Thoughts on Segregation... of costs that is.

Hello,

So, on our last blog, we began unpacking the audit program for DCAA's Accounting System review. Remember, that is the audit program used by DCAA to see if your accounting system is ready to handle a government contract. Well, last time we covered step 1 - verifying the accounting system's compliance with GAAP. In this issue, we continue with audit program Step 2 - Proper Segregation of Costs.

Step 2 - Proper Segregation of Costs.

So, what does "Proper Segregation of Costs" mean?

The easy answer would be to group your expenses by types. The common understanding is that we should not do this with people; however, when it comes to expenses, we do need to segregate them by like-kinds.

So, what are the types then? Good question! We’d have to know the types in order to group them, right? Well, let’s dive into this audit program step together.

Step 2 requires the auditor to review your accounting system and check to see if it can prevent direct charging of indirect expenses and indirect charging of direct costs.

In other words, your accounting system must be able to segregate direct vs indirect costs.

I assume that most of you understand the difference between direct and indirect costs, so rather than explaining that difference, let's dive into an example scenario.

Let's say at ABC company, you have an engineer, Ms. Angelina, who also serves as a manager.

Ms. Angelina spends a portion of her day working with the marketing department, another portion talking to her managers, and a portion of her day doing engineering work on a specific contract for a specific government agency.

You see, in this situation, there is a high risk for Ms. Angelina's time to be charged directly when she's actually working on an indirect function and vice versa. This situation presents a risk to the government, and also other clients of the company. If her indirect hours inadvertently get charged directly to a contract, that one customer ends up paying for indirect work that everyone else benefited from without having the other customers pay their fair share. This situation also presents the risk that the company may purposely charge some indirect costs directly to a contract in an effort to lower the indirect costs on other contracts. The risk here is that costs may be shifted between contracts through the misclassification of direct and indirect costs. Therefore, the audit program directs the auditor to verify that adequate controls, designed to prevent and detect such errors, exist.

The specific type of control that should be in place, and the effectiveness of such control, depend on the type of cost element (i.e. labor, materials, etc.) and business. Popular controls for labor include the use of Work Authorization Forms, restrictive timekeeping systems, and written Policies & Procedures that describe the proper treatment of such costs.

I hope that going over audit step 2 provided some insight into controls for direct vs indirect costs.

In our next issue, we'll unpack step 3 - accumulation of direct costs by contract.

Until then, as always, please feel free to reach out with questions or comments.

Happy Government Contracting!

Dan

Got the big contract, now what?

Have you won a government contract?

Congratulations!

Government contracts are great in that they provide stability and a foundation for continued growth.

In my perspective, winning a government contract is, in a sense, like taking on the responsibility to function as the government. I say that because you will enjoy the stability, but also own the risk of slim margins, and the responsibility of controlling costs. Your customer, the government, also has a great interest in how you manage your costs. After all, you are using tax payers’ dollars. A talk about the government budget and the now so familiar Continuing Resolutions will take place on another blog.

Today, let’s talk about the initial audit you may face as a government contractor.

The Defense Contract Audit Agency (DCAA) provides services to the DoD and the rest of the federal government for its audit needs. When a contract is awarded, it is common for the awarding agency to request DCAA to perform an Accounting System Survey of the contractor. In a nutshell, the government is trying to ensure that your accounting system can handle the contract.

Now that we know who conducts the audit, let’s find out what the actual audit looks like.

DCAA auditors conduct accounting system reviews based on one of the two following audit programs;

1. Pre-award Survey of Prospective Contractor Accounting System

2. Post-award Accounting System Survey

These audit programs are publicly available on DCAA’s website and serve as a step by step guide for the auditors. Check out the awesome video while you’re on their website!

As a contractor, it would help to know what the audit program steps consist of, right?

Well, how about we take a deeper dive and unpack DCAA's audit program for accounting systems?

Since the audit program does have many steps, roughly 30, I’ll go over the important ones on separate blog posts going forward.

For today, let's start with the first step in the audit program for the PreAward Accounting System Survey.

Audit Program Step 1

Generally Accepted Accounting Principles (GAAP)

The first step in this audit program asks the auditor to determine whether the accounting system is designed to be in compliance with GAAP.

What is GAAP?

GAAP is the accounting principles currently used in the United States and provides rules on how financial transactions should be accounted for. A few of the more famous principles within GAAP include the Revenue Recognition Principle and the Matching Principle.

A quick glance at the Revenue Recognition Principle:

The Revenue Recognition Principle helps us determine when to record the fact that we have made money. You may think of this as such a simple concept that it's strange to even have a principle.

We record revenues when we get paid, don't we?

Well, if you are on a cash based system, then posting a sale in your books when you get paid is correct. However, if you are going by the Accrual Basis, which is a GAAP requirement, then it gets just a bit more complicated. GAAP and its Revenue Recognition Principle state that you should record the fact that you have "made money" when you have "earned the right" to your customer's money. The principle states that you record revenues when you have delivered the product or completed the service, rather than when you actually get paid from your customers. This means that you record revenues when you have delivered on your promise regardless of whether they have paid you ahead of time, right as you complete the services, or even much later. This is what causes the need for an Accounts Receivable account and at times an Unearned Revenue account! So, how does an auditor determine whether your accounting system is in compliance with this principle? The answer is pretty simple. When I was at DCAA, I'd advise my auditors to ask for the company's Chart of Accounts and look for account names that indicate intentions to comply with the Revenue Recognition Principle.

Another fun concept in GAAP is the Matching Principle. The Matching Principle provides guidance on when to post expenses. It states that expenses are to be recognized at the time the relative revenue is being recorded. You're probably scratching your head by now... I know... This concept takes a little more time to understand. In any case, complying with this principle would result in accounts such as, Accounts Payables, Accumulated Depreciation, Prepaid Expenses, etc. Again, compliance with the Matching Principle can be observed by reviewing your Chart of Accounts and looking for names that indicate intentions to comply with this principle.

Good stuff!

Well, the Revenue Recognition Principle and Matching Principle are only two of the most famous principles in GAAP. In this same step, the auditor may seek for additional facts that prove the existence of basic accounting tools, such as a journal, general ledger, capability to produce trial balance sheets, adjusted trial balance sheets, and financial reports. Contractors can usually satisfy this step by showing the auditor the accounting software that they intend to use. Most accounting software today provide all of the above tools and functionalities. Hence, the reason for auditors to have more interest in the customized parts of your system, for example, your unique Chart of Accounts.

On our next blog, we will cover;

Step 2. Proper segregation of costs.

Until then, as always, please feel free to reach out to us with questions or comments.

Happy Government Contracting!

Dan

DCAA Compliance Seminar in Columbia, MD

Greetings,

We are hosting a DCAA Compliance Seminar right here in our hometown Columbia.

The course is designed for small government contractors that have the need to comply with compliance requirements on a budget.

Course content includes basic accounting concepts describing how to understand your financial statements.

Please RSVP by calling or emailing our office.

Thank you