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Subcontractor Indirect Rates - Audit Risks?


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Hi all,

New to the forum! I'm a government contracts specialist who consults for a variety of primes and subcontractors. Some of my clients are small businesses who have not yet primed a government contract, but implement a variety of government subcontracts. They have undergone external audits of their indirects and thus been issued CPFF subKs. Their subKs include FAR 52.215-2, so they could be subject to audits of both direct and indirect costs if the prime is audited. My question has two parts, the first general, the second more specific:

1. Since they have no NICRA and are not subject to CAS, what is the risk of their *indirects* being questioned under an audit per 52.215-2 (if the auditor determines the subcontract must also be audited). And if they are audited, would the auditor simply look for unallowable costs or would they also look at the way the indirect pools and bases were established? This leads to my next, more specific question...

2. One of these clients has 2 years of audited financials and had their indirects prepared by an outside firm using the ICE model. A colleague I work with who has extensive audit experience, reviewed their rates and claims that their rates are not compliant with ICE (OH is billed on direct consultant labor and B&P dollars are not broken out but are instead incorporated in OH labor, not the G&A pool) and they are therefore at risk if they are audited under 52.215-2. Is this a true risk, given that they are only a sub? Would an auditor realistically dig into how line items are allocated among indirect pools and, if necessary, require them to redo their rates and credit the subcontract any difference?

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If your clients have received CPFF subcontracts and/or task orders, somewhere along the line somebody had to determine their accounting system was adequate. Hopefully that was DCAA or another contract audit agency or (less good) an independent CPA. Anyway, in order to have an adequate accounting system, somebody had to conclude that the entity was (among other things) adequately identifying and segregating unallowable costs, and allocating indirect costs on a logical and consistent basis. With that as context:

1. The auditor is free to look at whatever they wish to examine. Normally I would expect them to focus on unallowable costs but they may look at the pools/bases associated with indirect rates. Since the entity is not subject to CAS, the auditor will use FAR 31.201-4 and 31.203 as the "standards" that establish what the contractor may/may not do in that area. (However, note that several of the CAS are incorporated into FAR Part 31 cost principles as a condition of cost allowability.) Critically, these are not the only areas of audit risk. For example, DCAA has a list of dozens of audit programs. Even excluding the audits related to CAS compliance, DCAA can execute any of those audit programs that it wishes to. Also, don't forget the Mandatory Annual Audit Requirements that DCAA is required to perform annually at many contractors. Finally, don't overlook the fact that other contract clauses beside 52.215-2 give USG auditors access to the contractor's plants and records. For example, see FAR Table 15-2, Note 2.

2. Each contractor elects its indirect cost allocation structure. None of the items you mentioned is necessarily a major audit finding. Specifically, OH may be allocated to direct consultant labor when the entity's indirect costs benefit the consultant -- e.g., the consultant uses an office within the contractor's facilities. It is unusual, to be sure, but it's not necessarily a major audit finding. (BTW, if you meant temporary agency labor not consultants, then DCAA audit guidance expressly recognizes that OH may be allocated to that labor.) B&P in OH versus G&A may be a finding (since 31.205-18 makes compliance with CAS 420 a condition of cost allowability); but if the contractor can show that its (sub)contract costs are not significantly impacted by including B&P on OH versus G&A, they could wiggle out of it. If there is a material impact to (sub)contract costs from the issue, then yes, the entity may have to credit contract costs -- not because there is a CAS noncompliance, but because the B&P costs would be unallowable and therefore the rates would have to be recalculated.

Finally, you say the entity doesn't have a Negotiated Indirect Cost Rate Agreement (NICRA). If it has a CPFF subcontract/task order, then it has 52.216-7 in its (sub)contracts. That clause requires submission of the "ICE Model" for government audit and eventual negotiation of indirect cost rates. If the contractor has complied with the requirements of 52.216-7 then it will soon have a NICRA. If it has not complied, then that's another (different) problem.

Hope this helps.

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here_2_help  thank you so much! Your response sheds a lot of light on audits in general for me... Super helpful! I have a couple follow-up questions/comments based on some of the information you provided...

You mention that because these subs have had audits done, somebody at some point deemed their accounting system adequate. I guess my follow-up question to this is: what if the audit wasn't conducted with USG contract compliance in mind? And what if the sub only has G&A and no fringe or OH (as is the case with one of my clients)? Is it still considered ICE-compliant?

I've heard that the type of audit that should be conducted is done in compliance with GAGAS and which results in a successful recommendation by the auditor via SF 1408. Would you deem that sufficient? Or are there other "must-haves" in an audit to make a sub's rates airtight?

Thanks so much!

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2 hours ago, govconconsult said:

You mention that because these subs have had audits done, somebody at some point deemed their accounting system adequate. I guess my follow-up question to this is: what if the audit wasn't conducted with USG contract compliance in mind? And what if the sub only has G&A and no fringe or OH (as is the case with one of my clients)? Is it still considered ICE-compliant?

I didn't say that. I said: Because these entities have received a cost-type subcontract, somebody had to conclude that the entities' cost accounting systems were adequate for cost-reimbursement contracting. (See FAR 16.301-3(a)(3).) A cost-type subcontract should not have been awarded until that evaluation/determination had been made. Yes, the SF 1408 documents the results of the evaluation. If an independent CPA (or better yet, a USG contract auditor) performed the evaluation, that would be sufficient.

What if the "audit" were not performed with USG contract compliance in mind? Then how would it be applicable? I would be very hesitant about relying on one audit with its own objective/scope to support another type of audit concern. Apples & oranges, in my view.

The sub's rates will never, ever, be "airtight." The SF 1408 documents an evaluation that the entity's written procedures and established practices should reasonably be expected to result in compliant accounting; however, the realty is the reality. People make mistakes. Management engages in "strategery" that ends up with a newspaper headline or two. That's why audits are performed. At the larger contractors, multiple audits are performed continuously.

2 hours ago, govconconsult said:

And what if the sub only has G&A and no fringe or OH (as is the case with one of my clients)? Is it still considered ICE-compliant?

As I posted before, each contractor elects its indirect cost allocation structure. There is no "one size fits all" approach. See FAR 31.203(c):

Quote

The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs. The contractor shall determine each grouping so as to permit use of an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping on the basis of the benefits accruing to intermediate and final cost objectives. When substantially the same results can be achieved through less precise methods, the number and composition of cost groupings should be governed by practical considerations and should not unduly complicate the allocation.

(Emphasis added.)

Hope this helps

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govcon, H2H has given you some good advice.  However, I come at this a little bit differently.  The audit clause, FAR 52.215-2 is based on statute.  The clause cannot be altered like other FAR clauses can to reflect the prime-sub relationship.  Thus, the audit rights in that clause are reserved to the government.  Although subcontractor costs can be audited by someone else, the government still has the right to audit CPFF subcontracts if the prime contract is one of the types listed in 52.215-2.  This right exists whether the prime is being audited or not.  In other words, the sub can be audited even if the prime is not.

Assuming FAR 52.244-2 is in the prime contract and consent to subcontract was required for this particular subcontract, FAR 44.202-2 requires the contracting officer giving consent to determine if the prime has a "sound basis for selecting and determining the responsibility of the particular subcontractor."  An aspect of responsibility is that the subcontractor have an accounting system that is adequate for the contract type contemplated.  Thus, the prime should have made this determination before awarding the subcontract.

FAR 52.216-7 is supposed to be inserted in cost reimbursement contracts.  That clause calls for the government to reimburse the contractor for allowable costs incurred by the prime.  This clause is not a mandatory flow down clause.  Thus, contractors can and do modify this clause for use in cost reimbursement subcontracts.  Whether this clause is in a subcontract or not, the prime is still only permitted to recover its allowable costs.  Thus, if an auditor determines that a cost  the prime reimburses a sub is unallowable, that cost will be disallowed at the prime level.  What rights the prime has against the sub is to be determined by the terms of the subcontract.  

As for submission of an indirect cost rate proposal, it is not uncommon for prime contractors to incorporate FAR clauses in subcontracts and to state that the clauses are modified to substitute "contractor" for "government" and "contracting officer" and "subcontractor" for "contractor."  Assume that FAR 52.216-7 is incorporated in the subcontract as it appears in the FAR, but the contractor has used the modifying language described above, there would be no requirement for the sub to submit  an ICP to the government, but the establishment of indirect cost rates would be a matter between the prime and sub.

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Thank you both for your replies!

H2H, understood re: differing indirect rate approaches. I'm familiar with that, though I guess my question was geared more toward determining if the ICE model is used even if the company only ends up with a single indirect rate. Basically, if a sub wanted to ultimately get to a point where they'd have indirects that could pass muster in an audit, would ICE be the model for them to develop their indirect(s)?

As to the audit piece, I'm ultimately trying to get at a sound, reasonable expectation for new subs who might be looking at receiving a CPFF subK but who don't have a NICRA or audited financials. They often want to know what type of audit they need to get for the prime to deem them worthy of FAR 16.301-3(a)(3), and who can conduct those audits. Through my own research and outside guidance I arrived at a GAGAS compliant audit using SF 1408. Sounds like that would be sufficient, from what I read in your message, but please correct me if I misunderstood.

RTF, agreed re: 52.216-7. When coming from the prime's perspective, we always flowed-down that clause to CPFF and T&M subKs even though it wasn't required.

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A contractor is not required to use DCAA's "ICE" Model to submit its annual proposal to establish final billing rates (as required by 52.216-7). It may use its own spreadsheet if that makes sense, so long as the spreadsheet is similar to what DCAA is looking for and contains the required Schedules. That said, DCAA has a new "contractor submission portal" these days. I haven't used it and I don't know how it will handle contractor-unique submissions.

Yes, a GAGAS-compliant audit by an independent qualified CPA, as documented via SF 1408, would be sufficient to determine for the contractor's interests whether it has gaps to be remediated. It's difficult to conclude that a CO would accept that as evidence that the contractor has an adequate accounting system (though a prime buyer might do so). Normally, a contractor submits a proposal to USG and the CO asks DCAA to perform an accounting system pre-award survey--and then relies on DCAA's audit report as evidence that the system is adequate.

Also, I would assert that 52.216-7 is always required when a flexibly priced contract type is being awarded, whether prime or subK. If the clause is missing, how do the parties "true-up" rates from bid rates to actual billing rates? The submission of an "incurred cost" (final biling rate) proposal is a critical requirement in that area--so much so that one bid protest decision at the Court of Federal Claims held that the submission of an adequate final billing rate proposal was sufficient evidence to show that the contractor had an adequate accounting system. (See Footnote 14 of that decision.)

That decision is relevant to that discussion, because it discussed how a CO could find that a contractor's accounting system to be adequate without an audit report from a federal agency contract auditor.

Quote

A government contractor can receive a cost-reimbursement contract without having a CFA provide an audit-and-adequacy determination. See, e.g., FreeAlliance.com, LLC v. United States, 135 Fed. Cl. 71, 73-74 (2017). Indeed, the FAR is silent with respect to how a procuring agency must assess the adequacy of a CAS, see FAR 16.301-3(a)(3), and agencies have accepted materials other than a CFA audit-and-adequacy determination, see, e.g., FreeAlliance.com, 135 Fed. Cl. at 73-74 (describing a solicitation in which offerors could submit a determination from a Certified Public Accountant as evidence that they possessed an acceptable CAS).

 

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3 hours ago, Retreadfed said:

If you used FAR 52.232-7 in the subcontract, why also include 52.216-7?  Doesn't that create conflicts between the two clauses?

There should be no conflicts because 52.216-7 addresses the cost allowability and true-up requirements associated with any indirect cost rates applied to materials ("M") whereas 52.232-7 covers all the other payment areas.

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18 hours ago, here_2_help said:

There should be no conflicts because 52.216-7 addresses the cost allowability and true-up requirements associated with any indirect cost rates applied to materials ("M") whereas 52.232-7 covers all the other payment areas.

