what Congress was thinking. But you can tell the FAR Councils what you think about either the interim or the proposed rule by submitting your comments. Details regarding how to submit comments on each of the rules can be found in the Federal Register notices—links above.
Take a Memo, Please
We all know that DCAA has developed a taste for checklists. It’s not just DCAA; the DAR Council thinks checklists are a wonderful thing as well. As a result, they are busy revising the DFARS to make use of checklists mandatory. But unlike the DCAA checklists, the DFARS checklists are completed by contractors and submitted to a Contracting Officer for review. The DCAA checklists are completed by auditors and, in some circumstances, can actually take the place of a detailed, GAGAS-compliant audit addressing the allowability, allocability, and reasonableness of a contractor’s claimed final direct and indirect costs.
For those contractors whose interaction with DCAA is limited to the auditor filling-out the checklist to assure that the proposal to establish final billing rates (aka “the incurred cost proposal”) is adequate—in the eyes of DCAA—what happens next? Well, DCAA will issue a Memorandum to the cognizant Administrative Contracting Officer (ACO) “listing the audit steps taken to assure that the contractor’s submission was ‘adequate’ and DCAA’s internal records will record that the contractor’s submission was audited, but that no report was issued. Questioned costs and total exception dollars will be reported as being zero.
A DFARS Class Deviation was issued by the Director, Defense Procurement and Acquisition Policy (DPAP) that permits DCMA Contracting Officers to use the DCAA Memoranda “for purposes of satisfying the audit requirements at FAR 4.804-5(a)(12), 42.705-1(b)(2), and 42.705-2(b)(2)(i).” Since the DCAA Memoranda will not show any recommended cost disallowances, we assume that DCMA will simply accept the dollars and indirect rates proposed by the contractor, and establish final billing rates on that basis.
What Congress will do when somebody tallies up the amount of dollars not audited by the Defense Contract Audit Agency remains to be seen.
But of course that’s not the end of the story. As we told our readers, DCAA will also issue Memoranda in lieu of GAGAS-compliant audit conclusions supported by evidentiary matter as contractors submissions near (or pass) the six-year statute of limitations found in the Contract Disputes Act. We’ve been told that those Memoranda will contain recommended disallowances and/or cost decrements based on average questioned cost issues related to that year (for partially completed audits) or based on average questioned costs related to prior years (for audits not performed at all). The key point is that DCAA will not be expressing a conclusion—just telling the CO about some issues—and so the agency believes it can issue these Memoranda without getting gigged for GAGAS noncompliances.
DCAA’s track record on GAGAS compliance is not particularly noteworthy, according to the DOD Inspector General. The agency can certainly reduce the risk of future scathing IG reports if it stops issuing audit reports. What Congress, GAO, and the IG will make of DCAA’s new risk-reduction strategy remains to be seen.
The onus will be on the DCMA COs and ACOs to establish final billing rates based on those Memoranda. There will be decrements and recommended disallowances, but it seems that those recommendations will be built on a foundation of sand, in terms of support. In other words, our information is that DCAA will be unable (or perhaps unwilling) to support the contents of the Memos, because they will generally lack much (if any) evidentiary support. We predict the situation is going to leave the DCMA folks in a quandary, especially if the contractor pushes back.
Our best information at this time is that if the DCMA CO/ACO believes the DCAA-recommended decrements lack merit or cannot be defended, then the contractor’s proposed costs and rates will be accepted and used to establish final billing rates.
Of course, DCAA’s penchant to issue Memoranda in lieu of formal audit reports is not particularly new. It first came to our attention in connection with the now infamous Contractor Recovery Initiative. In 2011, DCAA issued special audit guidance to permit its auditors to support this high-priority Pentagon initiative. The audit guidance permitted DCAA auditors to calculate their own Rough Order of Magnitude (ROM) estimates of the dollars allegedly owed to the Government from CAS noncompliances and voluntary changes in cost accounting practice, and to issue those ROMS without worrying about pesky requirements such as GAGAS. We suspected at the time that that cunning plan was not going to go well for either DCAA or DCMA.
While we don’t have a lot of evidence as to whether or not our suspicions will be validated, we note (for the record) that the four CAS matters Raytheon recently argued at the ASBCA were each generated out of the Contractor Recovery Initiative. Raytheon prevailed on three of the four, based on untimely Government claims. The fourth matter will be litigated on the merits, and the resulting decision will give us some insight into how well DCAA and DCMA fare in their strategy.
You had better get used to DCAA-issued Memoranda. Until somebody—be it the Courts, Congress, or Pentagon leadership—decides that such Memos are a poor substitute for actually doing audit work in compliance with GAGAS, they seem to be the new norm.
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Protecting the Government’s Interests
We have written quite a bit about the Contract Disputes Act Statute of Limitations (CDA SoL). We’ve written quite a bit because it’s an area where the law is evolving, and because it involves a nice intersection between contract administration and contract cost accounting.
