Copyright 2005, by the American Association of State Highway and
Transportation Officials. All Rights Reserved. This book, or parts
thereof, may not be reproduced in any form without written permission of
the publisher. Printed in the United States of America

**Uniform**

**Audit & Accounting Guide**

**For Audits of Transportation Consultants'**

**Indirect Cost Rates**

![](media/image1.png){width="1.9409722222222223in"
height="1.9055555555555554in"}

**Prepared by the American Association of State Highway and
Transportation Officials (AASHTO),**

**Audit Subcommittee**

**December 2005 Update**

**Assistance and consultation provided by:**

**Federal Highway Administration Resource Center, Atlanta, GA**

**and**

**American Council of Engineering Companies (ACEC) Transportation
Committee**

**An electronic version of this guide can be found at the AASHTO home
page:** [www.transportation.org]{.underline}

**Uniform Audit & Accounting Guide**

**Table of Contents**

**[Page]{.underline}**

Chapter 1 Introduction

About This Guide 1-1

Chapter 2 Background

Audit Types 2-1

Indirect Cost Rate-Cost Incurred 2-1

Indirect Cost Rate-Forward Pricing 2-2

Contract Pre-Award 2-2

Contract Cost 2-2

Auditing Standards 2-3

Matrix of GAGAS Auditing Standards 2-5

Sarbanes-Oxley Act & Other Standards 2-6

Chapter 3 Cost Principles

Federal Acquisition Regulations, Part 31 3-1

Reasonableness 3-2

Allocability 3-2

Unallowable Costs 3-3

Direct Costs 3-3

Distribution Base 3-3

Base Period 3-3

Chapter 4 Cost Accounting

Allocation Bases 4-1

Direct Labor Cost 4-1

Direct Labor Hours 4-1

Total Labor Hours 4-1

Total Costs 4-1

Total Cost Value Added 4-1

Usage 4-2

Cost Centers 4-2

Functional Cost Centers 4-2

Subsidiaries, Affiliates & Geographic Locations 4-2

Allocated Costs 4-2

Fringe Benefits 4-2

Overhead 4-2

General & Administrative 4-2

Computer/CADD Costs 4-3

Fleet or Company Vehicles 4-3

Equipment 4-3

Printing/Copying/Plan Reproduction 4-3

Direct Labor 4-3

Uncompensated Overtime Pay 4-4

Premium Overtime Pay 4-5

Other Labor Considerations 4-5

Contract Labor 4-6

Other Direct Costs 4-7

Field Office Rates 4-8

Field Office Indirect Costs 4-8

Chapter 5 Selected Items of Cost

Advertising & Public Relations 5-1

Bad Debt & Collection 5-2

Compensation 5-3

Reasonableness 5-3

Incentive Compensation (Bonuses) 5-3

Compensation Limits (Executive Compensation) 5-3

Pension Plans 5-4

Employee Stock Ownership Plans(ESOPS) 5-5

Severance Plans 5-5

Personal Use of Company Vehicles 5-6

Contributions or Donations 5-6

Facilities Capital Cost of Money(FCCM) 5-6

Depreciation 5-6

Employee Morale, Health & Welfare 5-7

Entertainment 5-7

Fines & Penalties 5-8

Bid & Proposal 5-8

Insurance (Key-Man & Re-Work) 5-8

Interest Costs 5-8

Lobbying Costs 5-8

Losses on Other Contracts 5-9

Organization & Reorganization Costs 5-9

Patent Costs 5-9

Retainer Fees 5-9

Relocation (of employees) Costs 5-9

Rent/Leases & Common Control (Related Parties) 5-10

Selling Costs 5-10

Travel Expenses 5-11

Legal Costs 5-11

Business Combination Costs 5-12

Alcoholic Beverages 5-12

**Listing of Common Unallowable Expenses** 5-13

Chapter 6 Management's Responsibility for Accounting

Schedule of Indirect Cost 6-1

Unallowable Costs 6-2

Financial Statements 6-2

Disclosures 6-3

Management Representations 6-3

Chapter 7 Audit Considerations

General Considerations 7-1

Internal Controls 7-2 thru 7-3

Understanding the Consultant's Business 7-3

Consideration of Other Financial and Contract Audits 7-4

Computerized Information Technology 7-4

Audit Risk and Materiality 7-4

Type and Volume of Contracts 7-5

Chapter 8 Audit Engagement Procedures

Labor Costs 8-1

Allocated Costs 8-2

Other Direct Costs 8-2

Other Audit Procedures 8-3

Chapter 9 Reporting & Report Disclosures

General Reporting Considerations 9-1

Auditors Report on Schedule of Indirect Costs 9-2

Schedule of Indirect Costs - Example 9-4

Report on Internal Control - Example 9-5

Minimum Report Disclosures 9-6 thru 9-11

Chapter 10 Cognizant Audits

NHS Act - Section 307 & 23 CFR 172 10-1

Cognizant Agency/ Cognizant Audits 10-2

Guidelines for Reviewing CPA Indirect Cost Audits 10-4

Chapter 11 Glossary of Terms

Alphabetical Listing of Common Terms 11-1 thru 11-6

Chapter 12 Listing of Resource Materials

Government Auditing Standards ("Yellow Book") 12-1

Federal Acquisition Regulations 12-1

DCAA Contract Audit Manual 12-2

American Institute of Certified Public Acountants (AICPA) 12-3

Accounting Standards - Current Text (FASB) 12-4

Federal Travel Regulation 12-4

Chapter 13 Other General Information

Acknowledgements 13-1

State Contacts 13-1

# - Introduction, About This Guide

this guide has been developed by the American Association of State
Highway and Transportation Officials (AASHTO) Audit Subcommittee with
assistance from the American Council of Engineering Companies (ACEC)
Transportation Committee and the Federal Highway Administration (FHWA)
Atlanta Resource Center. The AASHTO Audit Subcommittee is comprised of
the senior person representing the audit function for each state's
transportation or highway department. This guide was developed over
several years and initially approved by AASHTO at the organization's
2001 annual meeting and has been endorsed by the ACEC Transportation
Committee. Input was solicited from all regions for the 2005 update.

An electronic version of this guide can be found on the AASHTO home
page: **[www.transportation.org](http://www.transportation.org/)**

The purpose of the audit guide is to provide a tool that can be used by
individual state auditors, consulting firms and public accounting firms
that perform audits of consulting firms. The primary focus of the guide
is auditing and reporting on the indirect costs and resultant overhead
rates of consultants who perform engineering and engineering-related
work for State Highway Agencies.

This guide is not intended to be an auditing procedures manual but
rather a guide that will assist individuals in understanding
terminology, policies, audit techniques and sources for regulations and
specific procedures.

**Note: Individual states may have specific limits and guidelines.
Up-to-date contact information for all states can be found at the AASHTO
web site.**

# - Background

Most **State Highway Agencies (SHAs)** award contracts for engineering
and related services using Qualifications Based Selection (QBS)
procedures. Under QBS, consultant selections are based solely on
elements of qualification without consideration of price. Consultants do
not submit bids or priced proposals to be used as a basis for selection.
Once the SHA has made a selection based on the consultant's
qualifications, prices are negotiated based on the consultant's actual
cost and must be a reasonable price for the work to be performed.

Federal law \[23 USC Sec. 112 (b) (2) (C)\] requires that contracts for
engineering services be performed and audited in compliance with costs
principles contained in the **Federal Acquisition Regulations**
**(FARs).** Because most SHAs construct highway improvements using both
state and federal funds, most have state rules for selection and pricing
of state-funded consultant contracts that incorporate or are similar to
federal rules.

The timing and types of engagements performed to meet federal
requirements may vary between states and contracts depending on state
procedures and other circumstances. The engagements are performed to
ensure that consultant contract pricing is **based on actual costs
incurred** in compliance with the Federal Acquisition Regulations as
well as specific contract provisions.

**Contract Engagements** generally include the following:

### Indirect Cost Rates (Cost incurred) 

This engagement is performed to render an opinion on the consultant's
indirect cost rate(s) for a specified period (usually a fiscal year). In
addition to making sure that **[unallowable]{.underline}** costs have
been removed from overhead, the auditor must also make sure that
**[allowable]{.underline}** costs have been correctly measured and
properly allocated. Established rates are used to retroactively adjust
costs previously invoiced at provisional rates to actual cost. Many SHAs
also use established indirect cost rates of the most recently completed
fiscal year as a provisional rate to be used for estimating and
invoicing costs on new contracts. Risk and materiality would be measured
with consideration given to all contracts that may be priced using the
indirect cost rate.

### Indirect Cost Rates (forward Pricing) 

This engagement is performed to render an opinion on the consultant's
forward pricing indirect cost rate(s) used to prepare estimates of costs
that will be incurred in future periods. Forward pricing rates are
similar to cost incurred rates in that they have a **[basis in
historical costs]{.underline}**. However, forward pricing rates are
adjusted to reflect estimates of future costs and activity levels to
project indirect cost rates for future periods. Auditors of forward
pricing rates must evaluate the reasonableness of future projections as
well as the accuracy of historical cost information used as the starting
point for the rate development. While most contracts negotiated directly
with the federal government utilize forward pricing rates, **many SHAs
will only negotiate contracts using indirect cost rates based on
historical information.** Risk and materiality should be determined with
consideration given to all contracts, which may be priced using the
indirect cost rate.

### 

### contrAct pre-awards

Contract pre-awards are performed to evaluate the reasonableness and
accuracy of a cost proposal for a specific contract. The auditor may
examine the reasonableness of estimates used as well as the accuracy of
estimate components that are based on current or historical costs. When
conducting pre-awards, auditors often rely on work done by other
auditors. If other reports don't exist, auditors performing the
pre-awards may examine items like indirect cost rates. Risk and
materiality should be determined with consideration only to the contract
being covered by the pre-award. Auditors may be required to perform
additional work for very large contracts.

### contract Costs 

These engagements are performed to determine actual costs incurred under
contracts. The auditor should consider both direct and indirect costs to
determine whether costs invoiced were **[allowable]{.underline}** under
applicable cost principles and treated consistently with cost accounting
practices used to develop the consultant's indirect cost rate(s). When
conducting such engagements, auditors often rely on opinions rendered by
indirect cost rate auditors. In addition to using the indirect cost
rate, the auditor may be able to rely on evaluation and testing of
accounting systems that were performed during indirect cost rate
engagements. Risk and materiality should be determined with
consideration only to the contract(s) being covered.

## Auditing Standards

Auditing procedures and responsibilities may vary depending on the
nature of the audit or attestation engagement procedures performed by
the auditor. Several regulatory bodies may influence the types of
procedures that will apply to planning, performing and reporting on the
results.

#### Government Auditing Standards **("Yellow Book")**

These standards, published by the Comptroller General of the United
States of America, apply to audits of government entities and government
assistance paid to contractors, non-profit organizations and other
non-governmental organizations. They are often referred to as
**"Generally Accepted Government Auditing Standards" (GAGAS).** The
standards were revised and reissued in June 2003. Standards include the
following:

> GAGAS may be used in conjunction with professional standards issued by
> other authoritative bodies. For example, the American Institute of
> Certified Public Accountants (AICPA) has issued professional standards
> that apply in financial audits and attestation engagements performed
> by certified public accountants (CPA). [GAGAS incorporate the AICPA's
> field work and reporting standards and the related statements on
> auditing standards for financial audits unless specifically excluded.
> GAGAS incorporate the AICPA's general standard criteria, field work
> and reporting standards and the related statements on the standards
> for attestation engagements, unless specifically
> excluded.]{.underline} **GAGAS also prescribe requirements in addition
> to those provided by the AICPA to meet the needs of users of
> government audits and attestation engagements.** Auditors may also
> consider other standards depending on the purpose and requirements of
> the audit or engagement.

GAGAS categorizes government audits and attestation engagements into
three types for determining the appropriate standards. More than one
type may apply to an audit engagement depending on the audit objectives.

-   **[Financial Audits]{.underline}** are primarily concerned with
    providing reasonable assurance about whether financial statements
    are presented fairly in all material respects in conformity with
    GAAP or with a comprehensive basis other than GAAP. An example would
    be an audit of a Schedule of Indirect Costs (considered a financial
    statement) in compliance with Part 31 of the Federal Acquisition
    Regulations. Financial audits may also include other objectives that
    provide different levels of assurance and entail various scopes of
    work.

-   **[Attestation Engagements]{.underline}** concern examining,
    reviewing, or performing agreed-upon procedures on a subject matter
    or an assertion about a subject matter and reporting on the results.
    These engagements may cover a broad range of financial or
    nonfinancial subjects and can be part of a financial audit or
    performance audit. Examples include an entity's internal control
    over financial reporting, an entity's compliance with requirements
    of specified laws, regulations, rules, contracts, or grants and
    various prospective financial statements or pro-forma financial
    information.

-   **[Performance Audits]{.underline}** entail and objective and
    systematic examination of evidence to provide an independent
    assessment of the performance and management of a program. These
    audits are generally performed to improve program operations and may
    encompass a wide variety of objectives. Examples include whether
    legislative, regulatory or organizational goals are being achieved,
    the relative cost and benefits of a program and the validity and
    reliability of performance measures.

