DoD Regulation Would Tie Contract Payment to Contractors' Maintenance of 'Acceptable Business Systems'

By Joe Higgins

A recent proposal by the Department of Defense (DoD) would amend the Defense Federal Acquisition Regulation Supplement. It calls for requiring the withholding of contract payments for contractor failure to maintain what it terms "acceptable business systems."
The proposal is keynoted by the following statement: "Contractor business systems and internal controls are the first line of defense against waste, fraud and abuse. Weak control systems increase the risk of unallowable and unreasonable costs on government contracts. To improve the effectiveness of ... oversight of contractor business systems, DoD is considering a rule to clarify the definition and administration of contractor business systems."
Business systems covered by the new rule would include accounting systems, estimating systems, purchasing systems, earned value management systems (EVMS), material management and accounting systems (MMAS) and property management systems.
A new contract clause would require the Administrative Contracting Officer (ACO) to "immediately withhold 10% of each of the contractor's payments" once the ACO makes a final determination that a business system contains deficiencies.
The clause further specifies "if the ACO is withholding payments for deficiencies in more than one business system, the cumulative percentage of payments withheld shall not exceed 50% ... if the ACO determines that there are one or more system deficiencies that are highly likely to lead to improper contract payments being made, or represent an unacceptable risk of loss to the government, then the ACO will withhold up to 100% of payments until the ACO determines that the contractor has corrected the deficiencies."
This clause would be required "in solicitations and contracts when contemplating:
- A cost-reimbursement, incentive type, time and materials or labor-hour contract;
- A fixed-price contract with progress payments made on the basis of costs incurred by the contractor or on a percentage or stage of completion;
- A construction contract that includes the clause 52.232-27, Prompt Payment for Construction Contracts."
While the proposed regulation relies in large part on existing guidance on determining adequacy of estimating systems, EVMS, MMAS and property management systems, new clauses are proposed that cover accounting systems and purchasing systems. These new clauses greatly codify requirements that heretofore were matters of judgment and organizational style for many contractors.
The proposed clause, "Accounting system administration," describes an accounting system broadly as follows.
"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 data in compliance with applicable laws, regulations and management decisions."
The clause defines a deficiency as "a failure to maintain an element of an acceptable accounting system" and provides the following list of 17 "elements" of an acceptable system.
1. A basic structure that defines the form and nature of the organization as well as the management functions and reporting relationships;
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;
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. Periodic monitoring of the system, as appropriate;
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 FAR Part 31, Contract Cost Principles and Procedures, and other contract provisions;
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;
15. Cost accounting information as required:
(i) By contract clauses concerning limitation of cost (FAR 52.232-20) or limitation on payments (FAR 52.216-16); and
(ii) To readily calculate indirect cost rates from the books of accounts;
16. Billings that can be reconciled to the cost accounts for both current and cumulative amounts claimed and comply with contract terms; and
17. Adequate, reliable data for use in pricing follow-on acquisitions.
This pending change to requirements will surely place increased scrutiny on contractor business systems. And, once this change is implemented, the consequences of non-compliance could be very serious.
Now is the time for contractors to examine their systems against these pending new criteria.

Joe Higgins is a principal with JTH Consulting. He can be contacted at 301-875-7119 and jthconsulting@comcast.net.