09.07.10

Proposed Business Systems Rule Changes

On January 15, 2010, the Department of Defense (“DOD”) Defense Acquisition Regulations (DAR) Council submitted proposed rule changes to the Defense Federal Acquisition Regulation Supplement (DFARS) entitled Business Systems – Definition and Administration (DFARS Case 2009-D038), proposing changes to what is currently defined as Contractor Business Systems. In the proposed rule, the DOD states that the changes were proposed in an effort “to improve the effectiveness of DOD oversight of Contractor Business Systems.” If accepted, the proposed changes would drastically alter the landscape of Contractor Business System environments.

The DAR Council has received numerous public comments voicing concerns over the proposed rule. Despite this fact, months have passed without any revisions or any indication that public hearings will be held related to the rule.

This article discusses business systems (both as currently defined by regulations and as they would be defined under the proposed rule changes), the proposed rule changes, and implications of the proposed rule changes to Government Contractors.

Current and Proposed Business System Changes

Currently, the Defense Contract Audit Agency’s (“DCAA”) Contract Audit Manual (“CAM”) identifies ten business systems.¹  The ten business systems are as follows:

• Control Environment and Overall Accounting System
• General IT System
• Budget and Planning System
• Purchasing System
• Material System
• Compensation System
• Labor System
• Indirect and ODC System
• Billing System
• Estimating System

The systems listed above, which are more commonly referred to as Internal Control Audit Planning Summary (ICAPS) systems, have historically been the systems audited by the DCAA at major Contractors. The proposed rule changes would reduce the ten systems defined by the CAM down to six. The proposed rules include a new ‘business systems’ clause (proposed DFARS 252.242-7XXX), which defines all proposed systems, requirements to respond to determinations of systems deficiency, and rules for final determination of deficiency. The six business systems under the proposed changes are:

• Accounting System
• Estimating System
• Purchasing System
• Earned Value Management System (“EVMS”)
• Material Management and Accounting System (“MMAS”)
• Property Management System

It appears the six systems within the proposed rule are limited to those systems that are based on regulatory requirements within either the Federal Acquisition Regulation (FAR) or DFARS. See Table I below.

Table I

Proposed Rule “Business System”	Existing Regulatory Requirement
Accounting System	FAR 16.301-3 Limitations
Estimating System	DFARS 215.407-5 Estimating Systems DFARS 252.215-7002 Cost Estimating Systems
Purchasing System	FAR Subpart 44.3 – Contractor Purchasing Systems Reviews FAR Clause 52.244-2 Subcontracts
Earned Value Management System	DFARS Subpart 234.2 Earned Value Management Systems DFARS Clause 252.234-7002 Earned Value Management Systems
Material Management System	DFARS Clause 242.242-7004
Property Management System	FAR Clause 52.245-1 Government Property Systems

It is currently unclear whether other systems not specifically mentioned in the proposed rule would still be subject to audit by the DCAA.

Other Proposed Changes

The DOD is also proposing to implement compliance enforcement measures within the business systems clause which would allow the Administrative Contracting Officer (“ACO”) to withhold a percentage of payments if it was determined that any or all of the Contractor’s systems contained a deficiency. Details on payment withholds in the proposed rule changes are discussed later in this article.

Detailed Discussion of Business Systems

Accounting System

Per the DCAA Contract Audit Manual, a Contractor’s Accounting System consists of methods and records established to identify, assemble, analyze, classify, record, and report an entity’s transactions and to maintain accountability for the related assets and liabilities. The accounting system should be well-designed to provide reliable accounting data and prevent misstatements that would otherwise occur. Adequate accounting systems typically record transactions in accordance with Generally Accepted Accounting Principles (“GAAP”), segregate for unallowable costs, and properly apply indirect costs to final cost objectives, among other characteristics.

