The Defense Contract Audit Agency (DCAA) recently issued its sixth annual report to Congress on March 31, 2017 (the Report). DCAA primarily provides audit and financial advisory services to the Department of Defense (DOD) and has been ordered by Congress to issue an annual report. The report must address significant problems/deficiencies encountered during audits, statistics on audit performance during the previous fiscal year and a summary of recommendations to improve the audit process. The FY 2016 report highlights DCAA’s activity, its successes in FY 2016 and thoughts and predictions about FY 2017.
Here are the key takeaways from the latest report and our thoughts on how the contracting community may be impacted.
Organizational Structure and Staffing
What it says: Since its inception in 1965, DCAA has been organized by geographic regions allowing them to be close to the contractors they audit. However, DCAA noted that major defense contractors have steadily decentralized operations and increased office locations in the U.S. and worldwide. Over this time span, multiple DCAA regions have held jurisdiction over different audits for a single contractor, increasing the likelihood of inefficiencies in operations and communication.
After the recent success of its pilot program to geographically consolidate disbursed audit teams, DCAA has decided to realign its organizational structure into four Corporate Audit Directorates and three geographical regions, with a field detachment office focused on classified work (effective October 2016). The Corporate Audit Directorates are organized by major contractors, while the three geographic regions are primarily focused on small and mid‑sized contractors.
What it means: Large defense contractors will be brought under an executive team that provides one point of contact for all DCAA matters related to each contractor and its business. DCAA hopes this leads to improved efficiency and effectiveness, reduced redundancy and better customer service by centralizing internal support functions. DCAA also hopes for greater consistency in the implementation of policy and audit practices within the respective directorates and regions. It is expected to take some time for Corporate Audit Directorates and Regional Audit Managers to realign their priorities within their respective companies and geographies, leading to potential delays in routine audit practices.
What we think: Only time will tell if this reorganization will help DCAA address its efficiency concerns. It theoretically bodes well for contractors. That said, meaningful change takes time. DCAA is already prefacing these changes with an expectation for “delays in routine audit practices” – meaning the desired changes won’t happen overnight. Contractors should look for ways to strengthen and/or re-engage relationships with their DCAA points of contact and establish audit expectations early in the process.
FY 2016 Audit Performance
What it says: According to the report, the DCAA examined nearly $287 billion in FY 2016 across 4,269 audit reports issued. This increase—nearly $29 billion over FY 2015—was largely due to the DCAA setting its priorities to higher-risk areas and higher-dollar audits (a risk-based approach). This helped generate net savings of $3.6 billion in FY 2016, a $500 million increase over FY 2015. The DCAA returned $5.70 for each dollar invested, an increase of 90 cents from FY 2015. These increases in net savings and ROI were driven by greater sustention rates in forward-pricing-rate proposal audits and higher dollars associated with the audits. The report goes into detail behind these numbers and specifically addresses the incurred cost backlog, questioned costs sustained and completed audit reports.
Incurred cost (IC) audits remained DCAA’s top priority in FY 2016, totaling 2,103 of 4,269 audits. On average, IC audits took 138 days to complete. IC audits were followed by 981 special audits (e.g., typically those in response to requests from contracting officers for an independent financial opinion on elements of a contract or on a contractor’s accounting business system) took an average of 133 days to complete. A total of 873 forward-pricing audit reports were completed in FY 2016, averaging 86 days to complete. Other audits made up 312 of the 4,269 audit reports completed in FY 2016. These primarily included compliance with cost accounting standards, review of contractor business systems and contractor compliance with TINA.
One of DCAA’s ongoing priorities is to eliminate its incurred cost backlog. A dedicated team was established in FY 2012 to focus entirely on this effort. Despite this, the DCAA only closed 8,100 incurred cost years in FY 2016, compared to 9,400 in FY 2015. However, in FY 2016, the DCAA met its goal set by the National Defense Authorization Act to reduce the incurred cost backlog to within 18 months. To accomplish this, all non-DOD entity audits were stopped until the DCAA realized the goal (which it did in September 2016). With the incurred cost backlog at 4,677 submissions at the end of FY 2016, the DCAA could see its elimination soon and set the goal for March 2018. Unfortunately, the DCAA is already facing hurdles to keep up FY 2016 numbers in FY 2017.
