You’ve received a DoD Phase II contract. Are you aware of FAR Clause 52.216-7?
If you are receiving funds from the Department of Defense for a phase II contract, you have likely received a cost-reimbursable award. Cost-reimbursable awards must have a Federal Acquisition Regulations (FAR) and Defense Contract Audit Agency (DCAA) compliant accounting system, including compliance with FAR Clause 52.216-7.
FAR 52.216-7, or the allowable cost clause, means you have a cost-reimbursable award and must properly track your expenses to get reimbursed. Since you are responsible for accounting for you costs, you are also subject to several types of DCAA audits as well as the annual incurred cost submission audit.
Your FAR 52.216-7 compliant accounting system must segregate your costs as either a direct expense, an indirect expense or an unallowable expense.
- A direct expense: If it weren’t for this project, I wouldn’t have had this expense. The expenditure only benefits this specific project.
- An indirect expense: Is the cost of doing business and it benefits all of your projects. For example, rent, utilities, phones. We have a facility, and all of our projects take place within this facility. We use telephones and we have electricity. Those are indirect expenses of running the business.
- An unallowable expense: are expenses in the Federal Acquisition Regulation that the federal government just won’t reimburse you for. The fact that you and I went out to lunch and had a cocktail, the government doesn’t get any benefit from alcoholic beverages. That’s an unallowable expense.
How to budget for your DOD contract expenses.
Expect the unexpected
We’ve had thousands of clients winning tens of thousands of awards over four decades, and I have dealt with some of the most brilliant people on the planet, and none of them can foresee exactly how a project that won’t start for six months will ultimately play out.
Key takeaway: It’s not normal for you to be able to project exactly how a proposal or how a project is going to run.
The government doesn’t expect you to.
Know you have the right to re-budget
You have the right to re-budget funding between cost categories, as long as you’re not changing the scope of the project or spending in excess of 25% of the entire budget.
If you’ve got a million dollar Phase II award, you’d have to re-budget more than $250,000 of that award before you have to get the government’s permission.
The one caveat is that you can only re-budget between direct cost categories. For example, I was going to subcontract something, but I decided to do it in-house, so we re-budget budget monies from direct subcontractors to direct labor. Or, we were going to hire a consultant, but we decided to do the work ourselves. That’s perfectly fine.
However, if you don’t negotiate a formal indirect cost rate agreement, you cannot re-budget costs from a direct cost category to cover indirect costs. That’s a really big distinction that you need to understand!
To be reimbursed for costs, you need to report them to the government in an appropriate, compliant way
To get back to our thought process about direct, indirect or unallowable expenses…I received a phone call from a Principal Investigator a while ago, and he said, “Ed, is a lab jacket a direct or an indirect expense?”
My initial thought was indirect, because a lab coat could be worn during all projects, so all projects should pay for it, but instead of giving him my knee jerk thought, I asked for more information, and he told me, “Well, we do this one particular bovine experiment, and when we slaughter the cattle, it destroys our lab jackets.”
In that particular case, a lab jacket is a direct expense. The lesson here is that you can’t make blanket assessments of when a cost is direct or indirect, it’s always decided on a case by case example. Unallowable expenses are always specifically unallowable because the Federal Government says so, however, the way you charge costs as direct or indirect will depend on your business.
DCAA Audit Requirements for FAR 52.216-7 Compliance
As a rule, your largest indirect expense will be your people. That means non-billable salaries and wages, paid time off, time spent writing proposals, managing employees, managing consultants and vendors, time with accountants and lawyers, paying your bills, managing the business, etc.
When it comes to benefits, such as medical and dental insurance, paid time off, it’s very much a function of where in the country you are. You need to understand know what reasonable wage and benefit is for your specific part of the country.
For example, if you’re in Silicon Valley, you’re competing with Google for employees, and Google picks them up, drives them to work, feeds them, does their dry cleaning and drives them home. If you can’t compete, you don’t get the employees. If you’re in Ames, Iowa, I imagine your compensation packages wouldn’t need to be as aggressive to keep top notch employees, as the labor market there is less competitive.
So, you have to develop a sense of reasonableness. Reasonableness on the coasts, in the center of the country and down south mean different things to different DCAA offices.
I get asked all the time about bonuses. Are they allowable? Unallowable? It all depends on why you are giving the bonus.
If, at the beginning of the year, you sat with your employees and said, “Hey, I’d like to incentivize you. If you do A, B and C, I’ll give you a bonus.” Then, at the end of the year, you measure their performance against those benchmarks and as a result, they get a bonus, it’s an allowable expense.
However, if at the end of the year, you discover you’re under-running your indirect rates and you decide to give yourself a bonus, that’s not okay.
An incentive bonus needs to be documented thoroughly. The government auditors will look to see who is participating. Is it for everybody or really only benefit the owner(s) of the business? The more everybody participates and the more well-documented it is, the more they’re going to be okay with it.
Obvious, no brainer, of course it’s allowable.
Normally, rent is allowable, but when you own your own facility, it gets a little more complicated.
There is an overriding concept of doing business “at arms’ length” with your vendors where each represents their own economic interests. You arrive at a fair price at the end of a negotiation.
However, if you rent from yourself, the government will go through a formula and effectively try to figure out what the economic substance of the transaction.
Accountant and lawyer’s fees
One of my favorite questions is: “Are accountants’ and lawyers’ costs allowable?
Accounting fees are all allowable unless I’m doing your personal tax return, which has no benefit to the business. Other than that, there’s literally nothing that I could do that wouldn’t be reimbursable by the government.
With a lawyer, it depends. For example:
- If a lawyer helps you draft an employee handbook, that’s good business practice. That’s allowable. That’s an indirect expense.
- If a lawyer helps you get an H-1B visa, that’s an allowable expense. There’s a benefit back to the government.
- If a lawyer helps you raise Series A financing and charges you $40,000, all you’ve done is transfer a part ownership of the company from yourself to somebody else. The government didn’t get any economic benefit from that, so those legal fees are unallowable.
Some of these costs are fairly straightforward, but there’s always a case-by-case component. Some are more nuanced, and you need to understand that.
Labor Costs & Timesheets
The government is keenly aware that one of the largest expenses in most of their contractor’s general ledgers is labor costs—and that people can easily manipulate these costs. This is why you are required to have, use and be able to show a compliant timekeeping policy.
Government regulations literally say:
- An employee has to fill out their timecard in ink on a daily basis.
- An employee must record all time and sign off in ink on the timecard.
- The supervisor has to sign the timecard, again, in ink.
- All changes have to be crossed out and initialized.
So is it okay for you to have an electronic timekeeping system? Yes, as long as your electronic timekeeping system does all of the above. It effectively needs to create a forensic audit trail.
Not all systems do that. Just because you bought TSheets or Nexonia or Unanet does not necessarily mean you have an acceptable timekeeping system, unless you maintain it properly.
We picked up a new client who started a business spun out from a top research hospital and told us “I have an acceptable timekeeping system. I have TSheets.” Problem was, he personally hadn’t filled out a timesheet in over a year, was paying himself, and charging his time to contracts.”
Key takeaway: Compliant time sheets are an ongoing discipline, not a one-time thing.
Now another labor policy that you’re required to have is how you will account for uncompensated overtime.
What is uncompensated overtime? Here’s an example: You hire a new employee, and you’re going to pay them $80,000 a year salary. To make the math easy, let’s pretend there’s 2,000 hours in a year. You’re effectively going to pay this person $40 an hour.
Let’s say, in the month of January, he spends 10 hours on Project A. You bill 10 hours at $40 an hour ($400) to the government plus overhead, G & A and fee. You’ll get reimbursed.
But let’s pretend that at the end of the year, this guy actually charged 2,500 hours in total on his timesheets—and you did all of your math based on a 2,000-hour year. Remember, this is a cost-reimbursable type award. If you pay him $80,000, and he works 2,500 hours, that only $32 an hour. You’ve effectively overbilled the government by $8 an hour.
Now I’m here to tell you that if you underbill the government, they won’t say anything. There’s an implicit thank you.
However, if you overbill the government, they will quickly stick their hand out and ask to be reimbursed.
The most common cures for uncompensated overtime are:
- Pay for overtime. Almost none of our clients do this.