Per the proposed changes to the DFARS, a new Accounting System Administration clause has been recommended (proposed DFARS 252.242-7YYY). The accounting system requirements in the proposed rule changes include:

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:
    • By Contract clauses concerning limitation of cost (FAR 52.232-20) or limitation on payments (FAR 52.216-16); and
    • 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.

These control objectives are consistent with the objectives currently within Standard Form (SF) 1408, which is used in evaluating a prospective Contractor’s accounting system during the course of a Pre-Award Accounting Survey. Per FAR 16.301-3, a cost-reimbursement contract can only be used when a Contractor’s accounting system is adequate for determining costs applicable to the contract.

Estimating System

An estimating system, as described by DFARS 252.215-7002, is a Contractor’s policies, procedures, and practices for generating cost estimates which forecast costs based on information available to the Contractor at the time of estimate. It includes the Contractor’s organizational structure; established lines of authority, duties, and responsibilities; internal controls and managerial reviews; flow of work, coordination, and communication; and estimating methods, techniques, accumulation of historical costs, and analyses used by a Contractor to generate cost estimates and other data included in proposals submitted in the expectation of receiving contract awards. The proposed rule changes would revise the definition of an acceptable estimating system as follows:

An acceptable estimating system means an estimating system that complies with, but is not limited to, the system requirements [of the proposed regulations], and provides for a system that-

1. Is maintained, reliable, and consistently applied;
2. Produces verifiable, supportable, and documented cost estimates that are an acceptable basis for negotiation of fair and reasonable prices;
3. Is consistent with and integrated with the contractor's related management systems;
4. Is subject to applicable financial control systems;
5. Utilizes appropriate source data;
6. Utilizes sound estimating techniques and good judgment;
7. Maintains a consistent approach to estimating; and
8. Adheres to established policies and procedures.

Specific requirements for a compliant estimating system as defined in the proposed rule include the following:

An acceptable estimating system shall accomplish, but not be limited to, the following functions—

1. Establish clear responsibility for preparation, review, and approval of cost estimates;
2. Provide a written description of the organization and duties of the personnel responsible for preparing, reviewing, and approving cost estimates;
3. Assure that relevant personnel have sufficient training, experience, and guidance to perform estimating tasks in accordance with the contractor's established procedures;
4. Identify the sources of data and the estimating methods and rationale used in developing cost estimates;
5. Provide for appropriate supervision throughout the estimating process;
6. Provide for consistent application of estimating techniques;
7. Provide for detection and timely correction of errors;
8. Protect against cost duplication and omissions;
9. Provide for the use of historical experience, including historical vendor pricing information, where appropriate;
10. Require use of appropriate analytical methods;
11. Integrate information available from other management systems, where appropriate;
12. Require management review including verification that the company's estimating policies, procedures, and practices comply with this regulation;
13. Provide for internal review of and accountability for the acceptability of the estimating system, including the comparison of projected results to actual results and an analysis of any differences;
14. Provide procedures to update cost estimates in a timely manner throughout the negotiation process; and
15. Address responsibility for review and analysis of the reasonableness of subcontract prices.

These requirements are the same as those that are currently listed at DFARS 215.407-5-70(d) as the evaluation criteria for an acceptable estimating system.

Purchasing System

FAR Subpart 44.303 contains the requirements of Contractors Purchasing System Reviews (CPSR). Per FAR Subpart 44.303, the objective of a CPSR is to evaluate the efficiency and effectiveness with which a Contractor spends Government funds and complies with Government policies regarding subcontracting.

Per DCAA Contracting Audit Manual (Chapter 5, Section 600), a Contractor’s purchasing system is used for purchasing items (including make or buy decisions), subcontractor selection and monitoring, the selection of vendors, analysis of quoted vendor prices, negotiation of prices with vendors, placing and administration of purchase orders, and expediting delivery of materials, among other functions.

