FAR Overhead Audits The Good the Bad and

FAR Overhead Audits – “The Good, the Bad, and the Ugly” Presented by: G. Antonio (Tony) Kenon, CPA, CGMA

Poll Audience § Auditors § Controllers/CFO’s, CEO’s or management of a Company § Contracting officers, procurement officers, other Government Officials § Of the auditors in the room (Government and private) how many of you assist the audited contractor with at least preparing certain aspects of their OH schedule? 2

Learning Objectives § Enhance your understanding of the applicable authoritative guidance § Enhance knowledge of the fundamentals in performing an overhead rate audit • Understanding of some common types of findings and disallowances 3

Agenda 1. Overview of Authoritative Guidance – “Conceptual Framework” a. Accounting and Allowability Standards b. Auditing Standards 2. Fundamentals of an OH Audit – From Planning to Reporting 3. Common Issues and Findings Noted When Performing OH Audits 4. Q & A In the interest of time, general overview of many topics versus an in-depth on one or two topics 4

Polling Question: Phoenix was originally known as: A. Stonewall B. Pumpkinville C. Hohokam D. Salina 5

Answer: It was first called Pumpkinville, due to the large pumpkins that flourished in fields along the canals. Finally, Lord Darrell Duppa suggested the name “Phoenix”, as it described a city born from the ruins of a former civilization. 6

Authoritative Guidance Two Worlds: § Accounting and Allowability § Auditing 7

Authoritative Guidance - Accounting Polling Question: Which of the following is considered authoritative guidance for private, for-profit contractors when preparing their overhead rate schedule? A. IRS Tax Rules for Cost Deductibility B. Governmental Accounting Standards C. Federal Travel Regulations D. Federal Acquisition Regulations 8

Authoritative Guidance - Accounting § Generally Accepted Accounting Principles “GAAP” – codified in the Accounting Standards Codification (ASC) by Topic § Federal Acquisition Regulations “FAR” § Cost Accounting Standards “CAS” We will look at each one in more depth 9

Authoritative Guidance - Auditing Polling Question: Which of the following is considered authoritative guidance for auditors when auditing an overhead rate schedule? A. DCAA (Defense Contract Audit Agency) Audit Manual B. ASCE (American Society of Civil Engineers) Audit Manual C. Government Auditing Standards D. International Standards on Auditing 10

Authoritative Guidance - Auditing § Generally Accepted Auditing Standards “GAAS” § Generally Accepted Government Auditing Standards “GAGAS” (also know as the “Yellow Book”) December 2011 Revision § AICPA Attest Standards 11

AASHTO Audit & Accounting Guide § Non-authoritative practice aid brings together accounting and auditing concepts found in authoritative guidance into a convenient format § Tool that consolidates relevant FAR and CAS principles as well as auditing standards 12

GAAP and the Codification 13

Brief Overview of the Codification Polling Question: Have you heard of the Accounting Standards Codification (“ASC”)? 14

Brief Overview of the Codification What is the Codification? § The source of authoritative US GAAP recognized by FASB § An effort to reduce the complexity of accounting standards and to facilitate international convergence: - The effort resulted in a major restructuring of accounting and reporting standards § Topically organized format (approximately 90 topics) 15

Brief Overview of the Codification What is the Codification (continued)? § It is NOT intended to change U. S. GAAP § It superseded existing sources of U. S. GAAP, and any prior sources of U. S. GAAP not included in the Codification or grandfathered are not authoritative § It is the authoritative source for U. S. GAAP in addition to guidance issued by the SEC § If it is not in the Codification, it is not U. S. GAAP for Non. Governmental Entities 16

Codification Structure 17

Brief Overview of the Codification How is the Codification Structured? Areas Topics Subtopics Sections Subsections 18

Brief Overview of the Codification How is the Codification Structured? (continued) § Topics: - Broadest categorization of related content (for example, FASB ASC 405, Liabilities) - Correlate with IFRS / IAS standards § Subtopics: - Represent subsets of a topic (for example, FASB ASC 405 -20, which discusses the extinguishment of liabilities) - Generally distinguished by type or scope 19

Brief Overview of the Codification How is the Codification Structured? (continued) § Sections: - Represent the nature of the content in a subtopic - Examples are recognition, disclosure, and subsequent measurement 20

