Recent Developments in Cost Allowability Cara A Wulf

Recent Developments in Cost Allowability Cara A. Wulf Geoff Merritt NCMA Boston Chapter 57 th Annual March Workshop March 7, 2018 BDO USA, LLP Mc. Carter & English, LLP

Agenda § Recent ASBCA/COFC Decisions – Cost Allowability – Statute of Limitations – Cost Accounting Standards § Statutory and Regulatory Updates and Related Agency Guidance – Executive Compensation (DCAM Guidance) – 2017 NDAA – 2018 NDAA 2

Recent ASBCA/COFC Decisions BDO USA, LLP Mc. Carter & English, LLP 3

Cost Allowability Technology Systems, Inc. , ASBCA No. 59577, 17 -1 BCA ¶ 36, 631 § Doctrine of Retroactive Disallowance – What is (was) it? – Government precluded from challenging costs already incurred where the cost or accounting method in question previously had been accepted following final audit of historical costs; the contractor reasonably believed that it would continue to be approved; and it detrimentally relied on the prior acceptance. § Retroactive disallowance is a “species” of equitable estoppel against the Government, which requires a showing of affirmative misconduct by the Government § DCAA’s inaction in previous years doesn’t set any standard, or establish a ‘common basis for understanding” that would establish a prior course of dealing 4

Cost Allowability Kellogg Brown & Root Services, Inc. , ASBCA No. 56358, 17 -1 BCA ¶ 36, 779 § Doctrine of Prior Material Breach – What is it? – If a party to a contract is sued for breach, it may defend on the grounds that a legal excuse for nonperformance existed at the time of breach – If both parties breach, courts will often impose liability on the party that committed the first material breach § Government committed first material breach by failing to provide force protection § Government's prior material breach excused any subsequent noncompliance with the contract's PSC prohibition 5

Cost Allowability Quimba Software, Inc. , v. United States, 132 Fed. Cl. 676, 682 -83 (2017) • Accounting system deficiencies → lack of payment → deferred compensation • Court determined that the deferred compensation was allowable because the contractor’s compensation was “unintended, unavoidable, and unanticipated. ” • “As the government forced Quimba's hand, it would be inequitable to find these deferred compensation costs unallowable nearly thirteen years after the fiscal year in question. The facts in this case make it clear that Quimba's situation falls within [a limited regulatory] exception, and, had the government engaged in a more careful review of its own regulations, the parties could have avoided five years of unnecessary litigation. ” 6

Cost Allowability Northrop Grumman Corp. , ASBCA No. 60190, 2017 WL 7051796 § § § § USG disallowed the contractor’s retiree benefit costs of approx. $253. 4 M. Contractor utilized an accrual costing method that conformed to the Deficit Reduction Act and generally accepted actuarial principles to account for PRB costs. DCMA issued a notice of intent to disallow costs, contending FAR 31. 2056(o)(2)(iii) required NGC to use the FAS 106 measurement method Contractor implemented plan that reduced $307 M in future costs The Board found that the USG improperly disallowed the cost and unreasonably interpreted the cost principles, and that the USG was not harmed by the contractor’s disclosed and consistently followed practices. FAR 31. 205 -6(o) establishes a cost allowability celling that only disallows costs in excess of the limit. “The contractor has never, and will never, claim, and the government will never pay, amounts disallowed by the final decision. ” 7

Cost Allowability Raytheon Co. , ASBCA No. 57743, 17 -1 BCA ¶ 36, 724 • • USG claimed a number of categories of costs incurred and claimed by the contractor were expressly unallowable and subject to penalties under FAR 42. 709 -1. Contractor argued that the costs if unallowable, were not expressly unallowable. • • Private Aircraft Costs; Consulting Costs; Development of M&A Database Costs; Employee Compensation relating to Lobbying Activities Except for costs associated with lobbying, the Board found in favor of contractor citing prior precedent holding that to establish that a penalty should not be assessed unless “the Government. . . show[s] that it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable. ” Id. (citing Gen. Dynamics Corp. , ASBCA No. 49372, 02 -2 BCA ¶ 31, 888, rev’d in part on other grounds, Rumsfeld v. General Dynamics Corp. , 365 F. 3 d 1380 (Fed. Cir. 2004)).