Under the proposed rule, a new DFARS clause would be created, DFARS 252.244-7XXX, which would require that a system have the following requirements, to be considered adequate:

1. Have an adequate system description including policies, procedures, and operating instructions that comply with the FAR and DFARS.
2. Ensure that all applicable purchase orders and subcontracts contain all flow down clauses, including terms and conditions and any other clauses needed to carry out the requirements of the prime Contract.
3. Maintain an organization plan that establishes clear lines of authority and responsibility.
4. Purchase orders are based on authorized requisitions and include complete history files.
5. Establish and maintain adequate documentation to provide a complete and accurate history of purchase transactions to support vendors selected and prices paid.
6. Apply a consistent make or buy policy that is in the best interest of the Government.
7. Use competitive sourcing to the maximum extent practicable and ensure debarred or suspended contractors are properly excluded from contract award.
8. Evaluate price, quality, delivery, technical capabilities, and financial capabilities of competing vendors.
9. Require management level justification and cost/price analysis as applicable for any sole or single source award.
10. Perform appropriate cost or price analysis and technical evaluation for each subcontractor and supplier proposal or quote.
11. Document negotiations in accordance with FAR 15.406-3.
12. Seek, take, and document appropriate purchase discounts, including cash discounts, trade discounts, quantity discounts, rebates, freight allowances, and company-wide volume discounts.
13. Ensure proper type of contract selection and prohibit issuance of cost-plus-a-percentage-of-cost subcontracts.
14. Maintain subcontract surveillance to ensure timely delivery of an acceptable product and procedures to notify the Government of potential subcontract problems that may impact delivery, quantity, or price.
15. Document and justify reasons for subcontract changes that affect cost or price.
16. Notify the Government of the award of an auditable subcontract and perform adequate audits of those subcontracts.
17. Enforce adequate policies on conflict of interest, gifts, and gratuities, including the requirements of the Anti-Kickback Act.

These control objectives are similar to those historically used by DCAA in evaluating a Contractor’s Purchasing Controls as well as those used by the Defense Contract Management Agency in performing Contractor Purchasing System Reviews.

Earned Value Management System (“EVMS”)

A Contractor’s earned value management system, as described in FAR Subpart 34.2, is an integrated set of policies, procedures, and practices to support program and project management as a decision enhancing tool and a critical component of risk management. An EVMS measures actual performance of work scope and the associated cost and schedule versus an agreed to baseline plan, while using disciplined means of baseline change control for documenting any changes to the agreed to baseline plan.²  The proposed rule changes would add standardized language regarding system deficiencies and withholding of payment to regulatory language for EVM systems.

Material Management and Accounting System (“MMAS”)

Per DFARS 252.242-7004, a Material Management and Accounting System is a Contractor's system or systems for planning, controlling, and accounting for the acquisition, use, issuance, and disposition of material. Material management and accounting systems may be manual or automated. They may be stand-alone systems or they may be integrated with planning, engineering, estimating, purchasing, inventory, accounting, or other systems (DFARS Clause 252.242-7204). As discussed later in this article, the proposed rule changes would add standardized language regarding system deficiencies and withholding of payment to regulatory language for MMA systems.

Property Management System

A Contractor’s property management system, as described by FAR Part 52.245-1, should manage (control, use, preserve, protect, repair and maintain) Government property in its possession. The system must be adequate to satisfy the requirements of FAR Part 52.245-1, and in doing so, the Contractor should initiate and maintain the processes, systems, procedures, records, and methodologies necessary for effective control of Government property. During the period of performance, the Contractor should disclose any significant changes to their property management system to the Property Administrator prior to implementation. The Contractor’s responsibility extends from the initial acquisition and receipt of property, through stewardship, custody, and use until formally relieved of responsibility by authorized means, including delivery, consumption, expending, disposition, or via a completed investigation, evaluation, and final determination for lost, damaged, destroyed, or stolen property. This requirement applies to all Government property under the Contractor’s accountability, stewardship, possession or control, including its vendors or subcontractors.