The following page provides a summary matrix of applicable standards for
audits of Schedules of Indirect Costs.

## Matrix of Generally Accepted Government Auditing Standards (GAGAS)

Note: The standards to be used vary depending on the type of audit or
engagement. GAGAS standards generally include AICPA standards as well as
additional GAGAS required standards. The following chart may be used as
a guideline to determine the applicable standards. The Yellow Book
should be consulted for the complete text of the standards.

  ------------------------- ------------ ------------------------- ------------------------
  **Standard Category**     **Source**   **Financial Audit         **Examination Level
                                         Standards**               Attestation Engagement
                                                                   Standards**

                                                                   

                                                                   

  [General]{.underline}     AICPA        (none)                    Evaluation Against
                                                                   Criteria

                            GAGAS        Independence              Same as Financial

                            GAGAS        Professional Judgment     Same as Financial

                            GAGAS        Competence                Same as Financial

                            GAGAS        Quality Control &         Same as Financial
                                         Assurance                 

                                                                   

                                                                   

  [Field Work]{.underline}  AICPA        Planned & Supervised      Same as Financial

                            AICPA        Understand Internal       Similar to Financial
                                         Control                   

                            AICPA        Evidential Matter         Sufficient Evidence for
                                                                   Conclusion

                            GAGAS        Auditor Communication     Similar to Financial

                            GAGAS        Results of Previous       Same as Financial
                                         Audits                    

                            GAGAS        Detecting Material        Similar to Financial
                                         Misstatements             

                            GAGAS        Audit Documentation       Similar to Financial

                                                                   

                                                                   

  [Reporting]{.underline}   AICPA        GAAP or Not GAAP          (none)

                            AICPA        Consistent Between        (none)
                                         Periods                   

                            AICPA        Informative Disclosures   (none)

                            AICPA        Opinion or Expression of  (none)
                                         Non Opinion               

                            AICPA        (none)                    Engagement Subject
                                                                   Matter

                            AICPA        (none)                    Practitioner's
                                                                   Conclusion

                            AICPA        (none)                    Practitioner's
                                                                   Reservations

                            AICPA        (none)                    Report Distribution
                                                                   Restrictions

                            GAGAS        In Accordance With GAGAS  Same as Financial

                            GAGAS        Internal Control Report   (none)

                            GAGAS        Reporting Deficiencies    Same as Financial

                            GAGAS        Responsible Officials     Same as Financial
                                         Views                     

                            GAGAS        Privileged & Confidential Same as Financial
                                         Info                      

                            GAGAS        Report Distribution       Same as Financial

                                                                   
  ------------------------- ------------ ------------------------- ------------------------

-   The **Sarbanes-Oxley Act of 2002** was major legislation that
    affected publicly traded companies. It established the **Public
    Company Accounting Oversight Board (PCAOB),** which has the
    authority to set auditing standards for registered public accounting
    firms involved with publicly traded companies. One key provision is
    the requirement that annual reports must include an internal control
    report from management along with an attestation report from the
    firm's auditor. These standards and the internal control reports may
    provide assurances when determining adequacy of controls for
    publicly traded consulting firms.

-   Other audit standards and procedures may be considered depending on
    the circumstances (e.g. Institute of Internal Auditors, Federal
    Agencies, etc.).

#  - Cost Principles

## Federal Acquisition Regulations (FARs)

State Highway Agencies (SHAs) rely on the Federal Acquisition
Regulations (FARs), Title 48, Chapter 1, Part 31 \-- Contract Cost
Principles and Procedures for guidance when negotiating costs and
reviewing project proposals with consultants. The FARs contain cost
principles and procedures for pricing contracts, subcontracts, and
modifications to contracts. In addition, the FARs may also be used in
the determination, negotiation or allowance of costs when required by a
contract clause.

The following is a general discussion of applicable cost principles
described in Part 31 of the FARs. This discussion is on a summary level
only and is not intended to be a complete rendition of all cost
principles contained in the FARs.

The provisions apply to commercial organizations, educational
institutions, state, local and federally recognized Indian tribal
governments and nonprofit organizations. Subpart 31.105, dealing with
construction and architect-engineering contracts, states that the
allowability of costs shall be determined in accordance with Subpart
31.2. For the purpose of our discussion, we will focus on Subpart 31.2 -
Contracts with Commercial Organizations.

The total cost of a contract includes all costs properly allocable to
the contract under the specific contract provisions. The
**[allowable]{.underline}** costs to the government are limited to those
costs which are **[allowable]{.underline}** pursuant to Part 31.

In some cases, the contracting state may enter into an advance agreement
with a consultant to clarify the allocability and allowability of
special or unusual costs. Subpart 31.109 provides further clarification
of advance agreements, including examples of costs for which advance
agreements may be important.

In the absence of any advance agreements, the auditor must determine the
allowability of costs. To determine the **[allowability]{.underline}**,
the auditor should consider the following:

1.  Any limitations set forth in Subpart 31.2 of the FARs.

2.  Allocability;

3.  Standards promulgated by the Cost Accounting Standards Board (CAS);
    if applicable, otherwise, Generally Accepted Accounting Principles
    and practices appropriate to the particular circumstances;

4.  Terms of the contract; and

5.  Reasonableness.

A cost is **[reasonable]{.underline}** if, in its nature and amount, it
does not exceed that which would be incurred by a prudent person in the
conduct of competitive business. The reasonableness of specific costs is
not always easy to determine since such a determination depends to some
extent on judgment and interpretation of the FARs.

**[Reasonableness]{.underline}** depends upon a variety of
considerations and circumstances, including the following:

1.  Whether the cost is generally recognized as ordinary and necessary
    for the conduct of business or the contract performance;

2.  Generally accepted sound business practices, arm's length
    bargaining, and federal and state laws and regulations;

3.  The consultant's responsibilities to the government, other
    customers, the owners of the business, employees and the public at
    large; and

4.  Any significant deviations from the firm's established practices.

A cost is **[allocable]{.underline}** if it is assignable or chargeable
to one or more cost objectives or cost centers on the basis of relative
benefits received or some other equitable relationship. A cost must be
distributed in some reasonable proportion to the benefits derived. A
cost is allocable to a government contract if it:

1.  Is incurred specifically for the contract;

2.  Benefits both the contract and other work, and can be distributed to
    them in reasonable proportion to the benefits received; or

3.  Is necessary to the overall operation of the business, although a
    direct relationship to any particular cost objective cannot be
    shown.

Costs that are expressly or mutually agreed to be
**[unallowable]{.underline}**, including directly associated costs, must
be identified and excluded from any billing, claim, or proposal
applicable to a government contract. A directly associated cost is any
cost which is generated solely as a result of incurring another cost,
and which would not have been incurred had the other cost not been
incurred. When an **[unallowable]{.underline}** cost is incurred, its
directly associated costs are also **[unallowable]{.underline}**. The
practices to account for and present **[unallowable]{.underline}** costs
are described in 48 CFR 9904.405, Accounting for
**[Unallowable]{.underline}** Costs.

In evaluating a consultant's overhead, an auditor must consider direct
as well as indirect costs. A **[direct cost]{.underline}** is any cost
that can be identified specifically with a particular contract or
project. Costs identified specifically with a contract or project are
direct costs and are to be charged directly to the contract or project.
All costs specifically identified with a project are direct costs of
that project and cannot be charged to another project, either directly
or indirectly. Finally, a cost cannot be charged as direct and also be
included in any indirect cost pool. For reasons of practicality, any
small dollar direct cost may be treated as an indirect cost if the
accounting treatment is consistently applied to all projects and
produces substantially the same results as treating the cost as a direct
cost. However, any variances and credits should then also be treated as
indirect costs.

Indirect costs should be accumulated by **[logical cost
groupings]{.underline}** with due consideration of the reasons for
incurring such costs. Commonly, manufacturing overhead, selling expenses
and general and administrative (G&A) expenses are separately grouped.
The consultant's method of allocating overhead costs should be in
accordance with generally accepted accounting principles, which are
consistently applied.

Contracts may be subject to Cost Accounting Standards (CAS), which are
promulgated by the Cost Accounting Standards Board(CASB), an independent
board that reports to the Office of Federal Procurement Policy, within
the OMB. All Federal contracts in excess of \$500,000 are subject to CAS
regulations, unless specifically exempted.

A **[distribution base]{.underline}** common to all cost objectives or
projects is selected for allocation of an overhead or indirect cost
pool. **Many consultants use direct labor as the base for developing
overhead rates.** However, many large Federal contractors have rate
structures that are more complex and utilize more than a single base for
allocating costs. A typical example follows:

[Cost Pool]{.underline} [Allocation Base]{.underline}

Employee Fringe Benefits Direct Labor

Overhead Expenses Direct Labor + Fringe

General & Administrative Expenses Total Cost Input\*

\* In this scenario all costs are in the base for G & A expenses
including direct labor, indirect labor, fringes, OH, unallowables, sub
consultants, etc.

Once a base or bases have been established, they should not be adjusted
by removing individual components such as establishing individual
segment rates, whose costs are already included in the overall rates.
Rate structures and cost allocation methods must be consistent for all
Federal and State government contracts. See Chapter 4 for additional
information.

The **[base period]{.underline}** for most consultants' overheads will
normally be the firm's fiscal year. When a contract is performed over an
extended period, as many base periods shall be used as are required to
represent the period of contract performance. In certain instances an
agreed upon rate may be used over the duration of the contract.

# - Cost Accounting

## Allocation Bases

An allocation base is the means by which certain overhead or indirect
costs are distributed to final cost objectives. There are a variety of
allocation bases which are commonly used in cost accounting systems for
allocating indirect costs, however, for State Highway Agency (SHA)
administered engineering contracts **[direct labor cost]{.underline}**
is the most frequently used base. Whatever base is used for cost
allocation, it should be consistent for all government contracts. Some
of the common methods include:

### Direct Labor Cost

Direct labor cost is the most common and accepted base used to allocate
overhead costs on SHA contracts. Direct labor costs are generally all
project hours multiplied by labor rates and summarized for all employees
within the applicable allocation unit. Labor rates are based on actual
employee wages paid or represent wages effectively paid.

### Direct Labor Hours

The direct labor hour method is another way to allocate indirect costs
based on total direct hours charged in an appropriate allocation unit.

### Total Labor Hours (Total Hours Worked)

This method is similar to Direct Labor Hours allocation base, except
that the base includes all hours incurred for direct and indirect
activities. Use of this base assumes that costs incurred benefit both
direct and indirect objectives and should be allocated to the
appropriate pool receiving a benefit.

### Total Costs

Generally, this is the base used to allocate G & A costs. The base
consists of direct labor, fringe benefits, overhead costs, associated
non-salary direct expenses (including other costs sometimes referred to
as internal direct expenses) and subcontract costs.

### Total Cost Value Added

This basis is similar to the Total Cost base shown above to allocate G &
A costs. However, the value-added basis excludes materials (used
primarily in production only) and subcontract costs. Distortion in
allocations may occur due to a disproportionate amount of subcontract
costs or materials in the pool.

### Usage

This method allocates costs to direct or indirect activities on a common
unit, usually time or quantity used. For instance, an internal cost pool
such as one for computer-aided drafting and design equipment (CADD)
costs can be allocated specifically as a direct cost to a project or as
an indirect cost based on the number of hours actually incurred.

## Cost Centers 

Cost centers are established to accumulate and segregate costs.

###  Functional Cost Centers

This method segregates costs unique to a business activity, typically
for purposes of direct costing. Examples are CADD costs, vehicles and
reproduction services.

###  Subsidiaries, Affiliates, Divisions & Geographic Locations

Another method is focused on the corporate structure. Some examples of
cost centers used for accumulating costs are groupings of regional
offices, specific subsidiaries, affiliates, divisions, or field offices.

## Allocated Costs:

###  Fringe Benefits

Fringe benefits are the costs associated with the business' portion of
payroll taxes and benefits in employment. Such costs generally include,
but are not limited to: payroll taxes, pension plan contributions,
medical insurance costs, life insurance and employee welfare expenses.

###  Overhead

Overhead costs are costs that may benefit or are associated with two or
more business activities, but are not specifically allocated to an
activity for reasons of practicality. Overhead differs from general and
administrative costs (below) in that these costs can be associated with
a unit based on benefit. Some examples of overhead costs are rent,
depreciation, employee recruitment and training, and general or
professional insurance policy costs.

###  General and Administrative

This expense generally is all costs associated with the entire business'
operation, which cannot be specifically identified with a smaller unit
of business activities. Example: certain management or administration
costs that are incurred for an entire business unit may be considered G
& A, but other accounting or legal costs benefiting a segment of the
business may be considered part of the overhead pool of that specific
segment.

###  Computer/CADD Costs

Generally, this pool includes costs such as equipment depreciation or
rental; software including license costs; employee training costs on new
software; equipment maintenance; cost of special facilities or
locations; and systems development labor or support costs.