- Change the billing rate every month. Let’s pretend that this $80,000 a year guy gets paid monthly. It turns out to be $6,666.66 a month. You simply divide it by the number of hours that person charged that month and you come up with a different billing rate every month. If you have two or three or four employees, it’s probably fine if you’re using a manual timesheet. Now, if you have 20 employees and you’re going to change the billing rate every month, I hope you have an electronic timesheet because there’s a lot of risk of making an error.
- The last common cure is to credit the government for the overbilling to the indirect rate pool. You would effectively take the $8 an hour and you would charge that variance back as a credit to the overhead rate pool. If your indirect rates were running at, say, 130%, and you credited back the overbilling, then maybe the indirect rate goes down to 115% or 120%.
Confusing? Overwhelming? I’ve been speaking at the National SBIR Conference for years, and it’s at this point where people usually start thinking, “let’s just charge 40 hours a week on our timesheet so we don’t have this kind of problem.”
This is where you start to get into trouble. Anyone ever heard of a disgruntled employee?
DoD contracts and Whistleblowers
When you do business with the federal government, you’re dealing with a trillion-dollar business. There are hotlines for wronged employees to call and file a whistleblower complaint.
Know that whistleblower provisions state that anywhere from 15% to 30% of the damages recovered go to the whistleblower.
You have to so careful in the way that you document things and the way that you communicate with your employees.
Northwestern University had a purchasing coordinator, Melissa Theis, who noticed some irregularities. The University had to pay a $3 million fine and Melissa wound up with a $498,100 settlement.
The sad, true story of an MIT Professor
Decades ago, I had a client who was a tenured professor at MIT. He was developing a technology spun out of MIT’s Tech Transfer Office, and had about 25 employees. He was brilliant, and the technology he was working on was fascinating. His wife was the CFO.
One day the MIT professor asked his CFO wife for a divorce. The next day, the DCAA came knocking. Surprise floor check. The auditor had five employees that they wanted to interview. This is the government’s right.
They asked one employee what he was working on, which was a commercial technology. Then they asked for his timesheet which showed he was charging all of his time to a cost-reimbursable Phase II SBIR award. The auditor asked him, “Why are you working on this commercial technology and charging your time to this other project?” The employee pulled out a memo from the MIT professor, that said, “Please charge all of your time to this contract until it’s out of money, regardless of what you’re working on.”
The auditor’s jaw dropped, he went back to his office and stopped the company’s ability to progress bill the government. They were effectively blackballed in the federal government.
That MIT professor is now happily divorced, and he works for his research assistant, who now owns the company.
The documentation you need for your direct costs
Let’s talk a little bit about the documentation that you have to have for some of your direct costs.
- Consultants For consultants, you’re required to have a consulting agreement with an hourly rate and a detail of the scope of the work to be done. The consultant has to provide you with an invoice detailing the number of hours they worked and the work performed.
- Subcontractors When it comes to subcontractors, it’s really the same thing, but taken to an institutional level. Obviously you’re required to have a signed subcontract agreement, but the key here is that you need to flow down all the regulations in your prime award to all your subcontractors – making them subject to the same provisions. The Government sees them as co-investigators.
- Travel I spoke a little bit earlier about travel and the government. They have published per diem rates. Depending on where in the country you’re traveling, the rates are different. They’re higher in San Francisco than they are in Ames, Iowa.
- Materials When it comes to materials, you have to create a paper trail when you vouch expenses. An expense comes in. It should be clearly marked as a direct, an indirect or an unallowable expense. If it’s a direct expense, which project did it go to? All of the supporting documentation needs to be lined up with that voucher document.
There are many different types of audits for Department of Defense contracts. Some are easier to pass unscathed than others.
SBIR Pre award audits
When you’re going from a Phase I SBIR award to a Phase II award, typically Phase I is fixed price, and Phase II is a cost-reimbursable award. Before you get that $1.0 – $1.5 million Phase II award, the Defense Contract Audit Agency (DCAA) is going to come out and do a pre-award audit
DCAA’s goal in a pre-award survey is to review the prospective contractor’s accounting system and related internal controls to provide reasonable assurance that accounting system and cost data are reliable, risk of misallocations and mischarges are minimized, contract allocations and charges are billed the same way they are accounted for. More specifically, DCAA will focus on your ability to allocate costs among contracts in a logical manner, exclude unallowable costs, record employee labor hours and dollars by contract, segregate direct and indirect costs, provide timely, accurate cost accounting data to support billings, and provide accurate data to support incurred costs claimed by contract.