Brief Overview of the Codification How is the Codification Structured? (continued) § Subsections: - Allow further segregation and navigation of content - Occur in a limited number of cases - Unlike sections, subsections are not numbered 21

Brief Overview of the Codification Old Referencing General FASB Codification (New) FAS 5 ASC 450 Contingencies FAS 13 ASC 840 Leases – Operating and Capital FAS 109/ FIN 48 ASC 740 Income Taxes FAS 141(R) ASC 805 Business Combinations Note: ü There is a proposal to amend the FAR to update references to GAAP due to the codification 22

Brief Overview of FAR/CAS What is the FAR? Polling Question: 1. What is the FAR? 2. What is the purpose of the FAR? 23

Brief Overview of FAR/CAS FAR: Background § The Federal Acquisition Regulation (FAR), which had its beginnings in the Armed Services Procurement Regulation established in 1947 governing the federal government’s purchasing process § The FAR was codified in Title 48 of the Code of Federal Regulations (CFR) in 1984 to create a uniform structure for many federal agencies § Its purpose is to ensure purchasing procedures are standard, consistent, and conducted in a fair and impartial manner 24

Brief Overview of FAR/CAS FAR: Cost Principles Contracts Polling Question: What three elements must a cost have to be recoverable? 25

Brief Overview of FAR/CAS FAR: Cost Principles Contracts § The FAR Cost Principles: - Before a contractor may recover a particular cost, it must be: 1. Allowable (per FAR Part 31 and Contract) 2. Allocable 3. Reasonable - FAR Part 31 defines when and to what extent costs can be recovered under a government contract - The government can recover costs found not allowable, reasonable, or allocable to the contract 26

Brief Overview of FAR/CAS FAR Cost Principles (continued) FAR Part 31. 205 Contains about 50 selected costs § Expressly Allowable § Expressly Unallowable: - Costs specifically classified as unallowable: • Government won’t pay under any condition 27

Brief Overview of FAR/CAS FAR Cost Principles (continued) What Are Some Examples of Expressly Unallowable Costs alcoholic beverages entertainment - games, shows contributions / donations legislative lobbying fines & penalties bad debts club dues - social or health flowers (any reason) golf, tennis, fishing dinner tickets over per diem expenses traffic tickets non business subscriptions 28

Brief Overview of FAR/CAS FAR: Cost Principles Contracts Polling Question: True or False: If a cost is not mentioned in FAR Part 31. 205, it is automatically allowable 29

Brief Overview of FAR/CAS FAR Cost Principles (continued) FAR Part 31. 205 does not cover every element of cost § If a cost is not mentioned it does not imply that it is either allowable or unallowable § Determination of allowability is analogously based § Use cost principle that most specifically addresses or best captures the essential nature of the cost at issue 30

Brief Overview of FAR/CAS What is the CAS? Polling Question: 1. What is the CAS? 2. What is the fundamental objective of the CAS? 31

Brief Overview of FAR/CAS CAS: History § The CASB (“Cost Accounting Standards Board”) was established as an agency of Congress in 1970, dissolved in 1980, reinstated in 1988 § Authorized to develop cost accounting standards § The CASB has issued 19 costing accounting standards (“CAS”) that have the full effect of law 32

Brief Overview of FAR/CAS CAS: Objective § Uniformity and consistency in cost accounting 33

Brief Overview of FAR/CAS § CAS: CAS is concerned with three areas in cost accounting: 1. Measurement of cost 2. Assignment of cost to cost accounting periods 3. Allocation of cost to cost objectives 34

CASB Standards 401 Consistency in Estimating, Accumulating and Reporting Costs 402 Consistency in Allocating Costs Incurred for the Same Purpose 403 Allocation of Home Office Expenses to Segments 404 Capitalization of Tangible Assets 411 Accounting for Acquisition Costs of Material 412 Composition and Measurement of Pension Costs 413 Adjustment and Allocation of Pension Cost 414 Cost of Money as an Element of the Cost of Facilities Capital 405 Accounting for Unallowable Costs 415 Accounting for the Cost of Deferred Compensation 406 Cost Accounting Period 416 Accounting for Insurance Cost 407 Use of Standard Costs for Direct 417 Cost of Money as an Element of Material and Direct Labor the Cost of Capital Assets Under Construction 408 Accounting for Costs of 418 Allocation of Direct and Indirect Compensated Personal Absence Costs 409 Depreciation of Tangible Capital 419 Unused Assets 410 Allocation of Business Unit 420 Accounting for Independent General and Administrative Research and Development Expenses to Final Costs and Bid and Proposal Objectives Costs (IR&D and B&P) 35