Cost Allowability Raytheon Co. , ASBCA No. 57743, 17 -1 BCA ¶ 36, 724 (cont. ) • • USG claimed that employee compensation costs directly associated with lobbying activity that did not fall within the enumerated exceptions under FAR 31. 205 -22, the Lobbying and Political Activity Costs principle, were expressly unallowable. Board determined that “it would be unreasonable under all the circumstances for Raytheon to conclude that the salary costs of its employees engaging in the listed lobbying activities were allowable. ” Raytheon’s challenge to the contracting officer’s decision not to waive the lobbying penalty pursuant to FAR 42. 709 -5 was also denied The Board noted that “Raytheon’s burden to prove that [the CACO] abused his discretion or acted arbitrarily or capriciously in deciding not to waive the lobbying cost penalty he assessed is heavy. ”

Cost Allowability Exelis Inc. , ASBCA No. 58966, 17 -1 BCA ¶ 36, 708 • • The Board disallowed compensation paid under contractor’s long-term incentive plan. Specifically, the Board held that the compensation at issue was unallowable because it was calculated or valued based upon changes in the price of corporate securities. Under FAR 31. 206 -6(i)(1), this form of employee compensation is unallowable. The Board, pointing at a prior decision in Raytheon Co. , ASCBA No. 57576 et al. , 15 -1 BCA ¶ 36, 043, further explained that “in order to be unallowable the award. . . need not be solely dependent upon the change in price of. . . stock. Rather, the plain language of the cost principle more broadly renders unallowable any compensation that is ‘calculated’ or ‘valued’ based upon ‘changes in the price of corporate securities. ’” Exelis Inc. , 17 -1 BCA ¶ 36, 708 (quoting Raytheon Co. , 15 -1 BCA ¶ 36, 043).

Cost Allowability Luna Innovations, Inc. , ASBCA No. 60086, 18 -1 BCA ¶ 36, 919 § At issue: allowability of stock options – Luna recorded based on FMV of options at grant date, calculated in accordance with the Black-Scholes model (permissible under GAAP) § Standard for “expressly unallowable”: Government must show that it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable § While permissible under GAAP, still unallowable under FAR 31. 2056(i)(1) because options were “calculated, or valued, based on changes in the price of corporate securities. ” § Not “expressly unallowable” because there was a reasonable difference of opinion regarding allowability 11

Statute of Limitations Sparton De. Leon Springs, LLC, ASBCA No. 60416, 17 -1 BCA ¶ 36, 601 • • • Contractor billed intra-company direct costs in 2007, paid by the Government Contractor did not include these costs in the final indirect cost rate proposal in 2008, and subsequently executed a final rate agreement with the Government In 2014, Sparton submitted final vouchers with supporting documentation, inclusive of the previously invoiced intra-company costs. Government demanded repayment in 2015 due to inadequate support. ASBCA held claim was barred by the CDA SOL, Government should have known about the issue in 2007 and 2008. Right to audit under FAR 52. 216 -7(g), Allowable Cost and Payment, does not toll the application of the SOL to disallow claims for allegedly unsupported direct costs 12

Cost Accounting Standards Exelis, Inc. , ASBCA No. 60131, 17 -1 BCA ¶ 36, 679 • Board denied a motion to reconsider a Government claim that the contractor was noncompliant in accounting for the costs of a building lease. • Board confirmed proper interpretation of the standard’s text with Preamble A that a contractor may determine whether a lease should be capital or operating; CAS 404 only applies to a capital lease. • Board confirmed that it was not necessary to resort to GAAP to interpret the standards. • • • GAAP provisions are the “bottom rung of the hierarchy” for interpreting government contract cost accounting authority. DCMA was not proposing to use GAAP to resolve or fill a gap in the CAS, but rather was attempting “to force a different way of measuring costs on the contractor, changing the meaning of the standard, and creating a conflict between CAS and GAAP. ” Board confirmed that the contracting officer’s final decision failed to state a claim on which relief may be granted regarding a purported CAS 404 violation because the contractor elected to treat the lease as an operating lease.

