As if government contract accounting isn't complex enough. Limited Liability Corporation (LLC-formed) companies face an additional burden when complying with DCAA audit requirements that focus on labor collection and distribution.

Labor timekeeping
Regardless of the type of firm (S-corp, C-corp, LLC), government contract accounting requirements dictate, with few exceptions, that all employees record all time spent on-the-job. Paid time off is also expected to be recorded. This time is then converted to dollars and distributed as either a direct contract expense, or an indirect expense. (For uncompensated overtime accounting, see the previous blog entry.)

The government's expectation is that labor expenses booked against government contracts will reconcile to payroll. When employees are paid via regular W2 methods, this process is straight forward. All expensed labor and most of the fringe paid-time-off expense reside on the income statement.

LLC twist
Under an LLC compensation environment, the government still expects "labor" to be expensed as a function of time spent at work or for paid time off. That means, even in an LLC environment, a timekeeping system is essential.

The difference is, according to GAAP, LLC compensation is not a recognized expense, but rather a distribution of proceeds. The conflict naturally exists that the government wants to see labor as a compensated expense, but GAAP doesn't.

How to reconcile
Creative accountants are capable of designing a method to meet both of these requirements simultaneously. We happen to think our method does the job efficiently and in full compliance with both GAAP and DCAA rules.

One question we always get is how to account for uncompensated overtime. Almost every small business has at least one employee working gazillion hours over a standard 40-hour work week. The DCAA considers these hours "at work labor." They want these hours captured in the name of treating all contractors accounting and pricing systems equitably and consistently.

Not addressing this issue successfully now poses a huge risk since DCAA auditors have no wiggle room in overlooking it as a minor problem. Any deficiency in your accounting system will likely lead to a failing grade, according to the latest DCAA guidance to its auditors (see previous article). This could prevent you from obtaining lucrative flexibly-priced contracts or fixed price contracts financed through progress payments.

The DCAA way
The basic DCAA audit guidance for addressing uncompensated overtime is very simple and straight-forward. They will divide your yearly salary by all the hours you worked and used for personal time off. This results in your "effective" billing rate. The DCAA expects you to adjust your rate in your accounting system each pay period to reflect this effective rate. The drawback to this system is contractors have to make these adjustments in their accounting system every pay period. It also artificially reduces your hourly rate. The DCAA will use this lower rate when evaluating any proposal you have submitted to the government or a prime.

A better way
The DCAA guidance does recognize other methods as being suitably fair and consistent. One approach lets you use your existing timekeeping system to segregate your "extra effort" hours, dollarize those hours, and direct those dollars to the appropriate place on your balance sheet as a liability, similar to how you might already treat regular accrued wages. Periodically, you can bring those dollars back to the income statement as a credit expense in an indirect pool. This reduces your pool costs, which gives the government credit for your extra work. You also won't have to adjust your billing rates in your accounting system or for proposals.

Everyone's happy, even the DCAA. That's what life's all about for government contractors, right?

I had the pleasure and distinction of being the opening act of a Deltek Users conference recently in Denver. Rich Wilkinson, VP of Government Contracting for Deltek had put together a deck of slides discussing new audit guidance released from the Defense Contract Audit Agency (DCAA). This is something the DCAA traditionally provides toward the end of each year, just in time for the holidays.

I'll pause here to say Rich is one of the good guys in government contracting. A former Naval contracting officer and Deltek veteran, he's deeply connected with the current and changing govcon environment. As a thought leader, his opinions should be tapped frequently through his blog at http://govcontoday.deltek.com.

Back to the DCAA guidance, which is a series of memos that can be found on www.dcaa.mil. Look for the link to Open Audit Guidance.

The Deltek presentation honed in on memos 08-PAS-041 through -044, as well as 09-PPD-002. In general, the guidance to auditors increases the scrutiny of contractor accounting systems, and leaves the auditors little discretion in failing systems that may have been approved in the past. The general area of internal control and contractor responsiveness appears to be a strong focus.

Some selected examples:
If an accounting system happens to fail an audit (memo -041), the auditor is compelled to recommend to the contracting officer that payments be suspended.

Accounting systems will be deemed adequate or inadequate. No longer will they be deemed "inadequate in part" (memo -043). Auditors will not be allowed to suggest improvements to contractor accounting systems. We actually think that's a good idea. The DCAA dictates their preferred way for a number of accounting methods, but it's not always the best way. Accounting for uncompensated overtime is a prime example.

Our recommended action plan

• Revisit the DCAA Contract Audit Manual (CAM) relative to internal controls. The CAM is the DCAA playbook and available free on the DCAA website.
• Now would be the ideal time to identify and confront any material organizational or operational weakness in your accounting system. If management is still skeptical, turn around and show them the target on your back in the form of DCAA guidance.
• Address any previous finding from auditors. Any subsequent auditor will likely review these, as well.
• Prepare for a more confrontational tone from auditors.
• Continue to maintain a good relationship with your ACO, CO and technical counterparts. (DAD)