And because it involves DCMA and DCAA.
And you know how much we love to write about Department of Defense oversight agencies.
Anyway, we were discussing issues associated with the CDA SoL with a group of knowledgeable practitioners, and the topic came up about the door swinging both ways. This means that the same Statute of Limitations that prevents the Government bringing an untimely claim against the contractor also means that the contractor cannot bring an untimely claim against the Government. There was much discussion about what to do if one’s final billing rates were significantly in excess of one’s provisional billing rates, and DCAA hadn’t yet gotten around to auditing the proposal to establish final billing rates, and it was nearing the six-year SoL.
What to do indeed.
First of all, we’ve written about this before. We are certain that we’ve addressed this and told our readers that if they let the CDA SoL pass without asserting their claim(s), then they are in a very untenable negotiating position. So this topic is not particularly new news to us or our readers. We confess we got a little bored with the discussion, and our mind wandered a bit.
While others discussed what might be done as they approached their particular SoL deadlines, we started wondering about a slightly different topic.
We wondered how one might avoid getting into this predicament in the first place.
Our first thought was that one should never have provisional billing rates that are significantly lower than one’s proposed final billing rates.
As we’ve discussed before, the Allowable Cost and Payment Clause (52.216-7) states (at 52.216-7(e) Billing Rates) that provisional billing rates “shall be the anticipated final rates.” (Emphasis added.) If, during the course of contract performance, either contracting party believes that the provisional billing rates will be materially different from the final billing rates for the cost accounting period, then either party may request that the provisional billing rates be “prospectively or retroactively revised by mutual agreement … to prevent a substantial overpayment or underpayment.”
So if the parties are complying with the requirements of the Allowable Cost and Payment Clause, then the difference between provisional and final billing rates should be de minimis.
That’s the theory, anyway. We’re quite certain that practice does not match theory in this area. The primary reason for the deviation between theory and practice is that many Contracting Officers apply decrement factors to contractor’s proposed provisional billing rates in order to “protect the Government’s interests.” As a result of the desire to protect the Government’s interests, contractors are only approved to bill at provisional rates that are lower than the estimated final billing rates. The size of the decrements seems to depend on the individual Contracting Officer; some contractors have rather small decrements and others have rather larger decrements. The immediate impact is to reduce contractors’ cash flows, which is annoying, no doubt. But since the provisional billing rates should be synced up to final billing rates over time, the cash flow impact primarily manifests during the current performance year and, accordingly, is perceived as a temporary phenomenon and not something to get overly worked-up about.
There are two opportunities to sync up provisional and final billing rates. The first opportunity is at year-end, when the books close and indirect cost pools and allocation bases are known with some certainty. The other opportunity is when the proposal to establish final billing rates is submitted to the cognizant Administrative Contracting Officer. In that regard, FAR 42.704(e) states—
When the contractor provides to the cognizant contracting officer the certified final indirect cost rate proposal in accordance with 42.705-1(b) or 42.705-2(b), the contractor and the Government may mutually agree to revise billing rates to reflect the proposed indirect cost rates, as approved by the Government to reflect historically disallowed amounts from prior years’ audits, until the proposal has been audited and settled.
And of course, the provisional billing rates may be adjusted at any other time, so as to prevent a substantial overpayment or underpayment.
The express goal of the process is to have the provisional billing rates be as close as possible to the final billing rates that will, eventually, be negotiated and settled by the ACO and the contractor. So if the process is being followed by the contracting parties, then why should a contractor have a significant difference between its provisional and final billing rates, such that it would be compelled to file a “protective claim” with the ACO as the six-year CDA SoL approaches?
The answer would appear to be that either (a) too many Contracting Officers are not adjusting provisional billing rates to better reflect estimated final billing rates, or (b) too many contractors are failing to request adjustments to their provisional billing rates, so as to avoid a significant difference. In the latter case, shame on those contractors. In the former case, shame on those Contracting Officers.
The fact of the matter is that provisional billing rates should closely approximate final billing rates. Imposition of a large decrement factor on a contractor risks the government being unaware of a contract’s true costs, and receiving a large “surprise” when the final billing rates are negotiated. (We note for the record that too-low provisional billing rates do not relieve a contractor from having to comply with the Limitation of Cost/Limitation of Funds clause requirements.) Moreover, from the contractor’s perspective, having provisional billing rates closely approximate final billing rates means that the settlement of final rates will not have a significant impact on cash flow.
Contracting Officers who seek to “protect the Government’s interests” by imposing large decrements that reduce contractors’ provisional billing rates do themselves no favors. Unless those decrements are justified by historically experienced unallowable costs at the contractor, we think there’s a strong argument that those Contracting Officers are violating the express requirements of the 52.216-7 Allowable Cost and Payment Clause. (Remember that the clause states that provisional billing rates “shall be” the anticipated final billing rates. “Shall be” is an imperative direction that the Contracting Officer cannot ignore—see FAR 2.1, Definitions.)