CASB Standards Polling Question: True or False: All Contractors must follow all 19 Cost Accounting Standards? 36

CASB Standards Answer: False Full CAS Coverage: All 19 Standards apply only to Contracts subject to “Full” CAS Coverage ($50 million award or net CAS covered awards of $50 million or more in the preceding cost accounting period) “Modified” CAS Coverage The following 4 Standards apply “Modified” CAS Coverage ($7. 5 million federal award): 401 - Consistency in Estimating, Accumulating and Reporting Costs 402 - Consistency in Allocating Costs Incurred for the Same Purpose (FAR 31. 202) 405 - Accounting for Unallowable Costs 406 - Cost Accounting Period 37

CASB Standards Exempt from CAS Coverage: 48 CFR 9903. 201 -1 summarizes those contracts and contractors that are exempt from all CAS Standards For example: Contracts and subcontracts with small businesses. FAR Subpart 19. 3 addresses determination of status as a small business Contracts or subcontracts less than $7. 5 million 38

Brief Overview of FAR/CAS CAS: CAS and Cost Principles Are Not One and the Same § CAS addresses cost accounting on government contracts (“cost allocability”) § The cost principles “FAR” - address cost allowability § Cost allowability is a procurement matter and is a function of law, regulation, or contract Question: Can an unallowable cost be allocable? Answer: Yes, costs may be allocable but unallowable 39

Brief Overview of FAR/CAS FAR V. CAS What’s the difference? § FAR = Cost Allowability/Procurement § CAS = Cost Allocability 40

Auditing World 41

Authoritative Guidance – Auditing § Generally Accepted Auditing Standards (AICPA) § Attestation Standards (AICPA) § Government Auditing Standards (GAO – “Government Accountability Office”) We will look at each one in more depth 42

Auditing World – Generally Accepted Auditing Standards 43

Brief Overview of Generally Accepted Auditing Standards § General standards: - Audits are to be performed by a trained and proficient auditor - All matters relating to the assignment should be addressed with an independence in mental attitude - Due professional care is to be exercised 44

Brief Overview of Generally Accepted Auditing Standards § Standards of field work: - Work is to be adequately planned and properly supervised - To assess the risk of material misstatements, a sufficient understanding of the entity is necessary - Appropriate audit evidence is to be obtained through auditing procedures performed to afford a reasonable basis for an opinion 45

Brief Overview of Generally Accepted Auditing Standards § Standards of reporting: - Report whether the financial statements are presented in accordance with generally accepted accounting principles - Report the circumstances in which principles have not been consistently observed in the current period - Informative disclosures in the financial statements are to be reasonably adequate 46

Auditing World – AICPA Attestation Standards 47

AICPA ATTEST STANDARDS Three levels of service: § Examination § Review § Agreed-Upon-Procedures 48

AICPA Attest Standards There are currently 13 Attestation Standards § Attest Engagements AT sec. 101 Establishes a framework for attest engagements and outlines general attestation standards, including examples of examination reports and review reports Note: The Examination Standards (AT sec. 101) are incorporated in GAGAS Chapter 5, “Standards for Attestation Engagements”. Nice bridge back to AICPA Standards. 49

AICPA Attest Standards § SSAE No. 10 (as amended by SSAE No. 11) AT sec. 201 Agreed-Upon Procedures Engagements Outlines attestation standards and guidance applicable to practitioners performing and reporting on most types of agreed-upon procedures engagements § Compliance Attestation AT sec. 601 Provides guidance applicable to practitioners performing engagements related to an entity's compliance with requirements of specified laws, regulations, rules, contracts, or grants or engagements related to the effectiveness of an entity's internal control over compliance with specified requirements 50

Auditing World – GAGAS Also Known as “Yellow Book” 51

Brief Overview of GAGAS Under Government Auditing Standards, auditors follow the general standards included in Chapter 3 of the Yellow Book § Independence § Professional Judgment § Competence § Quality Control and Assurance 52

