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Government Contracting: Look Before You Leap!

 

Entering the government contracting sector seems especially enticing during a recession. While contracting may be a good fit for your business, make sure you’re aware of the unique aspects of dealing with the government.

By Tom Marcinko and Bill Foote, CPA

Government contracting is big business in the Commonwealth of Virginia. Many of the world’s largest government contractors are headquartered in our state (see Table 1).

According to a report published by George Mason University, the Department of Defense (DoD) alone spent $54.5 billion in Virginia during 2008, including $15 billion in payroll for the state’s 31 military installations and $39.4 billion in contracting for the procurement of goods and services. It is estimated that these contracts supported approximately 270,000 jobs within the state. Federal procurement spending in Virginia across all agencies totaled $53.9 billion in 2008.

Historically, some have considered federal government work to be a safe haven during uncertain economic times. While profit margins on government contracts are relatively low, Uncle Sam tends to be a reliable and potentially long-term customer. During the current recession, the lack of private sector work combined with “stimulus” spending under the American Recovery and Reinvestment Act of 2009 (ARRA) is causing some companies to consider government contracting. Many of these companies are small businesses.

Contracting with the federal government imposes requirements on companies not commonly found in the commercial market. By and large, the government is spending taxpayer dollars. Understandably, the government requires much greater visibility into how dollars are spent than is typically required in the private sector.

The objective of this article is to provide an overview of some of the unique aspects of government contract accounting and the challenges that commercial companies will encounter as they move into the government market.

Accounting systems

Government contractors must adhere to an additional layer of regulations and accounting procedures. The federal procurement process is governed by the Federal Acquisition Regulation, and the classification and allocation of contractor expenses are governed by the federal Cost Accounting Standards. In addition, there are several labor laws that may apply (i.e., the McNamara-O’Hara Service Contract Act, the Davis-Bacon Act and the Walsh-Healy Act). Failure to comply with these rules could lead to debarment.

There are no unique accounting requirements imposed on contractors who sell commercial-type products or services to the government on a firm fixed-price basis. However, almost all other contractors must have an accounting system that the government deems acceptable. This includes contractors who are required to submit supporting cost data with their cost/price proposals as well as any contractor who is awarded a time-and-materials, cost-plus-fee or fixed-price-incentive contract. Other than pure-play commercial product companies, most government contractors will sooner or later be required to have an acceptable accounting system.

To be considered acceptable, a contractor’s accounting system must have the attributes listed below. In addition, contractors are generally required to have written documentation of these procedures.

  1. Compliance with Generally Accepted Accounting Principles (GAAP)
  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 allocation of indirect costs to intermediate and final cost objectives
  5. Accumulation of costs under general ledger control
  6. A timekeeping system that identifies employees’ labor by intermediate or final cost objectives
  7. Interim (at least monthly) determination of costs charged to a contract through routine posting to books of account
  8. Exclusion of “unallowable” costs

Most commercial companies do not routinely perform these functions as part of their financial accounting. More significantly, many commercial companies (especially smaller ones) do not have the staff, knowledge, skills and software necessary to perform these functions. Accounting systems can be one of the biggest pitfalls for commercial companies when they try to enter the federal market.

Government contract types

There are three general types of government contracts: cost-reimbursable, time-and-materials and fixed-price. Under cost-reimbursable contracts, which are subject to a ceiling amount, a contractor is reimbursed for allowable costs and paid a fee, which may be fixed or performance-based. To the extent that costs exceed the ceiling amount or are found to be unallowable based upon applicable regulations, they may not be fully recoverable.

Under time-and-materials contracts, contractors are reimbursed for labor at negotiated hourly billing rates and for certain expenses. The risk with this type of contract is generally that the costs of performance may exceed the negotiated billing rates. With fixed-price contracts, specific tasks are performed for a specific price. Compared to cost-reimbursable and time-and-materials contracts, fixed-price contracts expose a contractor to greater financial risk due to the possibility of cost overruns.