Contractors who let themselves be put at a financial disadvantage by those Contracting Officers do themselves no favor either. Not only have they agreed (if only tacitly) to reduced cash flow, they’ve also let themselves be tied to the Government’s timeline for auditing, negotiating, and settling billing rates. As we all know, that process can take many years.
And for those contractors, as they approach the CDA SoL deadline, they must pay for their past decision(s) by submitting a claim for the money they’ve left on the table, lest they lose their right to assert that claim in the future.
CDA Statute of Limitations: The Path Forward
Remember that time we told you about some conversations with a DCAA auditor? We told you “the story continues,” and indeed it has. Over the past year we have continued to assist our client in continuing to support the continuing DCAA audit of its incurred costs, submitted a very, very long time ago. The reaudit of the previously performed audit has largely wrapped-up, though management review comments have led to a reaudit of the previously performed reaudit of the previously performed audit.
Truly, it is no wonder that DCAA now takes, on average, nearly four years to complete a single incurred cost audit.
But we are coming to the conclusion that DCAA and DCMA have come to the conclusion that they cannot win on disallowances of contractor costs, where the Contracting Officer Final Decision is issued more than six years after the submission of the contractor’s proposal to establish final billing rates.
Now, we believe it’s true (as we told you) that DCAA has implemented a policy to continue audits of submissions that are older than six years—especially on smaller contractors—because the agency believes that those smaller contractors may be ignorant of the recent legal decisions that have tended, generally, to strictly enforce the six-year timeclock. But we are learning that the agency strategy can be overturned, simply by the contractor stating its intention to use the untimeliness of the audit as an affirmative defense (or jurisdictional argument) in litigation. Apparently, the mere mention of the CDA SoL may be sufficient to get the DCAA auditor to stop—or perhaps even cancel—the audit.
That last bit isn’t completely definitive, but that’s what we’re hearing and we have no evidence that it’s not working. We’ll let you know how it goes, as we gain experience with this strategy. So stay tuned.
We are also learning that DCAA is desperately trying to beat the CDA SoL timeclock and support DCMA Contracting Officer rate finalization efforts. Where audits cannot be completed in time, DCAA is issuing Memos in lieu of audit reports. Those Memos are not GAGAS-compliant conclusions.
One minion recently reported to us that the Memos will be based on “average questioned issues in audits for that year.” The minion opined that the resulting recommended decrements would “sound good” but would be "arbitrary," and not be based on evidential matter. DCAA believes it can get away with such deficient findings because the Memos are not expressing conclusions and, accordingly, need not be compliant with GAGAS.
For those who are members of this site, you already have access to the DCMA training slides we posted. Those training slides (dated April, 2013) noted that DCAA had told DCMA that there were some 7,000 Incurred Cost Proposals for years 2008 and earlier that were “unaudited and at risk of going beyond a valid claim date.” The training slides also stated—
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No rates will be established without a DCAA memo or audit report
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If DCAA provides a decrement for consideration in a memo, a one page or less PNO/PNM discussing the basis for the ACO’s decision shall be placed in the incurred cost file
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Direct Costs: ACOs will not apply the DCAA offered decrement to direct costs unless DCAA has specific documentation relating to direct costs or DCAA issues a Form 1 for ACO disposition
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The rate year closeout file will consist of the letter from the ACO conveying the final rates and the DCAA memo. A one page PNO/PNM will be included if the ACO establishes the rates using a DCAA memo and settles at other than at the proposed rates
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The ACO will use the risk specific decrement information to settle rates where possible or issue unilateral rates. ACOs shall accept the rates as proposed if there is no known risk or the contractor does not accept unilateral rates and the ACO determines the decrement is not significant and/or cannot be defended.
So if you are a contractor with an proposal to establish final billing rates that is older than six years, or coming up on that six year due date, you should expect your DCAA auditors to issue a Memo to the ACO recommending a decrement based on prior questioned cost history. (Note: DCAA does not appear to be adjusting for sustention rates.) The ACO is likely to use that Memo in order to establish the final billing rates unilaterally—i.e., without negotiation and without the contractor’s concurrence.
The good news is that you don’t have to accept those unilateral rates, particularly if you can show the DCAA Memo was based on erroneously calculated decrement factors, or used decrement factors based on non-sustained questioned costs. If you can put doubt into your ACO’s mind that the decrement factors cannot be defended in court, then you stand a very good chance of having your proposed final rates be accepted by the ACO.
This is really, really good news for contractors.
The only thing missing from this acceptance of the situation by DCMA and DCAA is the guidance to DCAA FAO Managers that tells them to cancel audits as the six-year deadline approaches and they cannot issue a timely audit report. As we write this, DCAA continues to audit, even after the six-year timeclock expires. We suspect that automaton-like approach will change shortly.
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