Statutory and Regulatory Updates and Related Agency Guidance BDO USA, LLP Mc. Carter & English, LLP 14

DCAM 6. 414 -3(h) • The auditor should ascertain that the contractor’s market pricing is compliant with FAR 31. 205 -6 and the process cited in the Techplan Corporation ASBCA Decision. • Determine the position to be evaluated. • Identify survey(s) of compensation for the position to be evaluated that match the company in terms of revenues, industry, geographic location and/or other relevant factors. • Update the surveys to a common data point for each year through the use of escalation factors. • Array the data from the surveys for the relevant compensation elements at various levels of compensation, such as the average (mean) or selected percentiles, and develop a composite number for each. • Determine which of the numbers to use for comparative purposes. In most cases average or median data will be utilized as an initial position prior to performing a detailed financial performance analysis.

DCAM 6. 414 -3(h) • Apply a range of reasonableness, such as 10 percent, to the number or numbers selected. It is DCAA policy to use 10 percent as the range of reasonableness. A 10 percent range of reasonableness (ROR) was also supported by the ASBCA in the Information Systems & Networks Corporation ASBCA Decision. • Adjust the actual total cash compensation for lower than normal fringe benefits. (Calculate an offset. ) • Compare the adjusted compensation to the range of reasonableness. Differences should be questioned as unreasonable.

DCAM 6. 414 -3(i) • “Often contractors will propose that their executives should be paid more than 110 percent of the reasonable compensation based on the average compensation paid by comparable firms for executives with similar duties. Above average levels of compensation are usually identified by percentiles, such as the 75 th percentile. For an executive with responsibility for overall management of a segment or firm, such a proposal may be justified by clearly superior performance as documented by financial performance that significantly exceeds the particular industry's average. The ASBCA decision on Information Systems & Networks Corporation ASBCA No. 47849, “capped” executive compensation at the 75 th percentile when justified by performance. ”

75 th Percentile Executive Compensation “Cap” • ASBCA decision on Information Systems & Networks Corporation ASBCA No. 47849 • The “cap” referenced was only applied to the years 1987 to 1991 based on the specific circumstances pertaining to a portion of the case • ISN’s performance in years 1985 & 1986 entitled executives to be compensated at the 90 th percentile which was deemed reasonable by the ASBCA • J. F. Taylor decision ASBCA No. 56105, 56322 substantiates the use of an upper limit of reasonable compensation beyond the 75 th percentile cited by the DCAM • witness in the J. F Taylor case was not an expert in compensation

GSA - Truthful Cost or Pricing Data (fka TINA) • GSA_FRDOC_0001 -1308, Agency Information Collection Activities; Proposals, Submissions, and Approvals: Certified Cost or Pricing Data and Data Other Than Certified Cost or Pricing Data • Comments were due on or before November 13, 2017 • GSA seeks public comment concerning “[w]hether this collection of information is necessary for the proper performance of functions of the FAR, and whether it will have practical utility; whether our estimate of the public burden of this collection of information is accurate, and based on valid assumptions and methodology; ways to enhance the quality, utility, and clarity of the information to be collected; and ways in which we can minimize the burden of the collection of information on those who are to respond, through the use of appropriate technological collection techniques or other forms of information technology. ”