Brief Overview of GAGAS § For financial statement audits – GAGAS currently incorporate the fieldwork and reporting standards of generally accepted auditing standards (GAAS) and the related SASs issued by the AICPA § Under GAGAS, auditors also have fieldwork and reporting responsibilities that go beyond the AICPA standards, and are in addition to the AICPA standards 53

Brief Overview of Yellow Book Revision § Maintain independence when performing non-audit services (non-audit involvement) § If you prepare or help Contractor to prepare the OH schedule, need to buildin independence safeguards to comply with the revised Yellow Book Standards § Also, significant FAR-type audit adjustments might impair independence under the new Yellow Book Standards § Non-audit service practice aid available at AICPA Website: http: //www. aicpa. org/Interest. Areas/Governmental. Audit. Quality/Resources/A udit. Practice. Tools. Aids/Pages/Yellow. Book. Audit. Toolsand. Aids. aspx 54

Brief Overview of an Overhead Audit 55

Overview of How Our Firm Executes Overhead Audits for an A&E Company Three Major Components: § Planning and Risk Assessment Procedures § Further Audit Procedures (Internal Control Testing and “Substantive Audit Procedures”) § Reporting Materiality: § Used to Frame Audit Scope, Planning and Preliminary Analytical Review § All Disallowances are Reported as Adjustments Regardless of Materiality – GAGAS Public Accountability Concept (GAGAS 4. 26) 56

Audit Planning and Risk Assessment 57

Planning – Engagement Arrangements In the engagement letter: § Clarify granting access of audit working papers to Government officials and their representatives § Chapter 4. 16 Yellow Book: When performing GAGAS financial audits and subject to applicable provisions of laws and regulations, auditors should make appropriate individuals, as well as audit documentation, available upon request and in a timely manner to other auditors or reviewers. Underlying GAGAS audits is the premise that audit organizations in federal, state, and local governments and public accounting firms engaged to perform a financial audit in accordance with GAGAS cooperate in auditing programs of common interest so that auditors may use others’ work and avoid duplication of efforts. The use of auditors’ work by other auditors may be facilitated by contractual arrangements for GAGAS audits that provide for full and timely access to appropriate individuals, as well as audit documentation 58

Planning and Risk Assessment Procedures § GAGAS requires that the audit be properly planned § GAGAS requires auditors to document understanding of internal controls (accounting and compliance) - Accomplished through ICQ, walk-throughs and flowcharts (AASHTO Audit Guide Appendix B). Would be a good practice aid § GAGAS requires that proper audit risk assessment be performed 59

Planning and Risk Assessment Procedures Audit Risk Formula Polling Question: What is Audit Risk? 60

Planning and Risk Assessment Procedures Answer: Risk that an inappropriate opinion is rendered due to a material misstatement in the overhead rate schedule Audit Risk Formula AR = IR x CR x DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk 61

Planning and Risk Assessment Procedures Contractor’s fundamental assertions in a FAR based overhead rate schedule: 1. Occurrence 2. Accuracy 3. Allowability 4. Allocability 5. Reasonableness 62

Planning and Risk Assessment Procedures Inherent Risk The risk of a material misstatement occurring in an assertion assuming no related internal controls Related to: § Nature of the Consultant or industry § Nature of the financial statement account § Complexity of the Consultant (e. g. , Decentralized Operations) 63

Planning and Risk Assessment Procedures Control Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the Consultant’s internal controls 64

Planning and Risk Assessment Procedures Detection Risk that the auditors’ procedures will conclude that no material errors are present when in fact there are 65

Planning and Risk Assessment Procedures Illustration of Audit Risk 66

Planning and Risk Assessment Procedures Audit Risk Polling Question: Which risk can auditor directly control? 67

Planning and Risk Assessment Procedures Audit Risk of Material Risk that the Auditors Audit Risk = Misstatement * Fail to Detect the Misstatement = Inherent Control Detection Risk * Risk Audit Risk: Risk that an inappropriate opinion is rendered on the Schedule of Overhead due to a material misstatement It is a function of risk of material misstatement and detection risk 68