The proposed rule changes do not specifically address any changes to property management systems or the applicable FAR Clause; however, at a minimum, standardized language regarding system deficiencies and withholding of payment will be added to regulatory language for property management systems.

New Regulations and Clauses

Likely, the most material changes associated with the proposed rule changes are standardized clauses and regulations which would serve to formalize the ACO’s responsibilities regarding determining systems deficiencies and the Contractor’s response to any deficiency determinations, as well as the financial ramifications of potential Contract withhold. These processes and requirements would be applicable to all six business systems should the proposed rule changes become final. The proposed clause and regulatory changes include Business Systems Deficiencies, Business Systems (definitional), and Withholding of Payments.

Business System Deficiencies (Proposed DFARS 242.70X1)

Under the proposed rule changes, a new subpart 242.70 entitled Business Systems would be incorporated into the DFARS. This subpart would incorporate the proposed Business Systems clause (242.242-7XXX) into DOD Contracts. Under the new subpart, a cognizant auditor (most likely DCAA) would issue a report to the ACO identifying any system deficiencies, with sufficient detail to allow the ACO to understand what needs to be corrected and the potential magnitude of risk to the Government. Based on the report, if the ACO makes an initial determination of system deficiency, the ACO would need to provide notice of the deficiencies and a copy of the audit report to the Contractor, and provide notice to the Contractor to submit a written response. The Contractor would have 30 days to respond to initial determinations of system deficiencies. The ACO, with consultation from the auditor, would evaluate the Contractor’s response and notify contactor in writing of the final determination as to whether the business system contains deficiencies.

If the ACO makes a final determination that a Contractor’s system contains deficiencies, the final determination would include a notice of a decision to withhold payments. Additionally, for system deficiencies requiring corrective action, Contractors would have to submit an acceptable corrective action plan within 45 days after the initial determination of deficiencies if the deficiencies identified had not been corrected within those 45 days.

Once the Contractor notifies the ACO that the deficiencies have been corrected, the ACO will request that the auditor review the corrections to determine if the deficiencies have been resolved. Once the ACO is satisfied that the deficiencies have been resolved, the ACO would discontinue withholding payments.

Business Systems Clause (Proposed DFARS 252.242-7XXX)

As described above, the business systems clause outlines all proposed systems, requirements to respond to determinations of systems deficiency, and rules for final determination of deficiency. The new clause incorporates the proposed changes under 242.70X1. In addition, the new rules stipulate the parameters of the payment withholds associated with system deficiencies.

Withholding of Payments

Under the proposed rule changes, payment means any of the following payments authorized under the following:

• Interim payments under--
  • Cost reimbursement contracts;
  • Incentive type contracts;
  • Time-and-materials contracts;
  • Labor-hour contracts.
• Progress payments.
• Performance-based payments.

Under the proposed rules, final determination of system deficiencies would include a recommendation to the ACO to withhold payments under applicable contracts. In such circumstances, the ACO should immediately withhold 10% of each of the Contractor’s payments under that specific contract for each system deficiency. As stated above, the Contractor then has 45 days to submit acceptable corrective action. If deficiencies are not completely corrected, but an acceptable corrective action plan is submitted, the ACO will reduce the withholding on payments down to 5% until all deficiencies are corrected. If the ACO determines that Contractor failed to follow the accepted corrective action, the ACO can again raise the withholding penalty to 10%.

The language on the consequences to Contractors if more than one system is deficient is contradictory. Subparagraph (d)(3) of the new clause states that the cumulative percentage of all payments withheld would not exceed 50% of the Contract; however subparagraph(d)(4) states that if the ACO determines that one or more system deficiencies are highly likely to lead to improper Contract payments being made or represent an unacceptable risk of loss to the Government, the ACO may withhold up to 100% of payment until the Contractor has corrected deficiencies. The proposed rule changes dictate that once the Contractor has notified the ACO that system deficiencies have been remediated and the ACO is satisfied that the deficiencies have been corrected, the ACO is to discontinue payment withholding and is to release any and all monies previously withheld due to determinations of deficiency. Note that the payment withholding authorized in the proposed rule would not be subject to the interest-penalty provisions of the Prompt Payment Act.