DCAA Random voucher audits
The government is now required to perform random voucher audits on smaller contractors once a year. To ensure visibility into contract costs as work progresses, DCAA performs progress payment audits on individual invoices.
After you submit an invoice, you may receive a call from a DCAA auditor to let you know that the invoice submitted has been selected for audit, and you are now tasked with providing substantiation for each individual line item on the invoice – working backwards all the way to the supporting document for the initial creation of cost. From government invoice back to job cost report, then from job cost report back to source documents. From labor costs distributed traced back to payroll reports, and approved, properly coded timesheets. From consultant and subcontractor costs, traced back to approved properly coded invoices, and agreements. From travel costs traced back to expense reports, coding, approvals and analyses of per diem limitations. And finally. indirect costs applied traced back to the indirect cost rate agreement.
This is basically an intimidating, mini accounting system audit where they make sure that you are maintaining the accounting system that you told them that you would.
Incurred Cost Submission & the Incurred Cost Submission Audit.
When you write the budget for your cost-type proposal, you project an indirect rate. Let’s say you project an indirect rate of 120%. The auditor comes out during the pre-award and says your 120% indirect rate appears to be reasonable. You do a month’s worth of work. You bill at 120%. You do another month’s worth of work. You bill at another 120%. The year goes on and on and on.
Six months after the end of your fiscal year, you must submit your incurred cost submission to the DCAA. In a nutshell, this document represents your final cost accounting for all the activity from your business for the prior year, in accordance with the FAR, DFAR, CAS and any contract specific stipulations. Once this document is filed you are required to “true-up” your cumulative provisional billings to the government for each project to your final actual cumulative costs contained in the submission.
As an example, if your actual indirect rate comes out to 115%, and you’ve been billing 120%, you’ve overbilled the government, and the government will say, “I’d like my “5% overbilling back, please.” The next bill you submit to the government will include a credit for the amount that you’ve overbilled them.
If you’ve underbilled the government, you have the right to charge them, but remember you’re dealing with a political process. If I told you I was going to do your personal tax return for $50 an hour as long as I could control my overhead rate and, then in reality, I couldn’t control my overhead rate and I charged you an extra $25 an hour, you probably wouldn’t do business with me .
It’s really important that you do a good job of projecting your indirect rate properly and that you monitor your indirect rate as the business goes through its normal business cycles on a monthly basis.
Incurred cost submission audits
The annual incurred cost submission has a 100% chance of being audited by DCAA. Some good news — DCAA will perform a risk analysis and may cycle your audits between full-blown live audits and desk audits.
In a desk audit, DCAA performs analytical reviews, and ask you a bunch of questions through email. It’s much less intimidating than a live in-person audit.
If you stay in the low-risk pool for several years, you get cycled into full blown audits. The goal here is to have a low-risk audit, to make sure that you don’t have any audit findings, and to then only cycle through for these full-blown accounting system review audits on an occasional basis.
If you have failed an audit, whether it’s your incurred cost submission audit, a voucher audit, floor check audit or if they’re skeptical of your pre-award audit, you will not be placed in the low-risk pool, and they will do an in-person audit.
Basically, as long as you stay clean, they try not to come out and bug you. But if you show yourselves to be a problem, they show up a lot.
Jameson & Company and DCAA audits
With Department of Defense, contract audits are always performed by the Defense Contract Audit Agency (DCAA) There are about 4,500 auditors and 300 branch offices all over the country.
One of the key benefits being one of our clients who outsource all their accounting to us, is that the auditors show up at our offices, because that’s where the records are located. However, if the auditor wants to tour their facility, we hop on a plane and we walk around with the auditor. We try to control the process for the best outcome.
If you get to the point where you’re getting the wink and the nod from the Department of Defense, and they want to go through the pre-award audit process, we can help with all the financial negotiations. You can literally outsource the entire thing to us if you want. We can help you set up your accounting system. Give you training and periodic oversight. We can prepare the annual incurred cost submission and represent you during government audits. We can be as involved or as uninvolved as you want us to be.
We’ve written a whitepaper on understanding the different types of DCAA audits. You can read it here.