NCMA – Boston Chapter annual March workshop

1. www.pwc.com NCMA – Boston Chapterannual March workshop Recent industry actions that may impact your next government audit March 2012

2. Agenda • Defense Contract Audit Agency (DCAA) – Recent Initiatives and Guidance • National Defense Authorizations Act (FY2012) – Executive Compensation • GAO Report – DCAA Access to Internal Audit Reports • Regulatory and Industry Updates • Q&A / Open Discussion

3. Part 1 Defense Contract Audit Agency (DCAA) – Recent initiatives and guidance

4. Current Audit Environment and Trends • New regulations and heightened oversight • The oversight pendulum may be near the high point • Based on prior cycles of increased oversight, we may be close to the midpoint of a seven year cycle • The common theme of the latest round of regulatory changes, beginning with the mandatory disclosure rules in 2008, is that “guidance” has become “contractual” with enforcement penalties • Higher standards have been placed on contractors for self-governance and accountability • Compliance organizations are becoming more strategic and reliant on formal control systems using more advanced business processes and technology • Compliance systems can be a competitive advantage or disadvantage • Backlog of forward pricing rate and incurred cost proposals is a serious challenge

5. DCAA related – • Recent Industry – Government Meetings • Incurred cost proposals – new audit efforts underway • Business systems requirements saddle the government with a new source of audit backlog • Guidance expected on the new DFARS business systems final rule • Lingering issues – materiality, sample sizes and independence • Other areas of audit focus • Home office allocations • Advance agreements • Dependent health benefit costs • Post award audits • Long term DCAA strategy – accountability, quality, training, relationships and resources

6. DCAA related (continued) • Recent Industry – Government Meetings – DFARS Business System Specific • DCAA will no longer include a recommendation to approve/disapprove a business system in their audit reports • DCAA’s business system audits will be attestation compliance audits • State whether the contractor is compliant or noncompliant with each of the system criteria listed in DFARS • DCAA still determining whether any noncompliance with a system criteria will be considered a significant deficiency within the meeting of the regulation • Any material weaknesses will be considered a system deficiency • DCAA does not intend to be prescriptive or dictate a contractor’s system policy and procedures; the business system criteria are broad and there is more than one effective way to achieve the desired internal control • DCAA will no longer issue Flash Reports as a means of identifying potential system deficiencies - they will issue a complete noncompliance report with adequate supporting detail

7. DCAA “Rules of Engagement” for auditor communications (dated but still relevant) • DCAA issued audit guidance on establishing open and effective communications with all stakeholders – see Memorandum for Regional Directors (MRD) 10-PAS-035(R) • This aimed to clarify existing guidance on coordinating and communicating with the Contracting Officer and the contractor during every phase of the audit. • Per Generally Accepted Government Auditing Standards (“GAGAS”) 6.07, auditors must communicate certain information regarding their understanding of the services to be performed, in writing, during audit planning and prior to the entrance conference. • All parties participate in the contractor walk through of the proposal • Contractors can expect the following communication during the audit: • Keep stakeholders informed of major audit issues • Timely notification of required extensions • Status of audit clearly communicated • Contracting Officer participation in exit conference

8. What to expect in 2012 and beyond • Large increase in DoD contract auditing staff • According to media reports - DoD plans to add up to 1,612 employees to oversee and audit contracts over the next year in an attempt to catch up with a significant audit backlog. This increase in staff is intended to: • Shrink the $400 billion in unaudited contract bills • Help the government to recover up to $2.2 billion in overbillings • Increase the number of “incurred cost” audits as the number of audits decreased 44 percent from FY10 to FY11 • Continue efforts to build relationships with stakeholders • Increase quality of audits

9. Part 2 National Defense Authorizations Act (FY2012) – Executive compensation

10. Executive compensation • The National Defense Authorization Act (NDAA) for FY2012 was signed into law on December 31, 2011 • The law expanded the limits on reimbursable executive pay to cover all contractor employees instead of just the five most highly-paid executives in each company. However, it left the formula for determining the limits in place. • Currently the maximum executive compensation benchmark is set at$693,951 – this has not been updated since April, 2010. • This does not prohibit contractors from paying senior executives or other employees in excess of the benchmark, however, rather it makes compensation in excess of the benchmark unallowable per FAR 31.205-6. • Compensation expenses still must pass reasonableness test • Administrator of OFPP on Jan. 31 urged Congress “to take the critical step of repealing the existing statutory formula” governing the amount of executive compensation government contractors can claim as reimbursable costs and to bring the “the cap down to a level on par with what the government pays its own executives—approximately $200,000.”