The use of cost reimbursable contracts by the government has been on the rise in recent years. A recent survey by Grant Thornton indicated that 45 percent of federal contract dollars are spent on cost reimbursable contracts, with 35 percent and 20 percent spent on time-and-materials and fixed-price contracts, respectively. Changes could be on the horizon however, as the Obama Administration seems to favor fixed-price contracts over cost-reimbursable contracts.

In addition to the three types of contracts, there also are different contracting methods available in federal procurement. Two widely used methods are single award/defined statement of work contracts and indefinite delivery/indefinite quantity (IDIQ) contracts. Under a single award contract, an agency typically requests proposals and later awards a contract to a single contractor. In recent years, there has been a surge in IDIQ contracts. This is due, in part, to the shorter procurement process and lower level of procurement costs associated with IDIQ contracts.

IDIQ contracts, such as General Services Administration (GSA) Schedules, are umbrella contracts that outline basic terms and conditions (e.g., scope of work, labor categories and descriptions and billing rates) under which agencies may order services. With a GSA Schedule, qualified contractors basically submit a list of their services and the applicable pricing to the GSA, which in turn maintains all such Schedules for use by other federal agencies. This setup creates a more streamlined and centralized procurement process. Once awarded, however, a contractor must compete for individual delivery orders under a GSA Schedule contract.

GSA Schedules have become popular contract vehicles, especially for commercial companies entering the government market. GSA funds the program via the Industrial Funding Fee, a 0.75 percent surcharge on all GSA Schedule revenue. As such, a contractor’s accounting system must distinguish between GSA Schedule and non-GSA Schedule revenue.

Oversight

Many companies are required to have their financial statements audited on an annual basis. Government contractors also get audited by the Defense Contract Audit Agency (DCAA) or another cognizant audit agency. DCAA audits internal contractor systems (including accounting systems) for acceptability. DCAA also audits the actual cost data produced by the accounting system. Surveys published by Grant Thornton indicate that the cost most frequently challenged by DCAA is executive compensation. Other costs commonly challenged by DCAA include consulting fees and indirect cost allocations.

Recent reports issued by the Government Accountability Office (GAO) have been highly critical of DCAA, stating that DCAA was more committed to its “hours per audit” metrics than to audit quality, and that it had become too “friendly” with the contractors and government program managers.

DCAA has reacted to the GAO reports and the resulting public embarrassment and Congressional criticism in a predictable manner. DCAA is now committed to being the thorough, independent guardian of taxpayer money that it was created to be. Future audits will be more adversarial than in the past and no stone is likely to be left unturned. Success will no longer be measured based on meeting an “hours per audit” metric. Rather, success will be measured by completing audits in accordance with the applicable standards. The bottom line is that firms entering the government market must be prepared to deal with a newly aggressive audit agency.

A contractor with cost-reimbursable contracts is required to submit an annual Incurred Cost Submission. This submission includes all direct and indirect costs incurred by the contractor that were charged or allocated to government contracts. DCAA reviews the Incurred Costs Submissions to ensure that all included costs are supported with appropriate documentation and are otherwise allowable and allocable.

DCAA audits and Incurred Cost Submissions can result in contractors having to return money to the government. As such, organizations not familiar with these processes should consider seeking professional assistance from outside consultants.

Small business programs

The Small Business Administration administers numerous programs designed to help small businesses win prime contracts, as well as subcontracts, with the federal government. The overall statutory goal is for 23 percent of prime contracts to be awarded to small businesses, including five percent to small disadvantaged businesses; five percent to woman-owned small businesses; three percent to HubZone businesses; and three percent to service-disabled, veteran-owned small businesses. The actual small business contract goals vary by agency and are re-determined periodically. For example, for 2008 and 2009, DoD’s goals for small business prime contracts and small business subcontracts were 22 percent and 37 percent, respectively.

To qualify as a small business, a company must meet the size standard for the applicable industry, which may be expressed in terms of annual revenue or number of employees (rolling three-year average). For example, the thresholds for companies providing computer programming services and specialty trade construction contractors are $25 million and $14 million in revenue, respectively. For most manufacturing industries, the threshold is 500 employees.