###  Fleet or Company Vehicles

For the most part, these costs are company vehicles such as cars, survey
trucks, and vans that may be used for a direct or indirect cost
objective. Pooled costs may include depreciation, lease costs,
maintenance, insurance and operation costs such as fuel.

###  Equipment

Costs accumulated to this pool are similar to both computer and company
vehicle pools. Company equipment can be a wide variety of items from
small to large that are used in various activities.

###  Printing/Copying/Plan Reproduction

Costs in this pool are generally associated with reproduction from a
single page copied to multiple prints of large specialized drawings or
blue prints. The pool in most cases includes equipment, labor, ink or
toner, and paper supplies.

## Direct Labor

Labor costs are usually the most significant costs incurred in the
performance of Government contracts. Incurred labor costs form the basis
for estimating labor for future contracts. It is, therefore, imperative
that consultants establish and maintain a sound system of internal
control over the labor charging function.

Unlike other items of cost, labor is not supported by external
documentation or physical evidence to provide an independent check or
balance. The key link in any sound labor charging system is the
individual employee. It is critical to labor charging internal control
systems that management fully indoctrinate employees on their
independent responsibility for accurately recording time charges. This
is the single most important feature management can emphasize in
recognizing its responsibility to owners, creditors, and customers to
guard against fraud, waste, and significant errors in the labor charging
functions.

An adequate labor accounting system, manual or electronic, will create
an audit trail whenever an employee creates a timesheet entry. A system
that allows an audit trail to be destroyed is inadequate because the
integrity of the system can be easily compromised. Access to timesheets
should be controlled and preprinted, if possible, with the employee's
name, number and fiscal week. An inadequate system would allow employees
to erase prior entries without recording the adjustment; adjustments
should be maintained as part of the audit trail.

The consultant should have policies and procedures for training
employees to reasonably assure that all employees are aware of the
importance of proper time charging.

## Uncompensated Overtime

Companies may not be required to pay overtime to salaried employees for
hours worked in excess of 40 hours per week. Any hours worked by
salaried employees in excess of the normal 40 hours per week are
commonly called uncompensated overtime.

The consultant should have procedures to ensure that all hours worked
are recorded, whether they are paid or not, to assure the proper
distribution of labor costs. This is necessary because labor rates and
labor overhead costs can be affected by total hours worked, not just
paid hours worked.

**[Acceptable accounting methods]{.underline}** for uncompensated
overtime:

1.  Compute a separate average labor rate for each pay period based on
    the salary paid and the total hours worked. Apply this rate to all
    cost objectives worked on during the period, including paid absences
    and indirect activities, to distribute the salary costs.

2.  Determine a pro rata allocation of total hours worked during the
    period and distribute the salary cost using the pro rata allocation.
    If an employee worked 25 hours on one cost objective and 25 hours on
    another, each cost objective would be charged with one-half of the
    employee's salary.

3.  Compute a standard hourly rate for each employee for the entire year
    based on the total hours the employee is expected to work during the
    year and distribute salary costs to all cost objectives worked on at
    the standard hourly rate. Any immaterial variance between actual
    salary costs and the amount distributed would be charged/credited to
    overhead. Material variances would be charged to the cost objective.
    Billings should be adjusted for material variances.

Any other methods would require further review to determine
acceptability.

Some consultants' accounting systems may not assign costs to those hours
worked by salaried employees in excess of 8 hours per day or 40 hours
per week. Because there is a serious risk of mischarging costs to
government contracts under these circumstances, the following methods of
distributing these salary costs are **unacceptable**:

1.  Distribute labor costs to only those cost objectives worked on
    during the first 8 hours of the day.

2.  Allow employees to select the cost objectives to be charged when
    more than 8 hours per day are worked or the consultant has an
    informal policy as to how employees are to select the objectives to
    be charged.

    [Contracting state SHAs should be consulted to determine individual
    state interpretations where material amounts are
    involved.]{.underline}

## Premium Overtime

Consultants should have the capability of maintaining records that
segregate overtime premium amounts as direct or indirect costs. An
acceptable method is to charge premium overtime as a direct charge when
it is the consultant's regularly established policy and when appropriate
tests demonstrate that this policy results in equitable cost
allocations.

When employees normally work on multiple contracts it is often difficult
to determine which contract "caused" the overtime. Therefore, many
companies have a policy that overtime premium is allocated to overhead.

## Other Considerations

The consultant should have procedures assuring that labor hours are
accurately recorded and that any corrections to time keeping records are
documented, including appropriate authorizations and approvals.

The consultant should have procedures requiring that the total labor
dollars reflected in labor distribution summaries agree with the total
labor charges as entered in the time-keeping and payroll systems. This
reconciliation ensures the labor charges to contracts represent actual
paid or accrued costs and that such costs are appropriately recorded in
the accounting records.

The consultant should have procedures requiring that direct and indirect
labor costs directly associated with **[unallowable]{.underline}** costs
are identified and segregated.

#### Areas of Potential Risk 

1.  Overrun Contracts. When contract costs have exceeded or are
    projected to exceed contract value, these excess costs should not be
    diverted to other cost objectives such as indirect labor, overhead
    accounts or other contracts.

2.  Significant Increases in Direct/Indirect Labor Accounts. Trend
    analyses may disclose instances where charges to direct or indirect
    labor accounts have increased significantly. Sufficient review
    should be performed to determine the nature of the increase.

3.  Reorganization/Reclassification of Employees. The organizational
    structure of the consultant should be analyzed to determine if it
    permits inconsistent treatment of similar labor. For example, a
    program manager should not charge direct on cost-type contracts and
    indirect on fixed-price/ commercial contracts.

4.  Adjusting Journal Entries/Exception Reports (Labor Transfers).
    Adequate rationale and supporting documentation should be available
    for all significant labor transfers.

5.  Budgetary Control. Consultants may operate management systems that
    require strict adherence to budgetary controls. If the system is
    inflexible, labor charges may have a tendency to follow the
    identical route of the budgeted amounts. Rigid budgetary control
    systems can result in predetermined labor charges.

6.  Mix of Contracts. Costs should be identified and charged
    consistently in the accounting system regardless of type of
    contract.

#### Sole Proprietors' and Partners' Salaries

The compensation of owners or partners must be charged as direct labor
when they are personally engaged in performing under contracts. Salaries
must be determined by advance agreements or negotiation. Please refer to
each individual state policy for more specific requirements regarding
treatment of this compensation.

## Contract Labor/ Purchased Labor

In some cases firms contract for services provided by engineers,
technicians, etc. rather than hire individuals as employees. This is
commonly referred to as "Contract or Purchased Labor". The accounting
treatment varies, depending on the circumstances under which the
purchased labor costs are incurred.

Two acceptable methods of accounting for this labor are:

-   Charged as a direct cost to projects, or

-   Treated as other labor (direct or indirect as appropriate)

CAS 418 requires that pooled costs be allocated to cost objectives in
reasonable proportion to the causal or beneficial relationship of the
pooled costs to cost objectives. Purchased labor must share in an
allocation of indirect expenses where such a relationship exists and the
allocation method must be consistent with the consultant's disclosed
accounting practices. A separate allocation base for purchased labor may
be necessary to allocate significant costs to purchased labor, such as
supervision and occupancy costs, or to eliminate other costs, such as
fringe benefits, that do not benefit purchased labor.

## Other Direct Costs-Outside Vendors/Employee Expense Reports

Other Direct Costs typically include subcontracts, travel, long distance
phone calls, and outside printing. Costs based on charge-out rates
developed by the company, typically mileage and copying, are addressed
elsewhere. In order to be treated as a direct cost, the item must have
been needed for and used on that job, the "but-for" principle. But for
this job, the cost would not have been incurred. All similar costs must
also be treated as direct costs.

## Field Office Rates 

Field offices may exist in several forms. Regardless of the consultant's
organization, consistency in allocating costs to cost objectives is
critical.

A consultant's employees may work for a period of time in an on-site
office maintained by the SHA. Since the consultant's employees are not
working out of their own offices and are not receiving office support in
their day-to-day activities, the hours billed for them do not qualify
for the consultant's full overhead rate.

The purpose of the field rate is to pay the consultant for the fringe
benefits and home office support they do provide to their field
employees.

Approved costs directly identified with the project and consistently
treated as direct costs in the consultant's accounting records will be
allowed as direct project costs.

### Field Office Indirect Costs

As a general rule, SHAs do not require extensive staffing of
consultants' field offices. Most administrative and management functions
will be performed in the home or branch office. Therefore, an equitable
portion of these offices' indirect costs should be allocated to the
field office. The costs that are allocated, and the basis for the
allocation, depend largely on the consultant's customary accounting
practices. Some SHAs require separate cost centers for accumulation of
field office costs.

**[Fringe Benefits:]{.underline}** The fringe benefits applicable to the
field office direct labor costs should be allocated to the field office
overhead pool. If the consultant's accounting records do not maintain
separate accounts for field office fringe benefits, the fringe benefits
should be allocated on a direct labor basis:

**[Field Direct Labor]{.underline} = Field Office Direct Labor %**

**Total Direct Labor**

**[Indirect Labor --Non Project Time]{.underline}**: Labor costs
pertaining to non project time of professional staff is generally
recorded specifically within the Field or Home Office accounts. If these
costs are not segregated a ratio based on the Field Office Direct Labor
% may be used to allocate costs to the Field Offices.

**[Indirect Labor - Support Staff:]{.underline}** Indirect salaries
(accounting, legal, purchasing, personnel, management, etc.) should also
be allocated to the field office overhead pool. A ratio of total Field
Office labor to Total Company Labor would be a reasonable method to
allocate these costs. Some firms allocate the costs on a direct labor
basis.

**[Indirect Expenses:]{.underline}**

Certain field office related costs should be allocated 100% to the field
office pool (e.g. field equipment, on-site trailer rental for multiple
projects, field supplies, etc.).

Other general indirect expenses are allocated to the field office
overhead pool based on a reasonable estimate of the benefits accruing to
the field office pool. One possible method is to compute a percentage
based on the field office total labor compared to the total company
labor:

> **[Field Labor (Direct plus Indirect)\_\_\_\_\_\_\_\_\_]{.underline} =
> Field Office**
>
> **Total Company Labor (Direct plus Indirect) Labor %**

The resulting percentage is applied to the various general expense line
item accounts identified in a firm's overhead schedule.

**Note:** The firm must disclose the existence of Field Office Rates in
the Schedule of Indirect Costs. A separate column showing the Field
Office expenses, direct labor and resulting rate along with footnote
disclosure describing allocation methods used should be provided. An
example of a Schedule of Indirect Costs including a Field Office rate is
included in Chapter 9.

# - Selected Items of Cost

The purpose of this chapter is to provide guidance for **selected items
of cost**. It is organized by FAR Part 31.2 sub-sections in ascending
order, numerically. It is not meant to be authoritative or to supersede
the FARs. The entire text of the FARs should be consulted when
determining proper accounting treatment (see Chapter 12 for sources). A
listing of Common Unallowable Expenses, to be used as a quick reference,
is included at the end of this chapter.

## Advertising & Public Relations (FAR 31.205-1)

### Advertising Costs

Selected **[allowable]{.underline}** advertising costs include:

-   recruiting personnel required for performing contractual
    obligations;

-   costs of activities to promote sales of products normally sold to
    the U.S. government, including trade shows, which contain a
    significant effort to promote exports from the United States, or

-   employee recruitment costs in accordance with FAR 31.205-34.

Even those advertising costs that are **[allowable]{.underline}** must
be reasonable, allocable, and properly assigned to cost objectives.

**[Allowable]{.underline}** advertising can recruit direct as well as
indirect labor. Costs of recruiting employees with skills needed only
for commercial contracts are **[unallowable]{.underline}**, however.
Costs are considered **[unallowable]{.underline}** when no specific
vacancies are to be filled or if the advertising done is out of
proportion to the number or importance of the positions to be filled.

### Trade Show Expenses and Labor

> Expenses and labor pertaining to trade shows and other special events
> are generally **[unallowable]{.underline}** except as described above
> under advertising costs to promote export sales.

### Public Relations Costs

Public relations include functions and activities dedicated to enhancing
an organization's image or products and maintaining or promoting
favorable relations with the public.

Specifically, costs of promotional material, motion pictures,
videotapes, brochures, handouts, and magazines that are designed to
elicit favorable attention to the contractor are
**[unallowable]{.underline}** unless used primarily for employee
training and orientation. Costs of memberships in civic and community
organizations and costs of souvenirs, models, imprinted clothing,
buttons and other momentos provided to customers or the public are also
**[unallowable]{.underline}**.

**[Allowable]{.underline}** public relations costs include costs
incurred for (a) responding to inquiries on company policies and
activities; (b) communicating with the public, press, stockholders,
creditors, and customers; and (c) conducting general liaison with news
media and government public relations officers, to the extent that such
activities are limited to communication and liaison necessary to keep
the public informed on matters of public concern such as notice of
contract awards, plant closings or openings, employee layoffs or
rehires, and financial information.

## Bad Debts & Collection (FAR 31.205-3)

Bad debts, including actual or estimated losses arising from
uncollectible accounts receivable due from customers and other claims,
and any directly associated costs such as collection and legal costs are
**[unallowable]{.underline}**.

## Compensation (FAR 31.205-6)

### Reasonableness (refer to FAR 31.201-3 & 31.205-6(b))

Costs must be reasonable in amount considering what is normal for a
comparable business, the established compensation plan or practice of a
given contractor, or restraints imposed by business circumstances.

Auditors can challenge either the reasonableness of individual
components of employee compensation or the reasonableness of total
compensation costs.

### Bonuses and Incentive Compensation (FAR 31.205-6(f))

The following types of bonuses and incentive compensation are usually
**[allowable]{.underline}**: incentive compensation for management
employees, cash bonuses, suggestion awards, safety awards, and incentive
compensation based on production, cost reduction, or efficient
performance. To be **[allowable]{.underline}**, business or incentive
compensation must be:

1.  granted under an agreement entered into in good faith between the
    employer and the employee, before the services are rendered; **or**

2.  granted pursuant to an established plan or policy followed
    consistently (to the point of implying an agreement).

Auditors may challenge bonus plans that are not based strictly on
production, cost reduction, or efficient performance.

Bonuses and other forms of compensation for owners of closely held
companies should be reviewed carefully to ensure they are not dividends
that would be considered distribution of profits. **Distributions of
profits** are **[unallowable]{.underline}** for inclusion in either
direct or indirect labor costs.

### Compensation Limits (Executive Compensation Benchmarks) (FAR 31.205-6(p))

Compensation limitations involve numerous factors including size of
firms, type of industry, geographic area, classes of employees doing
similar work, type of ownership, form of compensation payments and other
factors. Auditors must review a wide range of company information and
review outside sources in order to determine reasonable compensation.

In addition to reasonableness, executive compensation for government
contractors is specifically limited by part 31.205-6(p) of the FARs.
This section of the FAR must be referenced in order to apply the limits
for senior executives.

Benchmarks are established annually by the Office of Federal Procurement
Policy (OFPP), which is under the Office of Management and Budget (OMB).
The Office of Management and Budget Administrator, pursuant to Section
808 of Public Law 105-85, determines the limits, which are based on
salaries of executives of publicly owned corporations that have annual
sales of over \$50 million. The term compensation includes wages,
salary, bonuses, deferred compensation, and employer contributions to
defined pension plans. The cost rule is applied to the senior executives
at corporate offices and business segments.

M**aximum limits** for contract costs incurred after the following
effective dates are as follows: (The amounts can be obtained annually
from the OMB web site)

**[Maximum Compensation Limits:]{.underline}**

July 1, 1996 \$200,000

January 1, 1997 \$250,000

January 1, 1998 \$340,650

January 1, 1999 \$342,986

January 1, 2000 \$353,010

January 1, 2001 \$374,228

January 1, 2002 \$387,783

January 1, 2003 \$405,273

January 1, 2004 \$432,851

January 1, 2005 \$473,318

### Pension Plans (FAR 31.205-6(j))

Pension plan expenses are complicated so that FARs, IRS regulations and
CAS regulations must be carefully reviewed in order to determine
allowability of costs. Generally, a pension plan is a deferred
compensation plan that provides for systematic payment of benefits that
are paid for life, or gives employees the option for benefit payments
for life. **Qualified pension plans** are written programs that meet the
criteria as set forth by the Internal Revenue Code. All other pension
plans are considered **unqualified pension plans**. Costs for either
types of plans [**may be** **allowable**]{.underline} depending on the
specific circumstances.

One of the critical FARs requirements is that, for pension costs to be
**[allowable]{.underline}** in the current year, they must be funded by
the due date for filing the federal income tax return. Pension costs
assigned to the current year but not funded on time are
**[unallowable]{.underline}** in any subsequent year.

The amount contributed to qualified pension or profit sharing plans on
behalf of principals and employees is **[allowable]{.underline}**.
However, the payments must be reasonable in amount and be paid pursuant
to an agreement entered into in good faith between the contractor and
employees, before the work or services are performed and pursuant to the
terms and conditions of the established plan.

Costs of changes that are discriminatory to the government or that are
not intended to be applied consistently in the future are
**[unallowable]{.underline}**. One-time-only pension supplements not
available to all plan participants are generally
**[unallowable]{.underline}**, unless the supplemental benefits
represent a separate pension plan and the benefits are payable for life
at the employee's option. Increased payments to retired participants for
cost-of-living adjustments are **[allowable]{.underline}** if paid in
accordance with a consistent policy or practice.

### Employee Stock Ownership Plans (FAR 31.205-6(q))

Employee stock ownership plans (ESOPs) are an individual stock bonus
plan designed specifically to invest in the stock of the employer
corporation. These complex plans have become more prevalent in recent
years. The contractor's contributions to an employee stock ownership
trust (ESOT) can be in the form of cash, stock, or property.

The purpose of an ESOP may be for deferred compensation or for a
supplementary pension plan; each would be covered by different
regulations. In order to determine whether certain ESOP costs are
allowable, FAR 31.205-6(q) should be referenced along with Cost
Accounting Regulations 48 CFR 9904.412 & .415.

Valuations for ESOPs must be done on a case-by-case basis and certain
contributions in excess of fair market value are
**[unallowable]{.underline}**.

### Severance Pay (FAR 31.205-6(g))

Severance pay or dismissal wages are extra payments made to employees
whose employment is involuntarily terminated. Severance pay does not
include payments under early-retirement incentive plans.

Severance pay is **[allowable]{.underline}** only when payment is
required by (1) law, (2) employer-employee agreement, (3) established
policy that is, in effect, an implied agreement on the contractor's
part, or (4) circumstance of the particular employment. Normal severance
pay relates to recurring, partial layoffs, cutbacks, and involuntary
separations and is an **[allowable]{.underline}** cost when properly
allocated.

**"Normal severance"** refers to routine employee terminations.
**"Abnormal severance"** refers to any mass termination of employees,
which is usually unpredictable. Actual costs of normal severance pay
must be allocated to all work performed at the contractor's facility.
Accruals of normal severance pay are acceptable (1) if the amount is
reasonable in light of prior experience, and (2) if it is allocated to
both government and nongovernment work. Abnormal severance, however, is
**[unallowable]{.underline}** as an accrued cost because of the
conjectural nature of the cost.

Special compensation to terminated employees after a change in
management control is **[unallowable]{.underline}** to the extent that
it exceeds normal severance pay ("golden parachute"). Special
compensation contingent on the employee remaining with the organization
after a change in management control is also
**[unallowable]{.underline}** ("golden handcuff").

## Personal Use of Company Vehicles (FAR 31.205-6(m)(2))

This cost is **[unallowable]{.underline}**, including the portion of
cost related to transportation to and from work.

## Contributions or Donations (FAR 31.205-8)

Contributions in the form of cash, property and services are
**[unallowable]{.underline}** except for costs of participation in
community services such as blood bank drives, charity drives, disaster
assistance, etc..

## Cost of Money (FAR 31.205-10)

This is an imputed cost related to investment in facilities used in
contract performance whether the source of the investment is equity or
borrowed capital. The resulting cost of money is not a form of interest
on borrowing.

The costs of the capital investment must be determined, measured and
allocated to contracts in accordance with CAS 414.

The estimated facilities capital cost of money **must** be specifically
identified in the cost proposals relating to the contract under which
the cost is to be claimed.

Accounting for the facilities cost of money is generally through a
memorandum entry of the cost. The contractor must maintain, in a manner
that permits audit and verification, all relevant schedules, cost data,
and other data necessary to support the entry fully.

The cost of money rate (**prompt payment rate**) is the arithmetic mean
of the interest rates specified by the Secretary of the Treasury. These
are published in the Federal Register around January 1 and July 1. For a
fiscal year ending December 31, the arithmetic mean would be the simple
average of the rates for the January 1 through June 30 period and the
July 1 through December 31 period.

The average book value of the investment base is multiplied by the cost
of money rate. The resultant value is divided by the allocation base
units (such as direct labor hours, or dollars of total cost input) for
the corresponding indirect cost pool.

Appendix A to CAS 414 contains the form for Facilities Capital Cost of
Money and Appendix B to CAS 414 contains a detailed example in which the
total cost of money on facilities capital is computed on a step-by-step
basis.

## Depreciation (FAR 31.205-11)

In general, depreciation of plant, equipment and other capital assets is
allowable if it does not exceed the amount used for financial reporting
purposes. Depreciation is generally based on the useful business life of
the asset and should not be based on accelerated depreciation methods
that may be acceptable for IRS tax purposes. Special consideration must
be given to consistency between organizations under common control,
fully depreciated assets, asset disposals, capital leases, rentals and
other special CAS provisions contained in the FAR.

## Employee Morale, Health &Welfare (FAR 31.205-13)

Employee welfare and morale expenses incurred on activities to improve
working conditions, employer-employee relations, employee morale, and
employee performance are **[allowable]{.underline}**. Expenses and
income generated by employee welfare and morale activities should be in
compliance with FARs 31.205-13. Note that employee morale type expenses
are often covered by the entertainment cost principle, 31.205-14. FAC
90-31, effective October 1, 1995 clarified that entertainment costs are
**[unallowable]{.underline}** under any cost principle, without
exception. Consequently, the entertainment cost principle at FARs
31.205-14 takes precedence over any other cost principle.

Although gifts are an expressly **[unallowable]{.underline}** expense,
the cost principle **specifically excludes two categories** of awards
from the **[unallowable]{.underline}** gift definition:

1.  Awards covered by the compensation cost principle FAR 31.205-6; and

2.  Awards made pursuant to an established plan or policy for
    recognition of employee achievements.

Recreation expenses are an expressly **[unallowable]{.underline}**
expense unless the cost claimed meets the following criteria:

1.  The cost is for employee participation in a sports team or employee
    organization.

2.  The team or organization is company sponsored.

3.  The team's or organization's activity is designed to improve company
    loyalty, team work, or physical fitness.

Costs incurred for employee welfare and morale, less credits for income
generated by these activities, are **[allowable]{.underline}** to the
extent that the net amount is reasonable. Reasonableness is considered
in nature and amount both for the contractor as a whole and for the
employee(s) benefited by the expenditure.

Whether or not the IRS has recognized certain costs as deductible
business expenses for Federal income tax purposes is not necessarily
determinative of their allowability under government cost-reimbursement
type contracts where such costs fail to satisfy allowability or
reasonableness criteria.

Types of activities that fall under this subsection are very restrictive
and limited. Examples of **[allowable]{.underline}** activities are
house publications, health clinics, wellness/fitness, employee
counseling services, and food and dormitory services.

## Entertainment (FAR 31.205-14)

Costs of amusement, diversions, social activities and any directly
associated costs such as tickets to shows or sports events, meals,
lodging, rentals, transportation, and gratuities are
**[unallowable]{.underline}**. Costs of membership in social, dining,
country clubs or other organizations having the same purposes are also
**[unallowable]{.underline}**, regardless of whether the cost is
reported as taxable income to the employees.

## Fines & Penalties (FAR 31.205-15)

Costs of fines and penalties resulting from violations of, or
noncompliance with, Federal, State, local or foreign laws and
regulations, are **[unallowable]{.underline}** except when incurred as a
result of compliance with specific terms and conditions of the contract
or written instructions from the contracting officer.

## Bid & Proposal (FAR 31.205-18)

The composition of bid and proposal costs is often a key issue. Although
marketing costs are very similar to bid & proposal costs, basic bid &
proposal costs are incurred in preparing specific documents, whereas
selling and marketing costs are more general in nature. Therefore, a
contractor should establish procedures for segregating bid & proposal
costs from selling and marketing costs.

Bid & proposal costs are **[allowable]{.underline}** and should be
treated as indirect costs unless the contract requires submission of a
proposal for subsequent work and authorizes the costs to be charged
directly to that contract.

**Pre-contract costs** are those costs that are considered as part of
the **direct costs** of the contract, but are incurred prior to
execution of the contract. These costs are **[unallowable]{.underline}**
as indirect costs.

## Insurance, Key-Man Life & Re-Work (FAR 31.205-19)

**["Key-man life insurance"]{.underline}** is insurance on the lives of
officers, partners or proprietors and it is considered an
**[unallowable]{.underline}** expense unless the insurance is included
as additional compensation.

"Re-work insurance" is casualty insurance to protect the contractor
against the costs of correcting its own defects, and is considered
**[unallowable]{.underline}**.

## Interest Costs (FAR 31.205-20)

Interest on borrowings (however represented), bond discounts, costs of
financing and refinancing capital (net worth plus long-term
liabilities), legal and professional fees paid in connection with
preparing prospectuses, costs of preparing and issuing stock rights, and
directly associated costs are **[unallowable]{.underline}** except for
interest assessed by state or local taxing authorities under the
conditions specified in 31.205-41.

## Lobbying Costs (FAR 31.205-22)

Lobbying and political activity costs are generally
**[unallowable]{.underline}**. Some examples of these types of costs are
activities that attempt to influence the outcomes of Federal, state or
local elections, contribute to political parties or organizations,
influence Federal, state or local legislation, influence legislative
liaison activities or influence employees of the executive branch of
government.

Certain activities **may be [allowable]{.underline}** if detailed
records are maintained They may include activities such as testifying at
hearings, providing technical information on topics directly related to
contracts, or lobbying activities that may directly reduce contract
cost.

## Losses on Other Contracts (FAR 31.205-23)

Any excess of costs over income under any other contract (including the
contractor's contributed portion under cost-sharing contracts) is
**[unallowable]{.underline}**.

## Organization & Reorganization (FAR 31.205-27)

All expenditures in connection with planning or executing the
organization or reorganization of the corporate structure of a business,
including mergers and acquisitions, or raising capital are
**[unallowable]{.underline}**. The exception to this is under (b), the
cost of activities primarily intended to provide compensation. These
costs will not be considered organizational costs but are governed by
FAR 31.205-6.

The rationale for disallowing these costs is that the government entered
into a contract with a specific entity considered competent to perform
the work and should not reimburse the costs of corporate changes not
incident to contract performance.

## Patent Costs (FAR 31.205-30)

Patent costs not required by the government contract are
**[unallowable]{.underline}**.

Certain costs **may be [allowable]{.underline}** if they are incurred as
a requirement of a government contract. They include costs such as
preparing disclosures, filing documentation, searching records and
counseling related to general patent matters.

## Retainer Agreements (FAR 31.205-33)

Work performed by professionals and consultants with special skills are
**[allowable]{.underline}** but must be supported by detailed evidence
of the nature and scope of the work performed. However, retainer
agreements which are not based on specific statements of work performed
are **[unallowable]{.underline}**.

## Relocation Costs (FAR 31.205-35)

Certain costs of relocating permanent employees are
**[allowable]{.underline}** if numerous requirements are met. **Some
examples** of the conditions which would cause the costs to be
**[unallowable]{.underline}** are:

-   mortgage-related costs if employees were not homeowners prior to the
    move

-   if the move was for a period of time less than 12 months

-   the move does not benefit the employer

-   employer does not have a consistent relocation policy for all
    employees

-   costs represent loss on sale of a home

-   continuing mortgage principal payments on sold residence

## Rent/Lease (FAR 31.205-36)

The most common form of renting or leasing real or personal property is
via an **operating lease** where the consultant pays rent to a third
party at prevailing market rates. These costs are generally
**[allowable.]{.underline}**

However, in some cases, property is considered a "purchased asset" and
must be accounted for as a **capital lease**. In the case of a capital
lease the capitalized value of the assets must be distributed over its
useful life as depreciation charges, or over the term of the lease as
amortization charges. Criteria were established by FAS-13 in paragraph
.007, which classifies leases. If a lease meets one or more of the
following four criteria, the lease shall be classified as a **capital
lease**. Otherwise, it shall be classified as an **operating lease**.

1.  The lease transfers ownership of the property to the lessee by the
    end of the lease term.

2.  The lease contains a bargain purchase option.

3.  The lease is equal to 75% or more of the estimated economic life of
    the leased property.

4.  The present value at the beginning of the lease term of the minimum
    lease payment (with certain exclusions) equals or exceeds 90% of the
    fair value of the leased property to the lessor at the inception of
    the lease over any related investment tax credit retained by the
    lessor and expected to be realized by him.

**[Common control]{.underline}** is another important issue when
considering the allowability of rental costs. Charges in the nature of
rent for property between any divisions, subsidiaries, or organizations
under common control, are **[allowable]{.underline}** to the extent that
they **[do not exceed the normal costs of ownership,]{.underline}** such
as depreciation, taxes, insurance, facilities capital cost of money, and
maintenance, provided that no part of such costs shall duplicate any
other allowed cost.

## Selling Costs (FAR 31.205-38)

Selling costs are **[allowable]{.underline}** if reasonable.

Selling and marketing costs cannot be adequately identified by mere
reference to account titles. Such a shallow analysis is not sufficient
to assess the allocability and allowability of costs within an account.
The actual composition of the account or the activities it represents
must be known and analyzed.

Any selling and marketing costs are subject to government challenge if
the costs can be considered unnecessary for government contracts. In
determining the reasonableness of selling costs, the government
considers the nature and amount of the expense in light of the expenses
that a prudent individual would incur in a competitive business, the
proportionate amounts expended as between government and commercial
business, the trend and comparability of current costs with historical
costs, the general level of selling costs in the industry, and the
nature and extent of the selling and marketing efforts in relation to
the contract value.

Some states have more specific policies regarding selling costs and
state that "general sales promotion" costs shall include/encompass any
activity conducted by a company that is meant to call attention to or
enhance the image of the company, its products and/or services. Any cost
associated with such activity shall be **[unallowable]{.underline}**.

## Travel Expenses (FAR 31.205.46)

Travel expenses, based on their nature and purpose may be
**[allowable]{.underline}** as either indirect or direct. Travel costs
incurred in the normal course of overall administration of the business
are **[allowable]{.underline}** and shall be treated as indirect costs.
Travel costs attributable to specific contract performance are
**[allowable]{.underline}** and may be charged to the contract. Costs
for transportation may be based on mileage rates, actual costs incurred,
or on a combination thereof; costs of lodging, meals and incidental
expenses may be based on per diem, actual expenses, or a combination
thereof, provided the method used results in a reasonable charge as
provided in **the Federal Travel Regulation (FTR).** Individual state
contract limits may be more restrictive.

Costs shall be **[allowable]{.underline}** only if the following
information is documented:

-   Date and Place

-   Purpose of Trip

-   Name of personnel or relationship to the company

-   For transportation costs a log must be maintained

## Legal Costs (FAR 31-205-47)

Costs incurred in connection with any proceeding brought by a Federal,
state or local government for violation by the consultant of a law or
regulation are often **[unallowable]{.underline}**. The FARs provide
specific criteria. Costs of legal, accounting, etc. that arise as a
result of a dispute between consultants that are partners in a joint
venture, or similar shared interest arrangement, are
**[unallowable]{.underline}**. This FARs section also requires that
these costs, including directly associated costs, which may be
unallowable, be segregated in the accounting system.

Legal costs pertaining to organization or reorganization activities are
**[unallowable]{.underline}**.

In certain situations, significant legal costs may be incurred in one or
more accounting periods and recoveries from settlements may be received
in subsequent periods. A portion of the recoveries should be credited to
the accounts where the legal costs were incurred.

## Business Combination Costs (FAR 31.205-49 &-52)

A business combination occurs when a corporation and one or more
incorporated or unincorporated businesses are brought together into one
accounting entity. These combinations are classified as mergers or
consolidations and are accounted for as purchases or pooling of
interests. The purchase method accounts for a business combination as
the acquisition of one company by another (merger). Any difference
between the cost of an acquired company and the sum of the fair values
of tangible and identifiable intangible assets less liabilities is
recorded as goodwill.

Costs for amortization, expensing, write-off, or write-down of goodwill
(however represented) are **[unallowable]{.underline}**.

When the purchase method is used, **[allowable]{.underline}** costs for
amortization, cost of money and depreciation are limited to the amounts
that would have been allowed had the combination not taken place.
Consultants must maintain detailed records which identify and track
elements of costs for future reporting periods.

## Alcoholic Beverages (FAR 31-205-51)

Costs of alcoholic beverages are **[unallowable]{.underline}** and
consultant's records should clearly segregate these costs and exclude
them from the indirect cost schedule. These costs should also not be
included in direct contract cost invoices.

## Listing of Common Unallowable Expenses

The following table provides a listing of expenses that are generally
not allowed (under provisions of the Federal Acquisition Regulations,
part 31.2) by commercial enterprises performing contracts for the
government. The list identifies transactions that are commonly incurred
by consulting engineering firms, but is not all inclusive.

  ----------------------------- -------------------------------------------------------
  **FAR**                       

  **[Reference]{.underline}**   **[Unallowable Expenses]{.underline}**

                                

  31.205-1                      Advertising

  31.205-1                      Trade Show Expenses

  31.205-1                      Trade Show Labor

  31.205-1                      Promotional Material/Brochures

  31.205-1                      Souvenirs/Imprinted Clothing Provided to Public

  31.205-1                      Membership in Civic and Community Organizations

  31.205-3                      Bad Debts

  31.205-3                      Collection Costs

  31.205-6                      Personal Use of Company Vehicles

  31.205-8                      Contributions or Donations

  31.205-13                     Employee Gifts & Recreation

  31.205-14                     Membership in Social/Dining/Country Clubs

  31.205-14                     Social Activities

  31.205-15                     Fines/Penalties

  31.205-19                     Key-Man Life Insurance

  31.205-19                     Re-Work Insurance

  31.205-20                     Interest Expense

  31.205-22                     Lobbying Costs

  31.205-27                     Organization/Re-organization Legal Fees

  31.205-27                     Organization/Re-organization Accounting Fees

  31.205-27                     Organization/Re-organization Incorporation Fees

  31.205-27                     Organization/Re-organization Labor

  31.205-27                     Capital Raising (Equity or LT Debt) Legal Fees

  31.205-27                     Capital Raising (Equity or LT Debt) Accounting Fees

  31.205-27                     Capital Raising (Equity or LT Debt) Lender Fees

  31.205-30                     Patent Costs

  31.205-33                     Retainer agreements

  31.205-35                     Relocation Costs (In certain circumstances)

  31.205-46                     Travel Costs in Excess of FTR Rates

  31.205-49                     Goodwill

  31.205-51                     Alcoholic Beverages
  ----------------------------- -------------------------------------------------------

# - Management's Responsibility for Accounting Records

It is the responsibility of management of companies involved in
government contracts to prepare timely, accurate financial information.
In most cases special schedules and disclosures will be required in
addition to normal annual financial statements, prepared for
stockholders, for lending institutions or for internal management.

It is the responsibility of management to require CPA's to provide
access to working papers to Federal or State Agency auditors.

## Schedule of Indirect Cost

The Schedule of Indirect Cost is the primary document for presenting the
overhead rate. It will be developed from financial statement and/or
general ledger amounts as well as from amounts in the company's cost
accounting system. This schedule must be in agreement with or reconciled
to financial statement and/or general ledger amounts.

The schedule should clearly display the **[unallowable]{.underline}**
amounts that have been removed from the indirect expense accounts. If
the schedule is presented "net of **[unallowable]{.underline}** costs,"
the details of the **[unallowable]{.underline}** costs must be disclosed
in the accompanying notes.

Direct labor should be included as a separate line item and must be in
agreement with general ledger and/or project accounting records.

Other items, such as Facilities Capital Cost of Money, may be shown as
required by individual states.

The Schedule of Indirect Costs or accompanying notes should show the
calculation of the overhead rate. In some cases multiple overhead rates
will be shown such as functional rates for segments of the business, or
rates for separate subsidiaries.

When a company uses Field Office (Onsite) rates in addition to Home
Office (Offsite) rates, costs and labor amounts for both rates should be
displayed on the Schedule of Indirect Costs. The rate structure and
allocation methodology should be clearly explained in the footnotes.

It should be emphasized the consultant is responsible for accounting for
costs appropriately and for maintaining records, including supporting
documentation, adequate to demonstrate that costs claimed have been
incurred, are allocable to the contract, and comply with applicable cost
principles. Examples of supporting documentation include time sheets and
usage logs. Costs which are not adequately supported may be disallowed
all or in part by the auditor. When accounting practices are
inconsistent with the FARs, costs resulting from such practices shall
not be allowed in excess of the amount that would have resulted from
those consistent with the FARs.

The consultant is responsible for maintaining consistency in estimating,
accumulating and reporting costs. All projects should benefit from the
same accounting procedures and processes.

## **Unallowable** Costs

FARs 31.201-6 requires that **[unallowable]{.underline}** costs and any
directly associated cost be identified and excluded from billings,
claims or proposals for government contracts. In addition,
**[unallowable]{.underline}** costs must participate in indirect cost
allocations just as they would if they were **[allowable]{.underline}**.
**See Chapter 5** for a list of **common [unallowable]{.underline}
costs.**

Consultants are to maintain adequate records to establish and maintain
the visibility of identified **[unallowable]{.underline}** costs
including directly associated costs. If a directly associated cost is
included in a cost pool that is allocated over a base that includes the
**[unallowable]{.underline}** cost with which it is associated, the
directly associated cost should remain in the cost pool. In all other
cases, the directly associated costs, if material in amount, must be
purged from the cost pool as **[unallowable]{.underline}** costs.

Salary expenses for the time employees participate in activities that
generate **[unallowable]{.underline}** costs should be treated as
directly associated costs provided the costs are material. Time spent by
employees outside the normal working hours would not be considered
unless the employee engaged in those company activities so frequently
outside the normal working hours that it would indicate that the
activities are a part of the employee's regular duties.