DCAA Audit Alert – Cost & Price Analysis • • DCAA on September 6, 2017 issued an Audit Alert on Requirement for Prime Contractor Cost and Price Analyses. Purpose of the alert was to provide answers to FAQs on requirement for prime contractors to conduct cost or price analyses to establish the reasonableness of subcontract prices and encourage use of early engagement to facilitate the prime contractor’s completion of its cost or price analyses • • “Early engagement can be instrumental in assisting the Contracting Officer with developing a plan to complete its review of prime and subcontract proposals and obtaining field pricing assistance in a timely manner. As part of early engagement, the audit team should participate in pre-solicitation procurement meetings to discuss general issues related to the procurement, such as the identification of expected major subcontracts proposals, the prime contractor’s completion schedule for conducting cost or price analyses as required by FAR 15. 404 -3(b), and the need for Government assistance (e. g. , assist audit). ” “These early engagement activities help to establish expectations on timely contractor and subcontractor support, identify procurement milestone requirements”, etc.

DCAA Audit Alert – Cost & Price Analysis • Question No. 17 of the DCAA Proposal Adequacy Checklist • • Is there a price/cost analysis establishing the reasonableness of each of the proposed subcontracts included with the proposal? If the offeror’s price/cost analyses are not provided with the proposal, does the proposal include a matrix identifying dates for receipt of subcontractor proposal, completion of fact finding for purposes of price/cost analysis, and submission of the price/cost analysis? QUESTION: If CPA is not completed per FAR 15. 404 -3(b), is the question answered as inadequate and could the overall proposal be considered inadequate? ANSWER: Question 17 should be marked as inadequate, with comments entered indicating a matrix has been included • Overall adequacy for audit depends on many factors including materiality and the significance of the noted inadequacies. Generally, this inadequacy alone will not result in the audit team’s inability to proceed with the audit. …The proposed subcontract costs will be reported as unsupported (less any potential questioned costs).

DCAA Audit Alert – Cost & Price Analysis • QUESTION: Does an audit of a subcontract proposal relieve the prime contractor from its responsibility to perform cost or price analyses of the subcontract proposal? • ANSWER: No. A Government audit of the subcontract proposal does not relieve the prime contractor of its responsibilities. FAR 15. 404 -3(b) requires that prime contractors and higher-tier subcontractors conduct cost or price analyses of each subcontract proposal and include the results of these analyses in the price proposal.

DCAA Audit Alert – Cost & Price Analysis • QUESTION: If the prime contractor is denied access to the subcontractor’s cost data, does the prime contractor have to perform any analysis of the subcontractor’s proposal? • ANSWER: Yes. At a minimum, the prime contractor should perform and document its efforts to complete the FAR 15. 404 -1(b) required price analysis of its subcontractor and coordination with the Contracting Officer to obtain any necessary audit/pricing support from the Government.

DCAA Audit Alert – Cost & Price Analysis • QUESTION: If the prime contract audit team has requested an assist audit of a subcontract, but the prime contractor has NOT performed the FAR 15. 404 -3(b) required cost or price analyses to establish the reasonableness of the proposed subcontract price by fieldwork completion, should the prime audit team classify the proposed subcontract costs as unresolved or unsupported? • ANSWER: Unsupported. Regardless of whether or not the prime contract audit team requested or received an assist audit (subcontracts are part of the subject matter), if the prime contractor has not completed its cost or price analyses, the subcontract cost should be shown in the prime contractor proposal audit report as unsupported. However, if the prime contract audit team has received an assist audit and there are questioned costs, the prime contract audit team should question the corresponding subcontract costs in the prime contractor proposal audit report and classify the balance of the proposed subcontract costs as unsupported.

DCAA Audit Alert on NASA’s Participation in DCAA’s Risk-Based Sampling Process for ICPs • • DCAA on May 2, 2017 issued an Audit Alert Regarding NASA’s Participation in DCAA’s Risk-Based Sampling Process for Incurred Cost Proposals. The MRD indicated that NASA will no longer accept low-risk determinations issued by DCAA on contractors where the preponderance of the work relates to NASA contracts and directed Field Audit Offices to cease issuing low-risk determinations on behalf of NASA for these contractors. For authorized audits where NASA does not have the preponderance of the work, audit teams must coordinate with NASA, as part of the low-risk determination process, to determine whether any issues/concerns exist on NASA contracts before issuing the low-risk determination. The MRD further reminded auditors that DCAA should not be performing NASA audits unless specifically approved by NASA (see MRD 16 -OAL-019(R)).

