Achieving a more equitable outcome?

Introduction

The Defense Contract Audit Agency (DCAA) recently issued a Memorandum for Regional Directors (MRD) titled “Revised Audit Guidance on the Cost Impact Calculations for a Unilateral Cost Accounting Practice Change.” The DCAA made this change in audit guidance to reflect certain Armed Services Board of Contract Appeals (ASBCA) decisions and the application of the board’s decisions to the range of unilateral Cost Accounting Practice (CAP) change scenarios. The DCAA also wanted to highlight the importance of understanding the nature of the unilateral CAP change and how it will affect future measurement, assignment and allocation impacting accumulation and reporting of cost on government contracts and subcontracts. The change in the guidance addresses the auditor’s calculation of the estimated increased cost to the government, in the aggregate, resulting from the CAP change and is intended to ensure that the calculation is more equitable.

Unilateral cost accounting practice changes

A unilateral change in cost accounting practices is a change to its disclosed cost accounting practices made by a contractor. The Federal Acquisition Regulation (FAR) allows a contractor to implement a unilateral CAP change; however, the government will not pay increased cost because of the CAP change. Therefore, it is critical for the auditor to estimate the cost impact to the government resulting from the contractor’s change in accounting practices. The key to estimating the effect of the change is the estimate to complete (ETC) for relevant associated contracts. The estimated impact to the government is calculated by comparing the ETC on affected Cost Accounting Standards (CAS)-covered contracts using the new cost accounting practice to the ETC using the old cost accounting practice. Increased costs, in the aggregate, represent the total amount owed to and to be recovered by the government resulting from the change.

A unilateral CAP change affects fixed price and flexibly priced contracts differently. On a flexibly priced contract, the increased or decreased costs allocated due to a unilateral CAP change are accumulated on the contract and the government actually pays for or receives the benefit of those changes. However, the price of a fixed price contract (the amount paid by the government) does not change absent a modification to the contract.

The audit team should evaluate the unilateral CAP change to understand the type of CAP change, the universe of all affected CAS-covered contracts and subcontracts, the movement of cost among contract groups and customers and all business units impacted by the unilateral CAP change. The contractor’s basis for the ETC amounts for the new cost accounting practice and the old cost accounting practice must be applied prospectively from the effective date of the change through the end of contract performance.

Changes to the DCAA guidance

The change in guidance addresses how the auditors should approach the calculation of the increased cost to the government in the aggregate understanding that it is more than just a mathematical calculation. Special consideration needs to be given to the actual total cost impact on both flexibly priced and fixed price contract groups to ensure the estimated increased cost to the government in the aggregate is equitable. The audit team should not simply add the impacts calculated for flexibly priced and fixed price contract groups; rather, the audit team should determine the difference between the amount to be paid by the government on affected contracts in total using the new cost accounting practice compared to what it would have paid had the change not been made.

CAP change scenarios

The MRD discusses the four overall scenarios that could result from a unilateral CAP change and how each should be handled to equitably estimate the increased cost to the government, in the aggregate. Here are the four scenarios:

In the first scenario, an increased ETC on flexibly priced contracts and a decreased ETC on fixed price contracts, BOTH result in increased cost to the government. In this case, the cost impact to the government, in the aggregate, will generally be the greater of the two cost impact amounts. This is based upon the assumption that the unilateral CAP change resulted in the same costs being shifted from the affected fixed price contracts to the affected flexibly priced contracts. When this occurs, the auditors should only count the same costs as “increased costs” one time.

In the second scenario, with increased ETC on flexibly priced and increased ETC on fixed price, the result is increased cost to the government on flexibly priced and decreased cost on the fixed price contracts. When this situation occurs, the cost impact to the government, in the aggregate, will generally be the increased cost amount on the flexibly priced CAS-covered contracts. The increased costs on flexibly priced contracts will be realized by the government in the form of higher actual billings, while the fixed prices (cost to the government) on fixed price contracts remain the same. The MRD states that the contractor is not entitled to offset the “decreased costs” for the fixed price contracts against the actual increased costs that will be paid on flexibly priced contracts because the FAR says that the government will “not pay increased costs, including a profit enlarged beyond that in the contemplation of the parties to the contract when the contract costs, price or profit is negotiated, by reason of a contractor's failure … to follow consistently its cost accounting practices.”

When the unilateral CAP change results in decreased ETC on the flexibly priced CAS-covered contracts (decreased cost to the government) and decreased ETC on the fixed price CAS-covered contracts (increased costs to the government) as in scenario three, the cost impact to the government, in the aggregate, will generally be limited to the excess of the increased fixed price costs over the decreased flexibly priced contract cost. Under this scenario, fewer costs will be accumulated on both the fixed and flexibly priced CAS-covered contracts. The decreased costs on flexibly priced contracts will be realized in the form of fewer or smaller actual billings and therefore should be considered in the calculation of the increased cost in the aggregate. The decrease in cost accumulations on fixed price contracts represents an increased cost to the government, because had the new cost accounting practice been used to negotiate the fixed price contracts, the negotiated price would have been lower. The contractor is not entitled to additional profits because of a unilateral CAP change; therefore, these costs are also considered when estimating the increased cost to the government, in the aggregate.

The final overall scenario, decreased ETC on flexibly priced contracts and increased ETC on fixed price contracts, results in decreased cost to the government on BOTH flexibly priced and fixed price contracts. When the unilateral CAP change results in decreased cost to the government on both the flexibly priced and fixed price CAS-covered contracts, there is no increased cost to the government in the aggregate.

Conclusion

Generally, the revised treatment and calculation of estimates of increased cost to the government described in the MRD appear to properly combine or offset estimates of increased and decreased cost to the government to arrive at the goal of an equitable estimate of increased cost to the government, in the aggregate, for unilateral CAP changes. However, the second scenario—the FAR reference provided by the DCAA notwithstanding—could be viewed as not entirely fair to the contractor therefore missing the objective of achieving a more equitable estimate.

In that second scenario, the changes in ETC on the fixed price contracts would result in decreased cost to the government on the fixed price contracts, and some may argue that to truly meet the definition of in the aggregate, these decreased costs should be considered along with the increased costs associated with the flexibly priced contracts. However, the auditors maintain that because the prices on those fixed price contracts had already been negotiated and established, the government would not benefit from those reduced costs and that giving consideration to the reduced cost on the fixed price contracts in estimating the cost impact would be akin to allowing the contractor additional profit which the FAR does not allow.

At Baker Tilly, we’ve advised numerous clients on the cost impacts of planned CAP changes. We would love to hear what you think about the DCAA’s recent changes to its guidance on how to estimate increased cost to the government, in the aggregate, for unilateral cost accounting practice changes. Contact the Baker Tilly government contractor solutions team to continue the discussion.