What it means: The DCAA’s cost recovery efforts have been considerably slowed and, in many cases, stalled for the government while industry is finding itself with a weighty burden of maintaining records for a growing number of matters for longer periods. Reaching the threshold to take on non-DOD audits could lead to a bigger backlog. The less time the agency has to spend on incurred costs audits, the more issues will arise in other areas further down the road. Thus, DCAA will do as it did in FY 2016 and prioritize the highest payback audits, forward pricing and incurred cost. Its goal to perform accounting system, estimating system and MMAS audits may get off the ground, but it may not pick up much speed. It is still questionable whether or to what extent the DCAA will continue to involve itself with non-audit support activities. There are compelling reasons that the DCAA should focus only on auditing DOD-incurred cost proposals, or at least until they have completely eliminated the backlog.
What we think: The battle against the backlog is real and will continue to impact contractors as contract funds expire and indirect rates remain unsettled. We expect DCAA to continue to raise the bar for Incurred Cost Proposal (ICP) “adequacy” determinations.
Additionally, as more DCAA resources remain focused on the incurred cost issue, the backlog could grow in others areas (i.e., business systems). Overall, we expect the timeliness of audits to remain a challenge for the foreseeable future.
Questioned Costs Sustained
In FY 2016, $4.7 billion of $9.0 billion questioned costs were sustained, or 52.5 percent. This number is an increase over the previous two years, largely due to improved engagement with contracting officers. The table above compares questioned costs and sustention rates for fiscal years 2012‑2016.
What it means: DCAA only correctly identifies questioned costs half the time—they are not correct the other 50 percent of the time.
What we think: Our hope is that DCAA will devote resources to increasing its sustention rate for questioned costs and strengthening its methodology for questioning costs.
Recommended Actions or Resources to Improve the Audit Process
What it says: The report identifies contract auditing as a critical step in the government’s acquisition process and determines DCAA’s independent opinion directly affects the value that the government, tax payer and warfighter receive. DCAA suggests two ways to help prevent potential acquisition disruptions and improve the audit process efficiencies:
- Early DCAA engagement on congressional proposals; and
- Assistance in maintaining a steady staffing level.
Additionally, DCAA looks to ensure Congress has critical information when developing proposals and making decisions. The DCAA’s inconsistent staffing has been a thorn in its side. The DCAA wants the budget to maintain staffing at 5,100 employees. This is a 600-employee increase from its current level of 4,524, the lowest since FY 2009.
What it means: DCAA is seeking more authority and manpower to carry out its mandate.
What we think: How DCAA would fare with earlier engagement in the congressional proposal process is unclear. Without the manpower to overcome the audit backlog, gathering, analyzing and communicating such information to Congress in a timely enough manner to produce meaningful input is a tall order.
Business System Initiative
What it says: DCAA is responsible for auditing three of the six major business systems: Accounting, Estimating, and Material Management and Accounting. With the focus of its limited resources primarily on high-risk forward pricing and incurred cost audits, few business system audits had been completed in FY 2016.
As such, in FY 2017, DCAA is investigating ways to leverage internal audit work performed by the contractor without violating standards. One initiative includes using Textron Corporation’s internal group to perform certain portions of field work. In another initiative, DCAA is asking contractors to submit working papers from the Sarbanes-Oxley testing performed as part of its financial statement audit and other internal accounting system audits.
What it means: In FY 2017, the DCAA plans to commit resources to audit high-risk Estimating Systems and Material Management and Accounting Systems (MMAS), starting with fully tested audit programs published in early FY 2017. If the DCAA is able to get current on incurred cost audits, taking business system audits to a larger scale can help make the relationship between DCAA and industry more efficient, assuming industry is prepared for the event. However, DCAA’s intent to leverage existing internal audit workpapers may expose contractors to more risk for DCAA auditor interpretation.
What we think: Leveraging internal audits contractors are already performing sounds like a great way to lessen the burden of dealing with DCAA audits. But contractors should be wary. DCAA could require all government contractors to maintain a robust internal audit function. Leveraging such workpapers may result in DCAA expanding its audit procedures— not lessening.
With another year in the books and another DCAA report to Congress, what did we learn?
- A re-organization/streamlining of DCAA is coming. Contractors should be prepared for delays in routine audit work, but look for opportunities to strengthen relationships with DCAA and establish audit expectations early in this process;
- DCAA continues to focus on incurred cost audits, and while the backlog dwindled, the recent hiring freeze has forced DCAA to reassess its elimination goal of March 2018;
- DCAA suggests Congress give it more authority and manpower to complete its objective, and
- DCAA is exploring ways to leverage internal audit workpapers to support business system audits. Contractors should take heed.
We look forward to seeing how the year ahead progresses.
Parker Wolfinger, Senior Associate, contributed to this article.
Giacomo Apadula is a Managing Director and can be reached at email@example.com.
Parker Wolfinger, Giacomo Apadula Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP