Recently we wrote about a Department of Energy Inspector General report in which an audit performed by KPMG led to a DOE Contracting Officer taking action to disallow roughly $1.3 million of General & Administrative expenses that Fluor Federal Services had billed to the Savannah River Nuclear Services joint venture (of which Fluor was the majority owner). Fluor did not agree with the findings of the audit report nor did it agree with the proposed disallowance. We opined that only time would tell whether Fluor “pays up, negotiates a smaller settlement, or takes this issue to Court.”

The thing is, the situation faced by Fluor is far from uncommon. Many contractors are facing the same choices, courtesy of government auditors and cognizant Contracting Officers who have apparently forsaken the official preference, found in the FAR, to resolve potential disputes through negotiation rather than litigation. We even wrote about the phenomenon of increasing litigation in this article.

And yet we have to acknowledge that the DOE is publishing guidance to its Contracting Officers that, if followed, will tend to reduce cost-related disputes and avoid litigation. We are talking about the April 2013 version of the DOE Acquisition Guide, especially section 31.4 (Allowability of Incurred Costs). Here’s a link to the official document.

The Guiding Principle of the document is stated clearly:

Determining the allowability of incurred costs requires understanding the five FAR requirements for reimbursement. The subject is complex. Misunderstandings can be minimized by early communication.

Did you notice that seemingly obvious—and yet profound—statement at the end of the Guiding Principle? We couldn’t agree more: Misunderstandings can be minimized by early communication!

Oh, but there’s more.

The Guide states—

The chapter also encourages Contracting Officers to be proactive in minimizing potential disputes over cost reasonableness and to communicate their view of a potentially troublesome cost’s reasonableness to their contractors in writing before the cost is incurred.

Again, advice that’s seemingly obvious and yet so important. But if it’s so obvious, then why is the advice so rarely followed? Ponder that for a second.

The Guide discusses cost reasonableness, cost allowability, and allocability. That’s good stuff and we hope COs review it in detail. But the part that caught our eye was the role of early communication and Advance Agreements in avoiding disputes. We so like the language that we are going to print it here, in full.

Disputes over an incurred cost’s reasonableness can be a source of unnecessary friction between the Government and a contractor. Once the contractor has incurred a cost in fulfilling its obligations under its contract it is understandable if the contractor is extremely reluctant to pay the cost out of its own pocket. Courts and Boards have been sympathetic to contractors’ appeals of Government decisions to disallow costs because the costs were unreasonable.

On the other hand, if the contractor knows before it incurs a cost that the cost’s reasonableness will be questioned, most disputes regarding a cost’s reasonableness can be avoided. A contractor would likely avoid incurring any cost the Government had indicated it would consider unreasonable.

Advance agreements are not always employed. And it is neither practical nor desirable to address every cost under every circumstance under cost-reimbursement contractual arrangements. There are occasions, however, where the Government is aware the contractor may be contemplating incurring certain costs that would likely lead to disputes over their reasonableness. In such situations, both parties will benefit from a statement from the Contracting Officer indicating what the Government will consider reasonable.

Those are the kind of words that come from an entity that is looking to avoid disputes and litigation. You won’t find those words in the DCMA OneBook. And more’s the pity.

Similarly, we would love to see DCMA adopt the following CO guidance—

In administering cost-reimbursement contracts and other contractual vehicles under which the Government must reimburse a contractor’s incurred costs, Contracting Officers should consider if it is prudent to specify what the Government will consider reasonable regarding a particular cost prior to the contractor’s incurring the cost. The Contracting Officer may proscribe the cost, set a ceiling on the cost, establish criteria for determining the reasonableness of the cost, or take any other action he/she deems prudent to avoid unnecessary disputes regarding the reasonableness of a potential future cost before the contractor incurs it. Contracting Officers should attempt to accomplish such understandings working with contractors, but if circumstances do not permit mutual agreement to be reached in a timely manner they should not hesitate to take unilateral action. Written communication of any ilk from a Contracting Officer to a contractor will help minimize misunderstandings over what the Government will consider reasonable.

[Emphasis added.]

May we close by offering the opinion that DCMA would do well to adopt both the philosophy and the guidance of the Department of Energy? May we respectfully suggest that it’s past time for the adversarial relationship between the Pentagon and its contractors to be replaced by a more cooperative relationship that acknowledges the partnership that is necessary for both parties to accomplish their objectives?

If DOD doesn’t start proactively issuing guidance to its COs to help prevent disputes and avoid litigation—guidance similar to the DOE language we’ve quoted here—then the tsunami of litigation will continue to swell until it inundates the courts, ultimately leaving only the attorneys on dry land.

Government contract cost accounting practitioners recognize that not all Cost Accounting Standards are created equal. Some Standards, such as CAS 406 or 407, are generally considered to be more straightforward and comprehensible than others; whereas some of those other Standards (e.g., CAS 415) are generally considered to be tough nuts to crack.

In other words, some Standards are more difficult than others to comply with. The two pension Standards—CAS 412 and 413—definitely fall into the “tough nuts to crack” category. They are considered by most practitioners to be perhaps the most difficult and complex Cost Accounting Standards to understand, let alone comply with. They are more difficult for a variety of reasons, not the least of which is that you need a really good actuary to help make the necessary adjustments between GAAP accounting and government contract cost accounting.

They are so complex that, when revised in 1995, the revisions initiated a “storm of litigation” that continues to this day. And the litigation involves big dollars, too. In many cases, there may be literally tens of millions of dollars at stake.

Take, for example, General Dynamics’ appeal of a Contracting Officer’s Final Decision asserting that GD was in noncompliance with the requirements of CAS 412 for its Fiscal Years 2005 through 2009. It was estimated that approximately $53 million (plus interest) rode on the outcome.