DCAA Annual Report to Congress - March 31, 2017 • Organizational Structure and Staffing • Since its inception in 1965, DCAA has been organized by geographic regions allowing them to be close to the contractors it audits. • DCAA noted that major defense contractors have steadily decentralized operations and increased office locations in the U. S. and worldwide. RESULT: multiple DCAA regions have held jurisdiction over different audits for a single contractor, increasing the likelihood of inefficiencies in operations and communication. • DCAA has decided to realign its organizational structure into four Corporate Audit Directorates and three geographical regions, with a field detachment office focused on classified work. • • The Corporate Audit Directorates are organized by major contractors, while three geographic regions are primarily focused on small and mid‑sized contractors. Large defense contractors will be brought under an executive team that provides one point of contact for all DCAA matters related to each contractor and its business.

DCAA Annual Report to Congress - March 31, 2017 • Audit Performance • According to the report, the DCAA examined nearly $287 billion in FY 2016 across 4, 269 audit reports issued. This increase—nearly $29 billion over FY 2015—was largely due to the DCAA setting its priorities to higher-risk areas and higher-dollar audits. • Incurred cost (IC) audits remained DCAA’s top priority in FY 2016, totaling 2, 103 of the 4, 269 audits. On average, IC audits took 138 days to complete. • Followed by 981 special audits (e. g. , typically those in response to requests from contracting officers) took an average of 133 days to complete. • A total of 873 forward-pricing audit reports were completed in FY 2016, averaging 86 days to complete. • Other audits made up 312 of the 4, 269 audit reports completed (CAS, TINA, etc. ).

DCAA Annual Report to Congress - March 31, 2017 • Incurred Cost • DCAA’s ongoing priority is to eliminate its incurred cost backlog. • Despite this, DCAA only closed 8, 100 incurred cost years in FY 2016, compared to 9, 400 in FY 2015. • However, in FY 2016, the DCAA met its goal set by the National Defense Authorization Act to reduce the incurred cost backlog to within 18 months. • To accomplish this, all non-DOD entity audits were stopped until the DCAA realized the goal.

DCAA Annual Report to Congress - March 31, 2017 • September 2017 GAO Report to Congress: Additional Management Attention and Action Needed to Close Contracts and Reduce Audit Backlog: • DCAA did not meet its initial goal of eliminating its backlog by fiscal year 2016, and DCAA officials stated that they are unlikely to meet its revised goal by the end of fiscal year 2018. • Further, GAO found that in fiscal year 2016, DCAA averaged 885 days from when a contractor submitted an adequate incurred cost proposal to when the audit was completed. • The lag was due to limited availability of DCAA staff to begin audit work, as it took DCAA an average of 138 days to complete the actual audit work.

DCAA Annual Report to Congress - March 31, 2017 • Audit Resources • DCAA’s staffing levels have been inconsistent in recent years. • DCAA wants the budget to maintain staffing at 5, 100 employees. This is a 600 -employee increase from its current level of 4, 524, the lowest since FY 2009.