## Financial Statements

Financial statements will vary depending on the company ownership,
organization, size, etc. Publicly-held companies will generally have
audited financial statements which includes the opinion of the CPA firm.
Other entities may also have audited financial statements to serve the
needs of lending institutions, owners, government agencies, etc.

Many smaller firms will have financial statements, which are compiled by
accounting firms. In many cases, the accounting firms will also assist
in preparing the Schedule of Indirect Costs.

In some cases, the financial statements will be prepared by internal
accounting or management personnel.

In all cases the financial statements should include representations
from management that the amounts are timely, accurate and in compliance
with regulations that apply to their individual circumstances.

## Disclosures

**Disclosures are required to be included with financial statements and
special schedules.** This would include explanatory information about
the financial data. Disclosures may describe the types of accounting
systems and methods. They may describe the types of operations or
contracts. A schedule of principal owners is often included.

**Note: For examples of minimum disclosure requirements see Chapter 9.**

## Management Representations

In working with consultants it is important for auditors to obtain
written representations from management personnel. Specific
representations will vary depending on the circumstances as well as
other available information, such as audited financial statements. For
indirect cost overhead engagements, auditors should request
representations such as:

-   the financial information is **accurate**

-   the financial information is **complete**

-   the information is in **compliance** with government regulations
    (i.e. FARs)

-   estimates are based on **sound** financial data and **consistent**
    assumptions

-   all actual indirect cost rates represented to any government body
    have been disclosed

In some contract audit environments, a management-certified cost
proposal may be the starting point for the engagement and serves as
management's representation. The auditor should consider obtaining
additional representations on matters that arise during the course of
the engagement.

Some states require annual submissions of financial, procedural and
other company information as well as Schedules of Indirect Costs. Some
states require annual CPA audits/examinations of the Schedule of
Indirect Costs.

Under the provisions of the Sarbanes -- Oxley Act of 2002, publicly
traded companies must now submit annual reports that are management
representations of the company's internal control structure. Also
required is the CPA firm's attestation of the internal control reports.

# - Audit Considerations

Consultant indirect cost rates present unique and significant issues
that auditors must consider when planning and performing engagements.
For detailed information and guidance, the following are some
publications that may be helpful: (Additional sources are listed in
Chapter 12)

-   Government Auditing Standards ("Yellow Book") by US General
    Accounting Office.

-   Generally Accepted Auditing Standards, related Statements on
    Auditing Standards (SAS's) and Statements on Standards for
    Attestation Engagements (SSAE's) by American Institute of Certified
    Public Accountants (AICPA)

-   DCAA Contract Audit Manual by Department of Defense Contract Audit
    Agency

-   Internal Control -- Integrated Framework by Committee of Sponsoring
    Organizations (COSO) of the Treadway Commission

-   OMB Circular A-123 Revised, Management's Responsibility for Internal
    Control by US Office of Management and Budget

-   Auditing Standards promulgated by the Public Company Accounting
    Oversight Board (PCAOB) by SEC as a result of the Sarbanes-Oxley Act
    of 2002

-   Cost Accounting Standards (CAS), 48 CFR, Chapter 99, by Cost
    Accounting Standards Board (CASB), an independent board located
    administratively within OFPP

It must be emphasized that auditors **must exercise significant
judgment** in planning and performing engagements and take into
consideration the unique circumstances involved with each government
contractor and associated accounting systems. A wide variety of tools
and publications may be helpful in determining the appropriate
procedures, testing methods and reporting formats.

Auditors must consider specific government regulations and individual
contract provisions when designing and performing procedures.

## Internal Controls

Management is responsible for maintaining an **effective internal
control structure**. Much has been written in both the public sector and
the government sector in recent years regarding appropriate internal
control procedures. The unique requirements of cost-based government
contracting require cycles and elements of internal control that must be
evaluated as part of the engagement. The following important elements
must be considered during the auditor's evaluation of internal control
of a consulting firm:

-   Systems for monitoring compliance with government procurement
    regulations

-   Estimating systems and proposal preparation practices

-   Contract cost accounting practices

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-   Systems for tracking and allocating labor cost

-   Systems for allocating non-labor direct costs

-   Systems for allocating costs through cost centers

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-   Billing procedures and controls

-   Miscellaneous Revenues/Credits

-   Change order identification, pricing, and reporting

-   Cost aspects of related-party and interorganizational transactions

    **Compliance with government procurement regulations** is an
    important aspect for government contractors. Examples include
    compliance with **Cost Accounting Standards (CAS)** and **Federal
    Acquisition Regulations (FARs) Part 31**. Controls must be in place
    that are designed to provide reasonable assurance of compliance with
    applicable regulations. Management must ensure that employees are
    made aware of compliance policies and that procedures are carried
    out and updated as regulations change.

    **Controls over estimating systems and preparation of proposals**
    are important so that management's risk of loss when signing a
    contract is minimized. The controls ensure that reliable cost
    estimates support contract proposals, that the cost data are
    accurate, current and complete, that the source of cost data is well
    documented. The estimating process should be consistent and written
    policies and procedures should be maintained.

    **Contract cost accounting practices and systems** are critical for
    government contracting. Well-controlled systems ensure that costs
    are distributed to cost objectives accurately and form a basis for
    comparing actual costs with estimated costs. Maintaining adequate
    controls provides reasonable assurance that:

-   Costs are accurately distributed to cost objectives

-   Costs are reasonable and in accordance with contract provisions

-   **[Unallowable]{.underline}** costs are segregated

-   Cost-allocation practices are reasonable and in conformity with
    applicable CAS/GAAP

-   Costs incurred on all projects are periodically reconciled to
    financial statements

**Accounting for labor** accurately is paramount to accurate cost-based
accounting. Detailed records must be maintained, accumulated and
controlled to ensure that both the **direct labor** and **indirect
labor** amounts are accurate. Procedures must be in place to ensure that
direct labor charges are distributed to respective contracts. Indirect
labor must be captured and assigned to appropriate indirect labor
categories. The total of direct labor plus the indirect labor displayed
in the general ledger must reconcile to the overall labor recorded in
the payroll system for the period.

Other areas where management must devote significant attention include:
**Disbursements/Expenditures, Allocations of Other Direct Costs, Billing
Procedures, Related Party Transactions** and **Interorganizational
Transfers.** Systems must be in place to ensure accurate recording of
transactions. Controls must exist to insure that entries are reviewed
and approved and that errors are promptly corrected. Management must
maintain records to support the transactions and provide for an audit
trail. Where integrated accounting systems are in place, management must
have procedures to ensure that transactions are accurately recorded,
summarized and transferred through the systems.

## Understanding the Consultant's Business

The auditor should obtain an understanding of the consultant's business.
The following are examples of categories of information that may be
obtained, as appropriate, and considered by the auditor in planning the
engagement:

-   The consultant's products and services, including the relationship
    of those products and services to cost-based government contracts

-   The nature, size, and location of the consultant's operations

-   Mix of government and commercial business

-   Competition in the industry

-   Types of contracts (lump sum, cost plus fixed fee, time & materials)

-   The consultant's accounting policies and procedures

-   Key data for significant contracts including the following:

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-   Government Agency or Department

-   Type of Contract

-   Contract Price

-   Revenues, costs and profit/loss recognized to date

-   Incentive, escalation, or other relevant contract provisions

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-   Government Regulations affecting contract accounting such as state
    cost principles

-   Key changes in operations, systems or segments of the business

-   CAS Disclosure Statement and Revisions if applicable

-   Key information-processing systems

-   Related party and interorganizational transactions

-   Litigation, claims and disputes

-   Prior audited indirect cost rates

-   Prior filings with the SEC such as Form 10-K

-   Minutes of the meetings of the board of directors

-   Federal & State income tax returns

-   

## Consideration of Other Financial and Contract Audits

Information may be obtained from the contractor pertaining to other
audits. These may include Audited Financial Statements (by CPA firm),
audits by other SHAs, audits by local government agencies, audits by
federal government agencies (i. e. Defense Contract Audit Agency), or
financial statement compilations/reviews by CPA firms.

## Computerized Information Systems

The use of computers in the business environment is commonplace and is
dynamic and rapidly changing. Therefore, the auditor must carefully
assess the impact on the control environment. Accounting records may be
maintained on a wide range of equipment including large host-based
systems, networked environments, stand-alone PC applications and in some
cases outside vendors (i.e. payroll services). The use of the Internet
is now common for transmitting data or for accessing regulations and
other information involved in government contracting.

The auditor must apply the same standards for controls in highly
automated or manual systems. However, the audit tests may vary
significantly depending on the level of automation and integration of
the systems. In certain instances auditors may need to employ experts to
properly assess the internal controls. Particular attention should be
focused on the contractor's internal controls as new automated
accounting systems are implemented or significant upgrades are performed
on old systems. Contractor personnel must be adequately trained on new
systems and be knowledgeable of the impact of control procedures.

## Audit Risk and Materiality

Audit risk involves the possibility that the auditor's testing and
review may not detect material misstatements, mischargings or violations
of government regulations. If the auditor's assessment of internal
control risk is low, he/she may decide to accept a higher level of
"detection risk" by limiting the audit procedures. When the internal
control risk is considered to be high, the auditor will perform a
greater amount of testing in order to reduce the detection risk.

When making risk assessments, auditors must consider materiality. Under
GAGAS, the terms "material" and "significant" are synonymous. This is a
highly judgmental area where auditors must perform risk assessments in
order to determine appropriate levels of risk for the specific
engagement. One of the additional (beyond the three AICPA standards)
GAGAS standards relate to: **"detecting material misstatements resulting
from violations of contract provisions or grant agreements or from
abuse."**

[GAGAS 4.04 states:]{.underline} **"Auditors should use professional
judgment and consider the needs of users in applying the AICPA standards
and related guidance to audits of a government entity or an entity that
receives government awards. For example, auditors may need to set lower
materiality levels than in audits in the private sector because of the
public accountability of the audited entity, the various legal and
regulatory requirements, and the visibility and sensitivity of
government programs."**

[GAGAS 4.17a states:]{.underline} **"Auditors should design the audit to
provide reasonable assurance of detecting material misstatements
resulting from violations of provisions of contracts or grant agreements
that have a direct and material effect on the determination of financial
statement amounts or other financial data significant to the audit
objectives."**

[GAGAS 4.18 states:]{.underline} **"AICPA standards and GAGAS require
auditors to assess the risk of material misstatements of financial
statement amounts or other financial data significant to the audit
objectives due to fraud and to consider that assessment in designing the
audit procedures to be performed."**

## Type and Volume of Contracts

The level of risk to a consultant varies depending on the type of
contract (i.e. fixed-price-type or cost-type contracts). The audit
emphasis changes depending on the types of contracts or the mix of
contract types. If the consultant has primarily fixed-price (lump sum)
contracts, the auditor would place more emphasis on the contractor's
estimating procedures as well as those controls which are designed to
ensure that all direct costs are excluded from indirect costs. If the
consultant has primarily cost-type contracts the emphasis would be on
allowability and determination that costs recorded are not in excess of
specific contract limitations. Consultants with a mix of fixed price and
cost type contracts require special emphasis on consistent allocation of
costs regardless of whether contract revenues are based on cost
incurred.

The relationship of a consultant's cost based government contracts to
total contracts may have several impacts on the audit. Not only does
this relationship impact the auditor's assessment of audit risk through
materiality, the level of cost based contracts may have a significant
impact on the control environment and management's commitment to
internal control aspects unique to government contracting.

# - Audit Engagement Procedures

## General

The following guidelines should be considered when developing specific
audit procedures for consultant indirect cost rate engagements.

## Labor Costs

In the majority of consultant contracts labor is the largest single
component of cost. This component is made up of direct labor charges to
the contract and indirect labor charges allocated to the contract
through a factor or rate.

Verification of labor costs begins with the examination of the internal
control structure and testing of those controls as discussed in Chapter
7. Once this assessment has been made the auditor can determine the size
and depth of the audit sample for labor testing.

1.  The labor sample should be tracked from employee time records to:

-   The payroll records to assure hours recorded are paid.

-   The cost system to assure hours are posted properly to jobs.

-   The general ledger to assure that the total posted is recorded in
    the financial accounting system.

2.  The overall labor in general ledger accounts should be reconciled
    to:

-   The job cost system

-   The payroll reports submitted to the Internal Revenue Service (i.e.
    941's).

3.  Audit procedures should also determine if the labor accounts and
    individual time card entries sufficiently screen labor to:

-   Determine the allowability of payroll cost. (i.e. Do the records
    separate excess compensation and time spent on
    **[unallowable]{.underline}** activities?)

-   Determine the proper allocation of labor. (i.e. Do the records
    charge all labor performed on similar tasks the same way?)

-   Determine if labor is posted in a manner from which the labor base
    can be computed. (i.e. If the base is direct labor without premium
    overtime do the records accumulate direct labor and direct premium
    overtime?)