11. Part 3 GAO report – DCAA access to internal audit reports

12. GAO report – DCAA access to internal audit reports • Background • The Government Accountability Office (“GAO”) was asked to determine the role of defense companies' internal audit departments and their ability to provide DCAA with information on their internal controls. They reviewed DCAA’s interactions with the internal audit departments at the five largest contractors and two smaller, but major, contractors. The report issued on December 8, 2011, assessed the following areas: • Selected defense companies' adherence to standards for internal audits; • The extent to which those companies' internal audit reports address defense contract management internal controls; and • DCAA's ability to examine internal audits and use information from these audits to conduct oversight. • The seven companies together conducted 1,125 internal audits during the review period, 520 of which were related to the defense contract control environment and one or more areas reviewed by DCAA. The recommendations made by the GAO are expected to have an immediate impact on DCAA’s tactical approach in accessing contractor records.

13. GAO report - Access to internal audit reports (continued) Summary of Report and Findings • The GAO report concluded that DCAA's access to and use of internal audit information from the companies' reports and work papers was limited. Reasons include: • Court precedent does not favor DCAA access to internal audit reports and work papers • DCAA’s lack of access exists in part because DCAA management is not aware of the access limitations and also because DCAA does not regularly track the status of requests for internal audit information • Contractor requirements that DCAA justify its request for information and demonstrate the relevance of the request to existing or planned DCAA audit effort. • DCAA Auditors stated they could not identify relevant internal audits and were uncertain whether those reports would be useful in any event.

14. GAO Report - Access to internal audit reports (continued) • Summary of Report and Findings (continued) • Other conclusions: • By failing to routinely access internal audits, GAO concluded, DCAA limits its ability to effectively and efficiently evaluate companies' internal controls. • The lack of access to information to which DCAA might be entitled limits their ability to conform to GAGAS • Considering the work performed by internal audit departments will allow DCAA to be more informed during audit planning • To increase DCAA's access to and use of internal audits, GAO recommended that the Secretary of Defense instruct DCAA to: • Ensure that the central point of contact for each company coordinates issues pertaining to internal audits; • Periodically assess information compiled by the central points of contact regarding the number of requests for internal audits and their disposition; and • Train its staff regarding how and when company internal audit reports can be accessed and used to improve audit efficiency.

15. GAO report - Access to internal audit reports (continued) • What Contractors Can Expect • Increase in requests for internal audit documents, including plans, reports, and work papers. Based on the DOD’s acknowledgement and commitment to implement the GAO’s key recommendations, contractors can expect DCAA to coordinate its approach in the following ways: • Formal tracking of the volume and status of DCAA’s request for access to internal audit data • Increased pressure on company leadership to facilitate auditor access • More informed DCAA auditors • Further emphasis on validation that contractors maintain compliance programs as required under FAR 52.203-13, Contractor Code of Business Ethics and Conduct • Increased pressure to establish standards and procedures to facilitate timely discovery of improper conduct • Corrective measures are promptly instituted and carried out Actions anticipated to be undertaken by DCAA to increase access will re-invigorate the debate over access to records

16. GAO report - Access to internal audit reports (continued) • Approaches to Permitting Controlled Access to Records • Striking the right balance between open access and total restriction of records in providing relevant records • Providing the DCAA point of contact with a list of listing audit reports, location of field work and corrective actions in place. Brief descriptions of audits can be paired with titles to assist DCAA in identifying relevant reports • Requiring that requests for internal audit information be made in writing with sufficient explanation to justify the relevance of the requested information • Providing a consistent medium of access which may include read-only access to audit information, copies of complete audit reports, copies of redacted reports or audit report summaries of actions, findings and recommendations • Maintaining the companies own log of DCAA requests for audit reports, the specifics of the request, the final determination on access and the rationale for permission or denial • Agreed detailed Corrective Action Plans as part of audit report

17. Part 4 Regulatory and industry update

18. DFARS Business System Final Rule (DFARS 252.242-7005) • Final rule became effective February 24, 2012 • Changes are not substantive from the interim rule • Key changes: • Clarifies rule only applies only to contracts awarded that are subject to Cost Accounting Standards. The change was made in response to a comment pointing out that, while the rule defines covered contracts as those subject to CAS, “a contracting officer will not typically know if the resulting contract will be subject to CAS when drafting the solicitation.” “The clause has been amended to make it self-deleting if CAS does not apply,” • Replaces language “periodic monitoring” with “management reviews or internal audits of the system to ensure compliance with the contractors established policies, procedures and accounting practices”

19. DFARS Business System Final Rule (DFARS 252.242-7005) • Recent intelligence • Not applied being to contracts below $50 million in award value • Applied on a contract by contract basis (DoD contracts only) • Past DCAA accounting system audit programs pilot - obsolete • Caution on significant value subcontracts

20. Harmonization of CAS 412 and 413 with the pension protection Act • Background • On Dec. 27, 2011, the CAS Board issued a long-awaited final rule bringing its standards in line with requirements of the 2006 Pension Protection Act on minimum pension plan contributions. The final rule is effective Feb. 27, 2012. • As background - CAS 412 addresses the determination and measurement of pension costs and their assignment to cost accounting periods while CAS 413 provides guidance for adjusting pension costs by measuring actuarial gains and losses. • The new rule changes CAS 412 and 413 to: • “Include the recognition of a “minimum actuarial liability” and “minimum normal cost” which are measured on a basis consistent with the liability measurement used to determine the PPA minimum required contribution”

21. Harmonization of CAS 412 and 413 with the Pension Protection Act (continued) • It also accelerates the assignment of actuarial gains and losses to accounting periods by decreasing the amortization period from a fifteen-year period to a ten-year period. “This accelerated assignment will reduce the period of deferral in cost recognition and is consistent with the shortest amortization period permitted for other portions of the unfunded actuarial liability (or actuarial surplus),” the rule says. • The ten-year amortization of gains and losses begins with the first cost accounting period this final rule is applicable to the contractor • There is a transition period consisting of five cost accounting periods, that will phase in recognition of any adjustment of the actuarial accrued liability and normal cost, applicable to all contractors with contracts subject to CAS 412 and 413.

22. Harmonization of CAS 412 and 413 with the Pension Protection Act (continued) • Cost Recovery • Opportunity to seek a request for equitable contract price adjustment due to shorter amortization period – Defined Benefit Pensions only. • Different treatment for contracts awarded pre and post effective date (February 27, 2012) • Pre effective date – equitable adjustments • Post effective date – recovery through forward pricing rates • Calculation of new forward pricing rates within 60 days of publication of final rule • Must apply the transition rules to phase-in recognition • No other updates to actuarial assumptions other than those required by the new rule • Required notification for required Cost Accounting Change • Disclosure statement updates • Impact of segment closings

23. CAS threshold – • CAS Board Interim Rule – July 12, 2011 • Effective Aug. 11, the threshold for application of the CAS increased from $650,000 to $700,000 in order to match the corresponding increase in the Truth in Negotiations Act cost and pricing data threshold that became effective October 1, 2010 • Future increases in the CAS threshold to reflect adjustments for inflation will be tied to any changes in the TINA threshold • Removes the previous language setting the CAS applicability threshold at a fixed amount • Future changes to the threshold will “self-execute upon any changes to the TINA” • As a point of information the TINA threshold and other acquisition-related dollar thresholds in the FAR are adjusted for inflation every five years Regulatory Update • Government Contracts

24. CAS board eliminates overseas exemption to cost accounting standards – • There have been two CAS exemptions related to foreign operations: • Contracts and subcontracts to be executed and performed entirely outside the U.S., its territories and possessions • This exemption has been eliminated as of October 10, 2011 • Contracts awarded to foreign concerns (which have a limited exemption) and are subject to CAS 401 and 402 only (less than modified coverage) • This exemption has not been eliminated • Definition - A “foreign concern” is a concern incorporated outside the U.S. or has its principal place of business outside of the U.S. (i.e., any concern other than a domestic concern – See DFARS 225.003) Regulatory Update • Government Contracts

25. CAS board eliminates overseas exemption to cost accounting standards (continued) – • CAS Board Comments • The Board said it was not persuaded that imposition of the cost accounting standards in situations in which the overseas exemption had been applied would create hardships for federal agencies, prime contractors, and subcontractors • Statutory basis used to justify the exemption no longer exists because the current statute from which the board derives its authority—the Office of Federal Procurement Act—does not limit CAS's applicability to the United States • There is no accounting basis for the exemption

26. CAS exemption clarified – • The CAS Board issued on October 5 a proposed rule for comment that would clarify that the exemption that applies to firm-fixed-price contracts and subcontracts awarded on the basis of adequate price competition without submission of cost or pricing data • Certified Cost or Pricing Data replaces Cost or Pricing Data • Comments were due by December 5, 2011

27. Required reporting of IR&D projects – • DoD has issued a final rule amending DFARS to now require major contractors to report independent research and development projects to the Defense Technical Information Center. These new requirements can be found at DFARS 231.205-18 (effective January 30, 2012). • For a contractor's annual IR&D costs to be allowable, the IR&D projects generating the costs must be reported to the Defense Technical Information Center (DTIC) using the DTIC's on-line input form – annual update required • Copies of the input and updates must be made available for review by the cognizant Administrative Contracting Officer (ACO) and the cognizant Defense Contract Audit Agency auditor to support the allowability of the costs. • For major contractors, the ACO or corporate ACO shall— • Determine whether IR&D/B&P projects are of potential interest to DoD; and • Provide the results of the determination to the contractor. • Major contractor means any contractor whose covered segments allocated a total more than $11 million in IR&D/B&P costs to covered contracts during the preceding fiscal year. Segments with allocation to covered contracts under $1.1 million, not counted.

28. Incurred cost submission related • FAR 52 .216-7 - Allowable cost and payment clause (Fixed and Incentive Fee) • Sets forth a description of an adequate final indirect cost rate proposal and supporting data • Detailed requirements – FAR 52.216-7(d)(2) – Basically the ICE Model • The new clause lists the specific schedules that must be submitted, unless otherwise specified • Supplemental information may be required during the audit • The Contracting Officer will be responsible for determining adequacy, not DCAA • Controversial items – “May Be Required” & “Not Necessary to Determine Adequacy” • Internal Audit Reports • Internal Audit Plans • Federal and State Tax Returns and • Board Minutes – among others…

29. Incurred cost submissions related (continued) • DCAA issued MRD 11-PPD-020(R) on November 4, 2011, revising the audit program for incurred costs and determining adequacy of incurred cost proposals • Revised audit program used for all audits initiated on or after October 1, 2011. • Key changes include detailed audit steps for areas such as: direct labor costs, contractor compensation costs and excessive pass-through costs. • Risk assessment procedures expanded to better establish audit scope. Includes step to perform detailed walk-through of the incurred cost proposal with the contactor. • Auditors will evaluate the incurred cost proposal for adequacy upon receipt and immediately notify the Contracting Officer of significant inadequacies.

30. Final rule on TINA interest calculations – • The FAR Case 2009-034 final rule amends the clauses at FAR 52.214-27, FAR 52.215-10, and FAR 52.215-11 to require “Interest compounded daily as required by 26 U.S.C 6622” be applied to government overpayments resulting from defective cost or pricing data (effective August 4, 2011).

31. Federal Awardee Performance and Integrity Information System (FAPIIS) final rule • DoD, GSA, and NASA adopted a final rule to the FAR requiring that the information in Federal Awardee Performance and Integrity Information System (FAPIIS), with the exception of past performance reviews, be made publicly available (effective January 3, 2012). • Recommendations • Closely monitor database • 7 day grace/dispute period

32. Mandatory display - DOD fraud hotline poster – • Effective September 16, 2011 –DoD contractors must now must display the DOD inspector general (IG) fraud hotline posters in common work areas within business segments performing work under DoD contracts • Final rule implements the DOD inspector general recommendation by amending the DFARS to supersede FAR 52.203-14(c), which applies generally to federal contractors and exempts them from displaying agency fraud hotline posters if the contractor has implemented a business ethics and conduct awareness program including a reporting mechanism such as a hotline • DOD IG found that “this exemption has the potential to make the DOD hotline program less effective by ultimately reducing contractor exposure to DOD IG fraud hotline posters and diminishing the means by which fraud, waste, and abuse are reported under the protection of Federal whistleblower protection laws”