Another aspect of small business programs relates to subcontracting. Companies awarded federal government contracts in excess of $650,000 must establish goals for awarding subcontracts to small businesses. Prime contractors are required to report semi-annually how much work they subcontracted to small businesses.

For companies that want to participate in small business programs, it is imperative that accounting systems be designed in a manner that supports their qualification under the size standards. Larger companies must ensure that accounting systems can track costs on small business subcontracts.

Stimulus

As previously stated, the ARRA has flooded the government contracting market with funds designed to provide jobs and stimulate the economy (see Table 2). The majority of stimulus outlays are expected to occur in 2010 and 2011. Top initiatives under ARRA include:

  • Healthcare IT
  • Energy (e.g., smart grid, green technology)
  • Broadband networking and services
  • Construction (including new buildings and refurbishment)
  • Infrastructure (including transportation and border protection)
  • IT modernization

Companies should be aware, however, that the stimulus comes with strings attached. One requirement is that contractors who receive stimulus funds must submit quarterly reports that contain, among other items, the amount of stimulus funds invoiced. Thus a contractor’s accounting system must be able to differentiate between stimulus funded and non-stimulus funded contracts and the resultant invoices. To complicate matters further, some contracts may have both stimulus and non-stimulus funds.

In addition, contractors receiving stimulus funds must report the total compensation for the five highest compensated officers. A contractor should ensure it is able and willing to provide this type of information before accepting a contract funded with stimulus dollars.

Some companies may choose to avoid ARRA contracts due to the related administrative and compliance costs. Another concern for companies is that in the government’s haste to stimulate the economy, contract requirements may not be defined clearly. In these situations, firms will be hesitant to bid on ARRA projects using fixed-priced contracts.

Mergers & Acquisitions (M&A)

For small privately held companies, exit planning can be a significant issue. An active M&A market can provide shareholders of such companies with exit planning alternatives. M&A activity fluctuates over time and varies from sector to sector. During the current recession, the broader M&A market has suffered, but within the federal sector the drop-off in M&A activity has been less severe.

It is expected that the federal M&A market will remain strong, including low- and middle-market deals. This is especially true for companies with proprietary capabilities that are well-positioned for high-priority government initiatives. In addition, as the credit markets stabilize it should lead to an increase in the number of closed deals.

Conclusion

The decision to move into the government market is usually made by an organization’s CEO based on business development considerations. However, entering the government market without understanding the accounting and other unique requirements exposes the company to the possibility of failing to win business, losing money and civil or (in extreme cases) criminal sanctions. Therefore, the CFO and controller should always be involved in any decision to enter the government market.

In addition, the company should review the qualifications of its CPA firm, because not all CPA firms are knowledgeable about the unique accounting requirements associated with government contracting.

Table 1: Virginia is for government contractors

Each year, Washington Technology (washingtontechnology.com) ranks the largest prime contractors in the federal market, the fastest-growing government contractors, and the top 8(a) small businesses. The 2009 rankings show that each of these three categories is dominated by companies headquartered in the Commonwealth.

Category

Virginia Firms

Top 100 largest government contractors

27

Top 50 fastest growing firms

29

Top 25 8(a) small businesses

7

Table 2: Stimulating the Commonwealth

According to the website recovery.gov, the value of ARRA contracts awarded to Virginia companies through September 30, 2009, totaled $894 million. This includes contracts from the following agencies:

Agency

Amount Awarded

Department of the Army

$55 million

Department of the Navy

$52 million

Environmental Protection Agency

$50 million

Naval Facilities Engineering Command

$103 million

Office of Science

$87 million

Tom Marcinko and Bill Foote, CPA, are with Aronson & Company, a nationally ranked top-50 accounting and consulting firm. As a member of Aronson’s Government Contracts Services Group, Tom assists clients with both pre- and post-award contract administration, compliance and other regulatory requirements. Bill serves as an officer in the firm’s Forensic & Valuation Services Group, where he assists government contractors with valuation projects and contract disputes. He is also a member of the VSCPA Editorial Task Force. Contact Tom at [email protected] and Bill at [email protected].