## Allocated Costs

Cost centers are developed to capture costs associated with a single
purpose. The costs are assigned to objectives based on unit charges.
Examples of categories for individual cost centers are printing,
computers and vehicles. The over/under allocation of costs is usually
handled as an adjustment to the overhead pool, which is where the cost
would have been charged if it had not been directed to the cost center.
If the over/under allocation is significant, consideration should be
given to adjusting the contract charges.

Some accounting systems will attempt to adjust the unit charge rate for
the over/under allocation of the cost centers. The goal of any cost
center is to minimize the over/under allocation by the application of a
properly estimated unit charge.

Audit issues of particular concern are:

1.  Costs posted to the center are properly **[allocable]{.underline}**.
    *Do the costs belong to the function being priced?*

2.  Costs posted to the center are **[allowable]{.underline}**. *Do the
    costs exclude interest, profit or other costs excluded under the
    FARs?*

3.  The unit charge records indicate the consistent assignment of all
    similar charges to projects.

Item three is the one most often overlooked by firms and can result in
substantial adjustments.

Some firms do not choose to set up cost centers. These firms estimate
the cost of providing certain services by pulling just certain elements
from ledger accounts (i.e. automobile depreciation from a general ledger
depreciation account). Once established, these unit charges are offset
to overhead as they are utilized on projects. This type of costing is
less precise and should not be utilized if the unit charges being
accumulated are significant to the firm's overall operation.

## Other Direct Costs

Invoices received from vendors or employees support these costs. They
are processed through the cost accounting system and assigned directly
to a project. The costs are not included in the overhead pool. Direct
accounts should be established in the General Ledger and all similar
costs should be posted to the accounts. Some examples are: project
travel, vendor printing, employee mileage, rented vehicles and
equipment, and subcontracts.

The audit procedures for these costs concentrate in two areas. The first
area is the direct cost accounts themselves. The procedures are:

-   Determine if costs are posted to the proper account and assigned to
    the correct projects.

-   Determine if the costs are **[allowable]{.underline}** in accordance
    with the contract and FARs.

    The second area would concentrate on the overhead accounts. The
    accounts tested would be the ones similar in nature of cost to those
    charged to the direct accounts. The main audit efforts should be
    concentrated on:

-   Determine if costs are consistently allocated to projects when they
    are incurred for similar purposes.

-   Determine if costs are priced consistently to direct and indirect
    cost objectives.

## Other Audit Procedures

Specific additional audit procedures are dependent upon the individual
firm being audited. Certain audit steps that may be required for one
firm are not necessary for another.

Several of these areas can be identified by a comprehensive preliminary
review of the following information:

1.  A detailed overhead rate schedule is needed to assure the auditee
    has separated **[unallowable]{.underline} costs** as required by
    FARs.

2.  An accounting and control survey is needed which will answer
    questions about possible areas of concern. Examples are:

-   Gains or losses on assets

-   Personal use of autos

-   Transactions with common control entities

-   Bonus plans

-   Direct costing policies

-   Acquisitions and re-structuring

-   Depreciation schedules

3.  A tax return prepared for the fiscal year(s) being audited. Many
    areas addressed in the return are of concern to the Internal Revenue
    Service as well as for government contracting.

4.  A disclosure statement (required by Cost Accounting Standards) when
    federal contracts exceed a given amount as follows:

    \(1\) Any business unit that is selected to receive a CAS-covered
    contract or subcontract of **\$50 million or more** shall submit a
    Disclosure Statement before award.

    \(2\) Any company which, together with its segments, received net
    awards of negotiated prime contracts and subcontracts subject to CAS
    totaling **\$50 million or more in its most recent cost accounting
    period**, must submit a Disclosure Statement before award of its
    first CAS-covered contract in the immediately following cost
    accounting period. However, if the first CAS-covered contract is
    received within 90 days of the start of the cost accounting period,
    the contractor is not required to file until the end of 90 days.

    \(3\) Other specific rules may apply and excepts can be made in
    certain circumstances.

# - Reporting & Report Disclosures

The auditors' reports may take a variety of formats and styles, but they
must meet the GAGAS Reporting Standards for:

-   Reporting Standards for Financial Audits, **[or]{.underline}**

-   Reporting Standards for Attestation Engagements

GAGAS reporting standards first incorporate the AICPA reporting
standards for each type and then require additional GAGAS standards.
There are a total of 10 standards for Financial Audits and 9 standards
for Attestation Engagements. The complete text of the standards is
available in the Yellow Book. See Chapter 2 for a summary matrix of the
standards.

This chapter will provide basic guidelines for reporting and minimum
disclosures that must be made by the consultant's management and
included in auditors' reports. [A typical report package contains the
following:]{.underline}

-   Independent Auditor's Report on Schedule of Indirect Costs

-   Schedule of Indirect Costs

-   Listing of Unallowable Account Adjustments with FAR References

-   Notes to the Schedule of Indirect Costs -- Minimum Disclosures

-   Independent Auditor's Report on Internal Controls

The American Association of State Highway and Transportation Officials
(AASHTO) Audit Subcommittee and the American Council of Engineering
Companies (ACEC) Transportation Committee have approved the report
formats.

Auditor's Report on Schedule of Indirect Costs

The following is an example of a typical audit report that would be
issued by a CPA firm or a State or Federal agency on the Schedule of
Indirect Costs for a consulting engineering firm. If the auditor
performed an "attestation engagement examination" the report wording
would be modified, but in both cases an auditor's opinion is required.
The complete report would include the Schedule of Indirect Costs and
Footnote Disclosures (see following pages).

**INDEPENDENT AUDITOR'S REPORT ON THE SCHEDULE OF INDIRECT COSTS**

Board of Directors

The Company

We have audited the Schedule of Indirect Costs for the fiscal year ended
December 31, 2004. This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion on this schedule
based on our audit.

We conducted our audit in accordance with generally accepted auditing
standards and the financial audit standards contained in the [Government
Auditing Standards]{.underline} issued by the Comptroller General of the
United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the
schedule is free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
Schedule of Indirect Costs. An audit also includes assessing the
accounting principles used and significant estimates made by management,
as well as evaluating the overall schedule presentation. We believe that
our audit provides a reasonable basis for our opinion.

The accompanying schedule was prepared on a basis of accounting
practices prescribed by Part 31 of the Federal Acquisition Regulations
(FARs) and certain other federal and state regulations as discussed in
Note 2, and is not intended to be a presentation in conformity with
generally accepted accounting principles.

In our opinion, the schedule referred to above presents fairly, in all
material respects, the direct labor, fringe benefits and general
overhead of the Company for the year ended December 31, 2004 on the
basis of accounting described in Note 2.

In accordance with the [Government Auditing Standards]{.underline} we
have issued a report dated April 4, 2005 on our consideration of the
Company's internal controls and its compliance with laws and
regulations.

This report is intended solely for the use and information of the
Company and government agencies or other customers related to contracts
employing the cost principles of the Federal Acquisition Regulations and
should not be used for any other purpose.

Bob Brooks, CPA, Director

External Audit Branch

April 4, 2005

Note: The following page displays a typical Schedule of Indirect Costs
for a firm that has both Home Office and Field Office rates. Unallowable
expense adjustments are clearly identified and referenced to appropriate
FAR sections or to specific State regulations, where applicable.

![](media/image2.wmf)

## Report on Internal Control

Note: The following is an example of a report on internal control with
no reportable conditions, which is a GAGAS requirement for financial
audits (See Chapter 2). For both financial audits and attestation
engagements auditors reports should disclose deficiencies in internal
control, fraud, illegal acts, violations of contracts or grant
agreements and abuse. (See the Yellow Book for specific reporting
requirements)

INDEPENDENT AUDITOR'S REPORT ON INTERNAL CONTROLS

Board of Directors

The Company

We have audited the Schedule of Indirect Costs of the Company for the
fiscal year ended December 31, 2004, and have issued our report thereon
dated April 4, 2005. We conducted our audit in accordance with generally
accepted auditing standards and the financial audit standards contained
in the [Government Auditing Standards]{.underline} issued by the
Comptroller General of the United States of America.

**[Compliance]{.underline}**

As part of obtaining reasonable assurance about whether the Company's
schedule is free from material misstatement, we performed tests of the
Company's compliance with certain provisions of laws, regulations and
contracts, including the provisions of the applicable sections of Part
31 of the Federal Acquisition Regulations, noncompliance with which
could have a direct and material effect on the determination of the
schedule amounts. However, providing an opinion on compliance with those
provisions was not an objective of our audit and, accordingly, we do not
express such an opinion. The results of our tests disclosed no instances
of noncompliance that are required to be reported under [Government
Auditing Standards]{.underline}.

**[Internal Control Over Financial Reporting]{.underline}**

In planning and performing our audit, we considered the Company's
internal control over financial reporting in order to determine our
auditing procedures for the purpose of expressing an opinion on the
schedule and not to provide assurance on internal control over financial
reporting.

The management of the Company is responsible for establishing and
maintaining internal control over financial reporting. In fulfilling
this responsibility, estimates and judgments by management are required
to assess the expected benefits and related costs of internal control
over financial reporting. The objectives of internal control over
financial reporting are to provide management with reasonable, but not
absolute, assurance that assets are safeguarded against loss from
unauthorized use or disposition, and that transactions are executed in
accordance with the Federal Acquisition Regulations Part 31. Because of
inherent limitations in any internal control structure, errors or
irregularities may nevertheless occur and not be detected. Also,
projection of any evaluation of the structure to future periods is
subject to the risk that procedures may become inadequate because of
changes in conditions or that the effectiveness of the design and
operation of policies and procedures may deteriorate.

For the purpose of this report, we have classified the significant
internal controls over financial reporting in the following categories:
cash disbursements and payroll.

Our consideration of the internal control over financial reporting would
not necessarily disclose all matters in the internal control over
financial reporting that might be material weaknesses. A material
weakness is a condition in which the design or operation of one or more
of the internal control components does not reduce to a relatively low
level the risk that misstatements in amounts that would be material in
relation to the financial statements being audited may occur and not be
detected within a timely period by employees in the normal course of
performing their assigned functions. We noted no matters involving the
internal controls over financial reporting and its operation that we
consider to be material weaknesses.

This report is intended solely for the use and information of the
Company and government agencies or other customers related to contracts
employing the cost principles of the Federal Acquisition Regulations,
and should not be used for any other purpose.

Bob Brooks, CPA, Director

External Audit Branch

April 4, 2005

## [Minimum Report Disclosures]{.underline}

The following represent disclosures that should be included with audit
reports, whether they are financial audits or attestation engagements.
In cases where examples are included they are for illustrative and
explanatory purposes only and are not intended to be all-inclusive
regarding rules and regulations. Some may not be appropriate for some
firms. Additional disclosures may be required for unusual or complex
issues. Disclosures should be included with the Schedule of Indirect
Costs for each fiscal year. They may be included in the Notes to the
Schedule of Indirect Costs or as a separate section within the report.

#### 1. DESCRIPTION OF THE COMPANY

Provide and overview of the company including when the company was
formed, type of organization (e.g. corporation, LLC, LLP, etc.), major
business activities, primary customer groups, type of ownership (e.g.
subsidiary of corporation, division of another company, privately held
firm) and any other pertinent general company information.

#### 2. BASIS OF ACCOUNTING

The basis of accounting practices should be clearly stated.

*Example:*

The Company\'s Schedule of Indirect Costs was prepared on the basis of
accounting practices prescribed in Part 31 of the Federal Acquisition
Regulations (FARs). Accordingly, the schedule of indirect costs is not
intended to present the results of operations of the Company in
conformity with accounting principles generally accepted in the United
States of America.

#### 3. DESCRIPTION OF ACCOUNTING POLICIES

Describe the financial accounting system (cash, accrual, hybrid, etc.)
and job cost accounting system (job order, modified job order, standard,
hybrid). Include a description of accounting policies and procedures
governing the classification of costs as direct or indirect. Describe
how project costs are accumulated and assigned to projects.

#### 4. DESCRIPTION OF OVERHEAD RATE STRUCTURE

Disclosures should include:

-   Identifying the Reporting Unit (e.g. company wide, business segment,
    technical specialty (design, construction administration,
    geotechnical, environmental, etc.) or geographical location)
    pertaining to the overhead rate(s).

-   Identifying the company's overall rate structure in terms of the
    base(s) for allocation. Describe if more than one base is used,
    depending on the customer (e.g. Federal or State project).

*Examples:*

[Single Base]{.underline}

All costs are allocated to Direct Labor

[Multiple Bases]{.underline}

Fringe Benefits -- allocated to Direct + Indirect Labor

Office Overhead -- allocated to Direct Labor + Fringes

General & Administrative -- allocated to Value Added Costs (All company
costs excluding sub consultants)

-   Identifying whether a dual rate structure exists for Field Office
    projects and Home Office projects. Specify the allocation methods
    used.

-   Identifying that Direct Project Costs, sometimes referred to as
    Other Direct Costs (ODC) are consistently charged to all projects,
    and not just projects that reimburse for ODCs (i.e. computer costs,
    reproduction, equipment charges and vehicle usage). Include a
    listing of cost items generally charged directly to projects.