The issue was GD’s use of actual market returns on its pension plan assets instead of actuarial “expected” returns, for purposes of calculating its Forward Pricing Rates. Just to give you a hint of both the complexities and big numbers involved, let’s throw out some numbers from the June 2011 ASBCA decision.

• The market value of GD’s pension plan assets (as of 1 January 1994) was $2,122,371,000.

• The actuarial value of GD’s pension plan assets (as of 1 January 1994) was $1,697,968,000.

• The “expected” actuarial value of GD’s pension plan assets (as of 1 January 1995) was $1,772,424,000.

• The “projected” market value of GD’s pension plan assets (as of 1 January 1995) was $1,998,698,000.

Since 1986, GD consistently estimated the next year’s market value of its pension plan assets using the actual market performance from the preceding year. For Forward Pricing purposes, future years’ performance was estimated assuming an 8 percent return on assets. When GD updated Forward Pricing Rates during the year (as it did from time to time), it used actual Year-to-Date performance plus an estimated 8% return for the unknown balance of the year. The government acquiesced to GD’s methodology for 20 years, but in 2006 the government objected to GD’s methodology for the first time, asserting that it violated the requirements of CAS 412. The government’s issue was that CAS 412 allegedly required use of actuarial assumptions that reflect long-term trends, so as to avoid distortions caused by short-term fluctuations; whereas GD’s methodology reflected short-term results.

In its response, GD noted that, under the Truth-in-Negotiations Act (TINA) it was required to identify cost or pricing data that was “accurate, current, and complete”—and thus was required to update actuarial assumptions with actual cost information where known. GD also argued that its market return data was “historical fact” and not an actuarial assumption of any sort. GD also asserted that using actual market returns reflected its “best estimate” of pension costs to be incurred, and thus complied with the fundamental requirement of CAS 412.

Judge Peacock, writing for the ASBCA, found that a fact is not an assumption, when viewed in isolation. However, when viewed in the context of pension accounting, the rate of return of plan assets was an actuarial assumption subject to the requirements of CAS 412. Judge Peacock also found that there was no conflict between the CAS pension measurement requirements and the FAR Part 15 TINA requirements, writing—

There is no conflict between the CAS and FAR cost or pricing data requirements. Although the FAR does require submission of ‘accurate, complete and current’ cost or pricing data for consideration, it does not dictate the relative importance of submitted data or how that data will be used in cost estimation, negotiation and pricing. Appellant assumes that the most current data is also the most accurate and complete data. That may or may not be the case. Appellant's assumption is particularly problematic here because the RPFPRs [Revised Proposals for Forward Pricing Rates] specifically (and pension cost estimation generally) are intended to make projections a number of years into the future. Moreover, the government maintains that the relevant ‘current’ (as well as most accurate) data is that required for use in the CAS 412 measurement methodology.

GD lost. It filed a Motion for Reconsideration. It lost that Motion as well. Then it filed an Appeal at the Federal Circuit. It lost there as well. Notably the decision was divided, with what seemed to us to be a well-reasoned dissenting opinion from Judge Wallach.

Let’s first look at the majority ruling, which affirmed the ASBCA decision. As might be expected, the Appellate decision essentially reiterated the ASBCA’s logic. For example, Judge Lourie, writing for the majority, wrote that—

We agree with the government that General Dynamics’ use of midyear market values and the subsequent blended rate for the base year violate CAS 412-50(b)(4). First, both the midyear market value and the subsequent blended rate are actuarial assumptions. CAS 412-30(a)(3) defines an ‘actuarial assumption’ as an ‘estimate of future conditions affecting pension cost.’ As a matter of principle, we agree with General Dynamics’ proposition that the actual value of the plan assets on a given day is a historical fact, not an actuarial assumption. That historical fact, however, must be distinguished from the two decisions concerning which data point to use and how that data point affects the established rate. …

Contrary to General Dynamics’ assertion, the presumed accuracy of the midyear value in the base year does not make the use of that value and the subsequent blended rate compliant with CAS. Indeed, the ‘accuracy’ argument raised by General Dynamics ignores the fact that the forward pricing rate is not only for the base year, but for a projection from three to nine years into the future. Indeed, even if General Dynamics’ approach may be an accurate representation over the short term, that is only because it impermissibly reflects short-term fluctuations. General Dynamics’ method improperly locks in that short-term fluctuation causing a distortion that alters the level of growth throughout the rest of the projection.

Judge Wallach did not agree with the majority opinion. He wrote—

The ASBCA’s decision denying GD’s appeal rests on two invalid assumptions, either of which, if corrected, is sufficient to mandate reversal: First, GD’s use of current, intra-year data is not an ‘actuarial assumption’ within the meaning of CAS 412; Second, even if the data used is an actuarial assumption, the actuarial assumption does not result in ‘distortions caused by short-term fluctuations.’ CAS 412-50(b)(4). For each reason, the Government did not carry its burden to prove a CAS violation. …

There is no evidence that GD’s use of intra-year data results in distortions caused by short-term fluctuations. To the contrary, the record reveals that GD’s method has proven more accurate. We should not require companies to abandon decades-long practices that are compliant with the CAS for less accurate calculating methods suggested by the Government.

Unfortunately for General Dynamics, any future hopes rest with the Supreme Court. And, as we all know, SCOTUS does not agree to hear very many government contracts cases.

For the rest of you, consider this: General Dynamics is one of the largest defense contractors in the world. It has access to some of the best accountants, actuaries, and attorneys. And it still ran afoul of DCAA. GD’s situation ought to make you worried—because if GD can screw up CAS compliance, then so can you.