33. Mandatory display - DOD fraud hotline poster (continued) – • The IG also found that “some contractors posters may not be as effective as the DOD poster in advertising the hotline number - which is integral to the fraud program” • DOD IG is also revising the fraud hotline poster to inform contractor employees of their federal whistleblower protections • DFARS 203.1004(b)(2)(ii) requires the clause to be included in a contract unless the contract is (1) for the acquisition of a commercial item, (2) will be performed entirely outside the United States or (3) below $5 million • Additionally, if the Contractor maintains a company website as a method of providing information to employees, the Contractor must display an electronic version of the IG poster at the website

34. DOD issues new draft guidebook for contract property administration – • Guidebook will replace DODI 4161.2-M, DOD Manual for the Performance of Contract Property Administration • The Guidebook covers acquisition, receiving, records, maintenance, subcontract control, utilization, storage, physical control, inventory, consumption, disposition, contract close out, reports and contractor self assessment • http://www.acq.osd.mil/dpap/policy/policyvault/USA004754-11-DPAP.pdf. • Related note - Final Government Property Rule Issued on March 2, 2012, effective April 2, 2012 • Final rule removes requirement for approval of contractor scrap procedures and eliminates the need to submit inventory schedules and scrap lists prior to disposing of ordinary production scrap. • “Surplus property” is now defined at FAR 2.101 • The rule fine-tunes a June 2007 rewrite of FAR Title 45, which introduced commercial best practices for the management of federal property in the possession of contractors

35. Former DOD officials - Final rule • As background: • 18 U.S.C. 207 prohibits individuals from representing a contractor to their former agency on particular matters that they handled while working for the federal government for various defined periods, according to the former officials' involvement and job. • A final DFARS rule, effective November 18, 2012 adds a new representation for offerors to provide as part of proposals for DOD contracts, including those for commercial items. • The rule requires offerors to represent at the time of contract award that all former DOD officials covered by the Procurement Integrity Act are in compliance with post-employment restrictions as required by 18 U.S.C. 207, 41 U.S.C. 2104, and section 847 of the fiscal year 2008 National Defense Authorization Act.

36. Former DOD officials - Final rule (continued) • Under 41 U.S.C. 2104, government acquisition officials may not accept compensation from a defense contractor during a one-year period if the officials performed certain duties at DOD involving the contractor and a contract valued in excess of $10 million. However, they may accept employment from a division or affiliate that does not produce the same or similar items. • Section 847 of the FY 2008 NDAA requires that senior DOD officials who have been personally and substantially involved in contracts over $10 million request a written post-employment ethics opinion before receiving compensation from a contractor. • The final rule points out that “covered DOD official” is defined in DFARS 252.203-7000(a) as an individual who “left DOD service on or after January 28, 2008,” and either: • Was personally and substantially involved in an acquisition with a value in excess of $10 million; and served in specifically highlighted positions; or • Served within DOD as “program manager, deputy program manager, procuring contracting officer, administrative contracting officer, source selection authority, member of the source selection evaluation board, or chief of a financial or technical evaluation team for a contract in an amount in excess of $10 million.”

37. NASA abandons FAR-based contracting for Next stage of commercial flight program • NASA announced on Dec. 15, 2011 that it will abandon Federal Acquisition Regulation-based contracting for the next stage of its Commercial Crew Program • Instead, the agency will use more flexible Space Act agreements, which are meant to promote competition by keeping more firms in the program. • Space Act agreements, created through the National Aeronautics and Space Act of 1958, involve NASA providing funds to private industry to stimulate the development of large-scale commercial space transportation. • They differ from FAR contracts in that they do not include quality assurance and other requirements that generally apply to government contracts. • NASA originally planned to employ firm-fixed-price contracting for its next phase, obtaining certified crew transportation capability from private industry by the end of fiscal year 2016. The contract was to be valued at up to $1.6 billion from July 2012 to April 2014. • But firms expressed concern that using a FAR-based approach would be expensive and cumbersome.

38. PwC contacts • John May617-530-5340john.m.may@us.pwc.com • Dan Walsh703-918-1316daniel.walsh@us.pwc.com • Gregg Pilotte617-530-4514gregg.s.pilotte@us.pwc.com

39. Questions

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