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 NonGovernmental 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:

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
405 Accounting for Unallowable
Costs
406 Cost Accounting Period
407 Use of Standard Costs for Direct
Material and Direct Labor
408 Accounting for Costs of
Compensated Personal Absence
409 Depreciation of Tangible Capital
Assets
410 Allocation of Business Unit
General and Administrative
Expenses to Final Cost
Objectives
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
415 Accounting for the Cost of
Deferred Compensation
416 Accounting for Insurance Cost
417 Cost of Money as an Element of
the Cost of Capital Assets Under
Construction
418 Allocation of Direct and Indirect
Costs
419 Unused
420 Accounting for Independent
Research and Development
Costs and Bid and Proposal
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/InterestAreas/GovernmentalAuditQuality/Resources/A
uditPracticeToolsAids/Pages/YellowBookAuditToolsandAids.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
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
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
Audit Risk =
=
Risk of Material
Misstatement
Inherent
Risk
*
Risk that the Auditors
* Fail to Detect
the Misstatement
Control
Risk
*
Detection
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
 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 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
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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:

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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