NDAA 2017 Section 820 – Defense Cost Accounting Standards, and Audit Process • Establishment of a new Defense Cost Accounting Standards Board (D-CASB) taking effect on October 1, 2018 • Responsibility for reviewing the CAS and recommending changes to them to the CASB • Exclusive authority, with respect to the Do. D, to implement the CAS to achieve uniformity and consistency in standards governing Do. D contracts • Develop standards to ensure commercial operations performed by USG personnel at the Do. D adhere to CAS that inform managerial decisionmaking • D-CASB chaired by Do. D CFO, 3 Do. D members, 3 private sector members • • Private Sector Representative of a “Non-traditional Defense Contractor” Private Sector Representative of a Public Accounting Firm

NDAA 2017 Section 820 – Defense Cost Accounting Standards, and Audit Process • Establishes new responsibilities for the existing CASB • Ensure that the CAS rely, to the maximum extent practicable, on commercial standards and accounting practices and systems • Review the CAS on an ongoing basis and conform such standards, where practicable, to GAAP • Review annually CAS disputes brought to the Board of Contract Appeals to consider whether greater clarity in the CAS could avoid such disputes

NDAA 2017 Section 824 – Treatment of IR&D Costs on Certain Contracts • • • Requires contractors to report IR&D and B&P separately from other allowable indirect costs, and separately from each other Codifies and limits the requirements for disclosure of IR&D projects • “Regulations prescribed may not include provisions that would infringe upon the independence of a contractor to choose which technologies to pursue in its IR&D program if the CEO of the contractor determines that the expenditures will advance the needs of the Do. D for future technology and advanced capability. ” Requires Do. D to establish an annual goal limiting the amount of reimbursable B&P costs (does not effect allowability) • Evaluation board to be formed to evaluate goal if not achieved

NDAA 2017 Section 893 – Amendments to Contractor Business Systems • Allows contractors to use third-party independent audits of their contractor Business Systems covered by the DFARS Business System rules in certain circumstances, eliminating the need for further Do. D review. • Do. D still plans to perform reviews as required to support contracting officer determinations but will leverage third-party reviews to adjust/limit its review activity. • Publicly traded contractors that are required to comply with Sarbanes-Oxley, for which they hire external accounting firms to test compliance with SOX Section 404, may also use those external firms to test their compliance with contractor Business System requirements. • If the external accounting firms express an opinion that the contractor meets the DFARS requirements, then those Business Systems need not be further audited by the Do. D.

NDAA 2018 Section 811: Modifications to cost or pricing data and reporting requirements • Section 811 increases the TINA threshold from $750 K to $2 million for all contracts entered into after July 1, 2018. • Section 811 also revises language in 10 USC § 2306 a(d) to require offerors to submit other than certified cost or pricing data sufficient to determine price reasonableness when certified cost or pricing data is not required. • The new threshold will be subject to periodic updating to keep pace with inflation pursuant to 41 USC § 1908. • Good news for contractors…however Contracting Officers will likely still require cost or pricing data without certification as they are still tasked with ensuring the cost or pricing data is fair and reasonable

Other changes to thresholds • Simplified Acquisition Threshold (SAT) - Section 805 increases the SAT from $100, 000 to $250, 000 • Micro-Purchase Threshold - Section 806 increases the Micro-Purchase threshold from $3, 000 to $10, 000

NDAA 2018 Section 803 - Performance of incurred cost audits • Not later than October 1, 2020, the Secretary of Defense shall comply with commercially accepted standards of risk and materiality in the performance of each incurred cost audit of costs associated with a contract of the Do. D. • To support the need of the Do. D for timely and effective incurred cost audits, and to ensure that the DCAA is able to allocate resources to higher-risk and more complex audits, the Secretary of Defense shall use qualified private auditors to perform a sufficient number of incurred cost audits of contracts of the Department of Defense to (among other things…) • Eliminate, by October 1, 2020, any backlog of incurred cost audits of DCAA • Ensure that incurred cost audits are completed not later than one year after the date of receipt of a qualified incurred cost submission • Maintain an appropriate mix of Gov’t. and private sector capacity to meet the current and future needs of the Do. D for performance of incurred cost audits • Not later than April 1, 2019, the Secretary of Defense shall award a contract to two or more qualified private auditors

Questions? Geoff Merritt BDO USA, LLP (617) 378 -3637 gmerritt@bdo. com Cara A. Wulf Mc. Carter & English, LLP (617) 449 -6583 cwulf@mccarter. com 38