DCAA Revises Guidance on Incurred Subcontract Cost Audits

By: Curt Smith, Manager

In Memorandum for Regional Directors (“MRD”) 19-PIC-001(R), dated January 11, 2019, the Defense Contract Audit Agency (“DCAA”) published audit guidance revising its policies and procedures for audits of incurred subcontract costs. In summary, prime contractor auditors will no longer request subcontract assist audits for the life of the subcontract. Rather, such auditors will evaluate risk every year and request subcontract assist audits as needed. DCAA is revising Section 6-802.5 of the Contract Audit Manual (“CAM”) and the 10100 Post Year-End Incurred Cost Audit Program to reflect the new guidance.

As an initial matter, contractors and subcontractors need to understand the government’s right to audit subcontractor costs. This right is derived from two statutes, one applicable to the Department of Defense, the National Aeronautics and Space Administration and the Coast Guard and the other applicable to the other executive agencies. These statutes are implemented in Federal Acquisition Regulation (“FAR”) 52.215-2. Under the statutes and FAR clause, the government has the right to audit the costs of any subcontract except a firm fixed price subcontract or a subcontract for commercial items. This is true regardless of the type of prime contract. Thus, even if the prime contract is a cost reimbursement contract, the government does not have the right to audit the costs incurred by a subcontractor performing a firm fixed price subcontract under that cost reimbursement prime contract.

DCAA is changing its approach on subcontract costs from life of the subcontract to a risk-based approach emphasizing communication between the prime contractor and subcontractor auditors to assess risks associated with subcontract costs each year. Prime contract auditors should communicate with subcontract auditors about audit history, prior issues, eligibility for the low-risk sampling pool, reliability of the indirect rates/budgets, and other issues that affect risk while subcontract auditors should make prime auditors aware of any significant subcontractor risks that become known during the year.

Communication concerning issuance of a low-risk memorandum (“LRM”) is considered critical. Adequate incurred cost submission (“ICS”) proposals of less than $250 million in auditable dollar volume (“ADV”)* are currently considered part of the low risk pool and are eligible for exemption from audit and the issuance of an LRM upon meeting certain criteria. DCAA typically selects proposals in the low-risk pool for audit through the use of statistical sampling.

Per the MRD, if prime auditors are aware of a material risk relating to subcontract cost, they should communicate with the subcontract auditor as soon as possible. The subcontract auditor can then determine whether the risk is material and/or pervasive enough to consider the subcontractor high risk. Subcontractors may be eligible for low-risk sampling if they are also a prime contractor and the prime auditor and contracting officer agree on that eligibility. The subcontract auditor should document the risk factors identified by the prime auditor and determine whether to proceed with performing an assist audit or issuing an LRM.

The MRD also reiterated the responsibilities of the prime contractor for managing its subcontractors and stated that auditors should not question subcontract costs based exclusively on deficiencies in the prime contractor’s subcontract management system. Instead, auditors should:

1. Design audit procedures sufficient to mitigate the risk to the government; and
2. Determine whether to report the deficiency.

Historically, DCAA has maintained an aggressive stance with regard to prime contractor obligations to manage subcontractors. However, prime contractors should be familiar with the Armed Services Board of Contract Appeals (“ASBCA”) decision in Lockheed Martin Integrated Systems Inc., ASBCA Nos. 59508 and 59509, dated December 20, 2016, where the Board took exception to DCAA’s perspective. The Board stated in its opinion, “In this case, we are presented with a claim based on a legal theory, originated by an auditor…. [The government] has gone forward with a claim for over $100,000,000 that is based on nothing more than a plainly invalid legal theory.”

*While not specifically defined in the FAR, CAM or elsewhere, ADV is typically considered by DCAA to be the total contract cost for flexibly priced government contracts and subcontracts incurred by a contractor during the current fiscal year. Flexibly priced contracts do not include contracts that are firm-fixed-price nor the “time” or labor portion of time and material contracts. ADV can be found on Sch. H and/or Sch. I of an ICS proposal.