Planning and Risk Assessment Procedures Typical “higher inherent risk” areas: § § § Bonuses Compensation reasonableness Depreciation Rent Indirect labor Marketing, bid and proposal costs Legal and professional costs Vehicle costs Corporate or segment allocation costs Cost pools for internally generated costs (remember CAS 402) Travel, entertainment, meetings 69

Planning and Risk Assessment Procedures Test of internal controls common cycles: § Control Environment § Payroll and job costing – detailed payroll cycle audit (minimum sample 26 time sheets per AASHTO audit guide) § Direct costs – none in overhead cost pool § Expense approval, expense coding (general ledger account and if applicable to discipline) § FAR Allowability screening § Subcontractor monitoring § IT controls § Spreadsheet controls 70

Planning and Risk Assessment Procedures Additional Items to Consider - Evaluate and test controls over: § Consistency in allocating costs for the same purpose CAS 402: - Should not charge a cost direct if those same kinds of costs have been charged indirect § Accounting for unallowable costs CAS 405: - Must have a process to identify unallowable costs and segregate those costs 71

Planning and Risk Assessment Procedures Control Risk to be assessed as low – need to audit key controls Controls need to be: § Suitably designed, and § In operation v Sample size needs to be sufficient to support a “Low” Risk Assessment Question: What if control risk is assessed at high? What should the auditor do? 72

Planning and Risk Assessment Procedures Polling Question: 1. Are auditors required to specifically address the risk of fraud? 2. What are some types of fraud risk in an overhead audit? 73

Planning and Risk Assessment Procedures § Don’t forget about fraud § Address fraud risk – SAS 99 and GAGAS 4. 10 -4. 13 requirement § Internal fraud brain storming 74

Planning and Risk Assessment Procedures Pulling it all together: § Detailed analytical review of overhead schedule line items § Utilize the results of our internal control work and results of our detailed analytical review § Assess Risk of Material Misstatement by account for each relevant assertion § Based on this risk assessment, further audit procedures are developed 75

Planning and Risk Assessment Procedures § So that detection risk can be at an appropriately low enough level § Goal: Audit risk at an appropriate level to render an opinion 76

Planning and Risk Assessment Procedures Example 1: Professional Fee Expense Accounts Relevant Assertion: Allowability AR = IR x CR x DR Low = High x Should be Low Question: What further substantive audit procedures should be performed? Would analytics alone be sufficient? 77

Planning and Risk Assessment Procedures Example 2: Professional Fee Expense Accounts Relevant Assertion: Allowability AR = IR x CR x DR Low = High x Low x Could be moderate or Low Question: What further substantive audit procedures should be performed? 78

Planning and Risk Assessment Procedures SAS 110 Guidance § The greater the risk of material misstatement, the less detection risk that can be accepted; consequently, the greater the extent of substantive procedures § Because the risk of material misstatement includes consideration of the effectiveness of internal control, the extent of substantive procedures may be reduced by satisfactory results from tests of the operating effectiveness of controls § Tests of details are ordinarily more appropriate to obtain audit evidence regarding certain relevant assertions about account balances, including existence and valuation 79

Further Audit Procedures 80

Further Audit Procedures § Audit account balance detail for those accounts that have a high risk of material misstatement (high inherent and control risk) § Normally employ a combination of high dollar value items and monetary unit or statistical sampling § We obtain support (audit evidence) to validate that cost occurred, allocable and allowable § Remember: GAGAS and GAAS third fieldwork standard requires that audit evidence obtained be sufficient and appropriate 81

Audit Evidence Polling Questions (What is sufficient and appropriate audit evidence? ): Are the following audit evidence sufficient and appropriate to support claimed costs? : 1. Credit card statement only to support office supplies 2. Hand-written receipt for a catered dinner to discuss strategic planning on Hotel Stationery 3. Employee Expense Report to support inter-office travel 4. Visa/Master Card receipt, no notation on receipt with charge coded to B&P account in overhead 82

Audit Evidence Appropriateness of Audit Evidence: To be appropriate audit evidence must be: § Relevant § Reliable 83

Audit Evidence Travel Costs: FAR 31. 205 -46(a)(7) states that costs are allowable only if the contractor maintains specific documentation to support claimed travel costs For claimed costs to be allowable, the following information must be documented: (1) date and place (city, town, or other similar designation) of the expenses, (2) purpose of the trip; and (3) name of person on trip and that person’s title or relationship to the contractor Per DCAA Contract Audit Manual Section 7 -1002. 2: This information must be maintained in a book, diary, account book, or similar records. Documentation such as cancelled checks, credit card receipts, and hotel bills are to be maintained as corroboration for expenses, but without the diary or similar records, they may not be sufficient support for deductibility 84

Reporting 85

Reporting The Auditor’s Risk Assessment Procedures and Substantive Further Audit Procedures performed in conformity with GAAS/GAGAS should be sufficient to do the following: § Reduce Audit Risk to an appropriate level to allow for the Issuance of an opinion on the schedule of overhead costs § Issue a combined report on internal controls over financial reporting and on compliance with applicable provisions of laws, regulations, and provisions of contracts or grant agreements including Part 31 of the FAR and other matters 86

Reporting Auditor is required to report deficiencies in internal controls and any instances of noncompliance with applicable provisions of laws, regulations, and provisions of contracts and grant agreements including Part 31 of the FAR. This includes the following: 1) Significant deficiencies and material weaknesses in internal control 2) Instances of fraud and noncompliance with provisions of laws or regulations that have a material effect on the audit and any other instances that warrant the attention of those charged with governance 3) Noncompliance with provisions of contracts or grant agreements that has a material effect on the audit 4) Abuse that has a material effect on the audit 87

Reporting Management’s response: § If there is internal control or other findings reported, should obtain and report the views of responsible officials of the audited entity 88

Reporting Internal control reporting is governed under SAS No. 115 and GAGAS Paragraph 4. 23 – 4. 27 Three categories of internal control deficiencies: § Control deficiency § Significant deficiency § Material weakness 89

Reporting SAS No. 115 Definition of a Control Deficiency “A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct misstatements on a timely basis” Remember Two Key Requirements for a Control: • Must be suitably designed – robust enough to meet its objective • AND in operation – you have to do it 90

Reporting § SAS No. 115 Definition of a Material Weakness “A material weakness is a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the Contractor’s overhead schedule will not be prevented, or detected and corrected on a timely basis” § SAS No. 115 Definition of a Significant Deficiency “A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance” 91

Reporting SAS No. 115 provides evaluation criteria to assist auditors in categorizing internal control findings: § Control deficiencies § Significant deficiencies § Material weaknesses There is an element of judgment: § Practical consideration: If there are significant FAR audit adjustments but no significant deficiencies and/or material weaknesses reported, auditors should consider documenting why 92

“Slight Detour” 93

Business Systems Definition of Accounting Systems Polling Question: Does FAR have a definition of an accounting system? 94

Business Systems Definition of Accounting Systems FAR Supplement 252. 242 -7006 Accounting System Administration “Accounting system” means the Contractor’s system or systems for accounting methods, procedures, and controls established to gather, record, classify, analyze, summarize, interpret, and present accurate and timely financial data for reporting in compliance with applicable laws, regulations, and management decisions, and may include subsystems for specific areas such as indirect and other direct costs, compensation, billing, labor, and general information technology 95

Business Systems Definition of Accounting Systems FAR 252. 242 -7006 Accounting System Administration Acceptable accounting system” means a system that complies with the system criteria in paragraph (c) of this clause to provide reasonable assurance that: - Applicable laws and regulations are complied with - The accounting system and cost data are reliable - Risk of misallocations and mischarges are minimized, and - Contract allocations and charges are consistent with billing procedures 96

Business Systems – Accounting Systems Criteria There are 18 -criteria in FAR 252. 242 -7006 paragraph (c) as follows: (c) System criteria. The Contractor’s accounting system shall provide for: 1) A sound internal control environment, accounting framework, and organizational structure 2) Proper segregation of direct costs from indirect costs 3) Identification and accumulation of direct costs by contract 4) A logical and consistent method for the accumulation and allocation of indirect costs to intermediate and final cost objectives 97

Business Systems – Accounting Systems Criteria 5) Accumulation of costs under general ledger control 6) Reconciliation of subsidiary cost ledgers and cost objectives to general ledger 7) Approval and documentation of adjusting entries 8) Management reviews or internal audits of the system to ensure compliance with the Contractor’s established policies, procedures, and accounting practices 98

Business Systems – Accounting Systems Criteria 9) A timekeeping system that identifies employees’ labor by intermediate or final cost objectives 10) A labor distribution system that charges direct and indirect labor to the appropriate cost objectives 11) Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account 12) Exclusion from costs charged to Government contracts of amounts which are not allowable in terms of Federal Acquisition Regulation (FAR) part 31, Contract Cost Principles and Procedures, and other contract provisions 99

Business Systems – Accounting Systems Criteria 13) Identification of costs by contract line item and by units (as if each unit or line item were a separate contract), if required by the contract 14) Segregation of preproduction costs from production costs, as applicable 15) Cost accounting information, as required: - By contract clauses concerning limitation of cost (FAR 52. 232 -20), limitation of funds (FAR 52. 232 -22), or allowable cost and payment (FAR 52. 216 -7); and - To readily calculate indirect cost rates from the books of accounts 100

Business Systems – Accounting Systems Criteria 16) Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms 17) Adequate, reliable data for use in pricing follow-on acquisitions, and 18) Accounting practices in accordance with standards promulgated by the Cost Accounting Standards Board, if applicable, otherwise, Generally Accepted Accounting Principles Note: Tax rules do not apply 101

Business Systems – Accounting Systems Criteria Question: Does your company appropriately address the 18 items? Points to consider: § Strong internal controls are essential § Auditors – Should document and audit key controls 102

Reporting – FAR Contracting Implication FAR Contracting implications: § Since accounting/financial reporting is one of the six “business systems”, a significant deficiency related to the business system for a CAS covered contract might have ramifications to the Contractor under a DOD Final Rule issued February 24, 2012 amendment to the FAR Supplemental regarding contractor business systems § Six business systems: 1) Accounting, 2) Estimating, 3) Materials Management and Accounting, 4) Government Property, 5) Purchasing, 6) Earned Value Management 103

Reporting – FAR Contracting Implication § A significant deficiency in a business system might result in payment withholds § Final Rule defines significant deficiencies: “shortcoming in the system that materially affects the ability of officials of the DOD to rely upon information produced by the system that is needed for management purposes” § This is a business systems definition and not an internal control definition (SAS No. 115) § Entire System issue 104

Reporting – FAR Contracting Implications Some practical considerations: § DOD’s Final Rule and the SAS No. 115 definition of a “significant deficiency” are different § SAS No. 115 is at the Individual Control level the FAR Supplement is at the Systems level § Auditor should follow SAS No. 115 for internal control deficiencies identified § Question – at what point do significant deficiencies and/or material weaknesses in internal controls render a business system to have a “Significant Deficiency”? Final rule does not provide specific guidance 105

Reporting – FAR Contracting Implications § This has ratcheted up the importance of internal controls for Company Management § And for auditors it is critical to identify and report significant deficiencies and material weaknesses in internal controls 106

Common Issues and Findings 107

Common Issues – Deficiencies Encountered Internal control related: § Not identifying and properly accounting for unallowable costs § Inadequate job costing system § Inadequate system for tracking allowable versus unallowable marketing § Inadequate/noncompliant system for tracking vehicle costs: direct, indirect and unallowable Internally generated costs: § Using the offset method instead of cost pooling § When using standard rates not properly disposing of significant variances 108

Common Issues – Deficiencies Encountered Lack of receipt documentation: § Travel related § Office meetings § Recruiting 109

Matrix of Findings Common disallowances noted: § § § § Vehicle costs Public relations and advertising costs No support Entertainment Excess compensation Direct costs in overhead Reasonableness Travel costs over maximum per diem Bonuses and incentive compensation Acquisition costs Insufficient documentation for travel costs Costs related to legal and other proceedings Compensation incidental to business acquisitions Amortization of acquired intangibles Idle facilities Related party rental costs 110

Wrap-Up § As Contractors you should follow relevant “Accounting Standards” and have adequate internal controls § As Auditors we must follow relevant “Auditing Standards” – see Appendix A of AASHTO Audit Guide § Important for all Stakeholders to have a comprehensive understanding of these requirements § As Auditors we are required to be Independent: “We just want it right” 111

Q & A 112

Thank you for your time To find out more about KLK, please visit us at www. klkcpa. com, or call (520) 884 -0176