Implications to Contractors

If the proposed rule changes were accepted, there would be a number of implications to Contractors. First, the potential impact to a Contractor’s cash flow of withheld payments in circumstances where deficiencies are asserted is significant. In light of significant questions about the consistency of application of any new audit standards, Contractors are concerned that what constitutes a deficiency will vary among DCAA branches and auditors, meaning consistent application of the standards would not be applied institutionally. The fact that there is currently no governing body to perform peer reviews of work performed by DCAA should only add to the angst Contractors already feel about the proposed rule and the potential financial impact.

Second, the costs of compliance to Contractors would likely significantly increase. These increased costs would be due to additional internal costs (such as training, review and refinement of official policies and procedures, re-evaluation of their current systems, etc.), as well as costs associated with supporting Government system audits. It is our understanding that the DCAA is currently trying to establish a group of auditors that specialize in system audits. This means that any efficiency gained through other types of Government audits would likely be lost on this new group of specialists, increasing support efforts and costs for Contractors.

Third, the impact of the proposed rule changes to competition among Contractors is unclear. The proposed rule provides no guidance or standards as to how system deficiencies should be considered during the award of a contract/subcontract. Currently, agencies and prime Contractors are required to assess a Contractor’s systems prior to awarding certain contracts. It is unclear under the proposed rules whether determinations of deficient systems would impact a particular Contractor’s status as a responsible provider or whether existing withholds would be sufficient to mitigate risks associated with system deficiencies. As such, the possibility exists that Contractors deemed to have deficient business systems could be put at a competitive disadvantage against its peers in the Government’s source selection process.

Fourth, Contractors looking to have systems audits performed have mostly been put on a holding pattern by the DCAA as the proposed rule moves through the regulatory process. Prior to the proposed rule, the DCAA made significant changes to how it audits Contractors’ systems. Collectively, these changes resulted in a significant change in the audit environment related to Contractors’ systems. One ramification of these changes is that some Contractor’s systems audits are now considered out of date and, as a result, their systems are considered to be unaudited. The DCAA has indicated to many Contractors that it does not intend to perform any new systems audits until the proposed rule is finalized. During the source selection process of the award of a contract or subcontract, this could put a particular Contractor at a competitive disadvantage against another Contractor with systems recently deemed adequate.

Recommendations

At a minimum, Contractors should be prepared to document to both their auditors and ACO the adequacy of their systems. It is recommended that Contractors

• Inventory and document key internal controls for each major system, including those with both DCAA and DCMA surveillance responsibility;
• Appropriately staff the compliance function and be prepared to demonstrate the effectiveness of internal control systems;
• Establish a robust record management system and communication process to be used in future audits; and
• Independently assess the adequacy of their systems to existing standards.

In addition, to the extent that a Contractor’s system has not been audited and the lack of audit puts the Contractor at risk for contract award, consideration should be given to engaging independent auditors to evaluate the adequacy of systems through an attestation engagement.

Conclusion

The proposed rule changes related to business systems are significant. In addition to substantially increasing the requirements for Contractors to maintain compliant systems, penalties for maintaining deficient systems would be substantially increased should the proposed rules become final. As the proposed rule changes get closer to potentially becoming final, Contractors should be prepared for potential implications. Full detail of the proposed rule changes, as well as implications to Contractors, are outside of the scope of this article. Contractors are advised to consult with Government Contract professionals in order to gain a full and comprehensive picture of how the proposed rule change may impact them.

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1 1 DCAA CAM Chapter 5, Section 102.
2 Earned Value Management System (EVMS). Department of Energy. July 26, 2010. <http://www.er.doe.gov/opa/PDF/g4133-10%20EVMS.pdf>

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