That's not exactly accurate.  If 52.232-7 is in the contract, 52.216-7 in its entirely applies to the material portion of a T&M contract.  On the other hand, if 52.216-7 is incorporated as a stand alone clause, with no limitations stated as to its applicability, it would apply to the entire contract including the  T (labor) portion.

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On 2/11/2021 at 6:30 AM, govconconsult said:

Some of my clients are small businesses who have not yet primed a government contract, but implement a variety of government subcontracts. They have undergone external audits of their indirects and thus been issued CPFF subKs.

1. What is the risk of their *indirects* being questioned under an audit...

2. A colleague I work with who has extensive audit experience, reviewed their rates and claims that their rates are not compliant with ICE...and are therefore at risk if they are audited...Would an auditor realistically dig into how line items are allocated among indirect pools and, if necessary, require them to redo their rates and credit the subcontract any difference?

My experience and practice with major prime contractors relative to this area is as follows:

1. A FAR 52.216-7 subcontract award would never have be made if based solely on an external audit of their indirects. That part of your post is a surprise to me. To justify award, we would first look for DCAA approval of an acceptable accounting system.  Failing that, an external audit opinion that the accounting system is acceptable, which would undergo various checks and discussions with the auditor to determine whether it should be relied upon. Failing that, we would propose sending company accounting staff to the potential subcontractor to verify there is an acceptable accounting system. In that case, If the potential subcontractor would not permit access to its books and records, there would be no award. What is an acceptable accounting system? See for example, DFARS 252.242-7006 for criteria, which includes mention of Cost Accounting Standards Board and Generally Accepted Accounting Principles. For these reasons, small businesses were rarely if ever qualified for cost type subcontracts. Invoices for reimbursement of incurred costs from awarded subcontractors were subject to periodic review throughout the period of performance. So, there is some risk there regarding indirect rates.

2. Retreadfed's comment mentioned practices by prime contractors regarding substitution of parties in flowing FAR 52.216-7. My experience and practice is the same. However, with respect to the determination of final indirect cost rate [subparagraph (d) of FAR 52.216-7], there was no substitution of parties and the subcontractor was required to directly submit an adequate final indirect cost rate proposal to the Contracting Officer (or cognizant Federal agency official) and auditor. I have no sense how much risk there is to a subcontractor regarding its final period of performance indirect rates in that process. I believe here_to_help's comments had something to say about that.

         

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Thanks all for the help! Between H2H's confirmation re: SF 1408 and Neil's reference to the DFARS (which don't apply to the agency my clients work with, but which serve as a strong basis for determining adequacy and seem to align closely with SF 1408), I think I've got what I need to move forward. Thanks again for the enlightening inputs!

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20 hours ago, Neil Roberts said:

See for example, DFARS 252.242-7006 for criteria, which includes mention of Cost Accounting Standards Board and Generally Accepted Accounting Principles. For these reasons, small businesses were rarely if ever qualified for cost type subcontracts.

The DFARS clause criteria are used to determine if a contractor has an adequate accounting system post-award.  In determining responsibility, the criteria listed on the SF 1408 are used.  A close look at the two indicates there is a substantial difference in the two.

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1 hour ago, Retreadfed said:

The DFARS clause criteria are used to determine if a contractor has an adequate accounting system post-award.  In determining responsibility, the criteria listed on the SF 1408 are used.  A close look at the two indicates there is a substantial difference in the two.

My response was relative to a prime action with potential subcontractors, since the poster advises subcontractors. For business risk reasons and internal costs, prime contractors may choose to verify that the subcontractor has an adequate accounting system before award and look to the eighteen criteria in DFARS 252.242-7006 for the standard. That would be especially applicable if that DFARS clause was included in the prime. Not saying that the DFARS clause would be flowed to the subcontractor. But, when DCAA or an outside audit was available and based on 1408, is was accepted.  

Edited by Neil Roberts
fat finger sent before ready and change in last sentence
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