-   Identify cost allocation practices between related business entities
    (e.g. parent company allocating costs to subsidiaries or divisions,
    allocations between subsidiaries or divisions, allocations to
    specific product lines, etc.)

#### 5. DESCRIPTION OF LABOR RELATED COSTS

A.  **Project Labor**

Describe how the company charges labor to all projects (i.e. actual,
average, or standard hourly rates).

B.  **Variances**

Describe how and when variances are recorded if using other than actual
labor costs.

C.  **Paid Time Off**

Explain the company's policy and accounting practice as to paid
vacation, sick leave and comp time. Include the consultant's policy as
to accounting for accrued sick leave upon termination

**D. Paid Overtime and Uncompensated Overtime**

> Indicate where the premium portion of overtime pay is recorded in the
> cost accounting system. Detail the procedures for recording
> uncompensated overtime incurred by employees charging direct project
> time.

*Examples:*

**[Premium Overtime]{.underline}** costs are incurred in meeting certain
deadlines. If an employee is eligible for overtime, they have their
choice of a cash payment equal to time and a half (premium portion), or
compensatory time off at time and a half. The premium portion of paid
overtime is included in the indirect cost pool.

**[Uncompensated Overtime:]{.underline}** The Company did not pay
certain salaried employees for time worked in excess of 40 hours per
week. The time in excess of 40 hours was credited to the indirect cost
pool. The credited amount (\$xx,xxx) consisted of hours worked in excess
of 40, times the employee's standard hourly rate.

**E. Highly Compensated Employees/Officers/Owners**

FAR §31.205-6(p) sets a specific dollar limit on the compensation
\[total compensation as defined in FAR §31.205-6(a)\] of "senior
executives. Other bases (such as independent salary surveys) may be used
to determine reasonable compensation levels. The reasonable compensation
limit or range that was used by the auditor should be disclosed in the
notes to the audit report. Distributions of profits to owners are
unallowable as direct or indirect labor costs.

*Example:*

The Company paid compensation to senior executives in excess of the FAR
§31.205-6(p) limit of \$342,986 per person. The total, which was
adjusted to the Schedule of Indirect Cost Pools, amounted to \$XXX,XXX.

**F. Pension Plans/ Deferred Compensation/ESOP**

If pension and/or deferred compensation costs (as defined by FARs
§31.205-6(j) and §31.205-6(k) respectively) are included in indirect
costs, identify whether the plan(s) meet the above regulations and
explain how the costs were determined (e.g. - cash contribution, stock
or options to purchase stock of the consultant, assets other than cash).

In regard to Employee Stock Option Purchase (ESOP) plans, identify the
dollar amounts of principal, interest, and administrative costs of the
contribution to the Employee Stock Option Trust (ESOT). Identify any
other significant impacts from market valuations, etc.

Example:

The Company has a 401(k) pension plan, meeting the requirements of FARs
§31.205-6(j), to which it makes a cash contribution of 2% of employee
salary per year.

In addition, the Company has a leveraged deferred compensation ESOP
started in 1984. The plan provides for cash payments of the appraised
value of the stock (held by the ESOT for the employee) upon retirement,
leaving the Company after 10 years service, or death. Since CAS
9904.415(a)(3) has not been satisfied, the Company assigns the payments
to the period in which the compensation is paid to the employee. The
amount of the company's share of ESOP expense included in the overhead
pool for the year is \$ xxx,xxx.

**G. Contract Labor**

Provide the methodology used by the consultant to account for contract
labor (not sub-contracts). In some cases this labor will be considered
to be a direct cost item invoiced to the project, but in other cases the
firm may choose to have this labor treated the same as employee labor,
and therefore it would be included in the direct labor base.

*Example:*

The Company uses contract labor for engineering related services, and
bills this labor as if it were for regular employees. The Company
provides office space, administrative support, and controls the contract
laborers. Therefore, contract laborers are considered employees, and
their labor costs (\$52,000 for the period audited) have been included
in the direct labor base.

#### 6. DESCRIPTION OF DEPRECIATION/LEASING POLICIES

Policies regarding costs related to acquisition and disposition of
assets should be clearly identified along with the related depreciation
methods. Costs and accounting treatment for capital and operating leases
should be disclosed.

*Example:*

Certain assets are purchased and depreciated, while others are leased
and considered operating leases, and the annual lease costs are included
in the overhead pool.

The depreciation reflected on the Company's financial statements differs
from the acceptable depreciation for federal income tax purposes. Since
the financial statement amounts included in the overhead pool are lower
than the amounts used for federal purposes, the amounts included in the
Schedule of Indirect Cost Pools are allowable under FAR §31.205-11(e).

#### 

#### 7. DESCRIPTION OF RELATED PARTY TRANSACTIONS

Identify any related parties, who are considered to have common control,
to the extent that audit adjustments are required, and the amounts of
required FARs adjustments \[per §31.205-26(e) and §31.205-36(b)(3)\].

Note: When calculating the Facilities Capital Cost of Money, the net
book value of the related party building may be included in the total
net book value of tangible assets for the company.

*Example:*

> > The Company rents one of its two offices from a Limited Liability
> > Partnership partially owned by a company shareholder. The actual
> > occupancy costs of \$350,000 include interest expense of \$140,500.
> > The rent expense recorded in the Company's financial statements
> > includes a \$400,000 charge from the related party LLP. The
> > calculation to determine the allowable portion of the rent would be:
>
> > Total rent expense recorded (from related LLP) \$400,000
>
> > Less: Profit included in rent charges (50,000)
>
> > Less: Unallowable interest expense [(140,500)]{.underline}
>
> > Allowable portion of related party rent \$209,500
>
> > Consequently, rental expense has been adjusted downward by \$190,500
> > to reflect the provisions of FARs §31.205-36(b)(3).
>
> > The officers of the Company have personal usage of Company vehicles.
> > Amounts attributable to this personal use (\$X,XXX for 20xx) were
> > disallowed.

### 8. FACILITIES CAPITAL COST OF MONEY (FCCM)

Provide the cost-of-money rate, as calculated in accordance with FAR
§31.205-10.

*Example:*

> > The cost-of-money rate has been calculated in accordance with FAR
> > §31.205-10, using average net book values of equipment and
> > facilities multiplied by the average treasury rate for the
> > applicable period. Equipment and facilities include furniture and
> > fixtures, computer equipment, vehicles, and leasehold improvements.
> > The calculation was made as follows:
>
> > **[12/31/xx]{.underline}**
>
> > Net Book Value of Corporate Assets \$267,520
>
> > Average Treasury Rate 5%
>
> > Computed Facilities Capital [\$ 13,376]{.underline}
>
> > Direct Labor Base \$1,042,535
>
> > Cost-of-Money Rate [1.28%]{.underline}

# - Reliance on Other Audits

## 

In order to avoid duplication of audit work it is common practice for
auditors to rely on the work of others. GAGAS 4.25 states:

"Underlying GAGAS audits is the premise that federal, state, and local
governments and other organizations cooperate in auditing programs of
common interest so that auditors may use others' work and avoid
duplication of audit efforts. Auditors should make arrangements to make
audit documentation available, upon request, in a timely manner to other
auditors or reviewers. Contractual arrangements for GAGAS audits should
provide for full and timely access to audit documentation to facilitate
reliance by others on the auditors' work."

Additional guidance is provided in GAGAS 7.33.

## NHS Act - Section 307

In 1995, Congress passed the latest version of the National Highway
System Designation Act (see
**[www.fhwa.dot.gov/infrastructure/progadmin/consultant]{.underline}**.)
The focus of Section 307 of this act was to remove the ceilings on
overhead rates and indirect salaries that had been established by some
states, avoid duplicate indirect cost audits of the same firm by
multiple audit entities, and reinforce the need for all audit entities
to use the Federal Acquisition Regulations for the purpose of
determining cost eligibility.

This legislation impacted how some states paid consulting engineers for
the overhead portion of their costs on federally participating
contracts. Heretofore, approximately half the states had self-imposed
ceilings on overhead limits and/or maximum hourly rates associated with
indirect labor. Section 307 of the NHS Act prohibited the use of such
limitations on federally participating contracts.

The NHS Act, however, did provide a one-year window for states to adopt
statutes that would establish "an alternative process intended to
promote engineering and design quality and ensure maximum competition."
If a statute were adopted by a state within this period, Section 307
would not bind the state. The deadline was ultimately extended to
6/9/98, and thirteen states adopted statutes within the allowed time
period. **Such states are referred to as** **"opt out states." They are:
CT,DE,FL,KY,LA,ME,MD,MN,NY,NC,UT,TN,WV.**

**Note:** The current Federal budget legislation (for years 2005-2006)
contains language, which, if passed, proposes to eliminate the concept
of "opt out states.

## Cognizant Agency/ Cognizant Audits

Section 307 also strived to establish an audit environment that was
uniform among the states and not duplicative. Uniformity was to be
achieved by requiring states or other audit entities to use the cost
principles found in the Federal Acquisition Regulations (Part 31 of
Title 48, Code of Federal Regulations) when performing cost audits of
consulting engineering firms. Many states had previously used the
Federal Acquisition Regulations to determine eligibility of indirect
costs on engineering contracts.

The avoidance of duplicate audits was addressed in Section 307 through
the introduction of the term **"cognizancy."** This term laid the
groundwork for states and other audit entities to be required to use the
work of others if an audit had been previously performed by a "cognizant
agency." Unfortunately, Section 307 did not provide a definition for
cognizant agency. In order to develop an acceptable definition of
cognizant agency and cognizant audit, the American Association of State
Highway and Transportation Officials (AASHTO) Audit Subcommittee and the
American Council of Engineering Companies (ACEC) Transportation
Committee joined forces to develop acceptable definitions of these terms
that could be used by the Federal Highway Administration when adopting
rules for the implementation of Section 307.

[The AASHTO Audit Subcommittee]{.underline} and the [ACEC Transportation
Committee]{.underline} unanimously adopted the following definitions for
these terms during their meetings conducted during the late summer of
2000.

> A **"Cognizant Agency"** is any one of the following:

-   Federal Agency

-   The Home State Transportation or Highway Department (i.e., state
    where the firm's accounting and financial records are located)

-   A Non-Home State Transportation or Highway Department to whom the
    Home State has transferred cognizance in writing for the particular
    indirect cost audit of a firm.

    A **"Cognizant Audit"** is achieved by any one of the following
    methods:

-   A Cognizant Agency performs or directs the work of a CPA who
    performs the indirect cost audit.

-   Non-Home State auditor or CPAs working under this State's direction
    issue an audit report and the Home State issues a letter of
    concurrence. If the Home State does not accept the audit of another
    State, the Home State will have 180 days from receipt to issue a
    cognizant audit; otherwise, the Non-Home State audit report will be
    cognizant for the 1 year applicable accounting period.

-   An indirect cost audit performed by a CPA hired by the firm will
    become a cognizant audit if one of the following conditions is met:

(a) The Home State reviews the CPA's working papers and the Home State
    issues a letter of concurrence with the audit report.

(b) A Non-Home State reviews the CPA's working papers and issues a
    letter of concurrence with the CPA report, which is then accepted by
    the Home State. If the Home State does not accept the Non-Home
    State's review, the Home State will have 180 days from receipt to
    complete a review of the CPA audit report and either concur with it,
    modify it, or reject it due to a material error requiring
    re-submittal; otherwise, the CPA audit report with which the
    Non-Home State has concurred will be cognizant for the 1 year
    applicable accounting period.

> Guidelines for the review are in the next section of this chapter.

### FHWA Final Rule: **Administration of Engineering and Design Related Service Contracts**

FHWA issued the final rule in July 2002 (see 23 CFR 172 Subpart A)
titled The FHWA considered the above definition of Cognizant Audit but
believed that more testing of the procedures would be required.
Therefore the definition was not included in the final rule.

The definition of **Cognizant Agency** was adopted in the final rule as
follows:

**"Any Federal or State agency that has conducted and issued an audit
report of the consultant's indirect cost rate that has been developed in
accordance with the requirements of the cost principles contained in 48
CFR part 31."**

In October of 2002 FHWA issued a "Supplemental Guidance Document for 23
C.F.R. 172, which provided information in a Question & Answer format
that specified how to achieve cognizant audits. For the most part, the
recommendation of AASHTO subcommittee was adopted in the FHWA guidance.

## Guidelines for Reviewing CPA Indirect Cost Audits

In addition to the above definitions, the AASHTO Audit Subcommittee
adopted guidelines to be used in reviewing indirect costs audits
performed by public accounting firms and issuing letters of concurrence.
The following minimum guidelines should be followed when a state
transportation/highway department audit organization reviews a CPA
indirect cost audit report and issues a letter of concurrence.

The reviewing state should obtain documentation that evidences the CPA's
accomplishment of the continuing education requirements identified in
paragraphs 3.45 thru 3.48 and the external quality control review
requirements found in paragraph 3.49 of Yellow Book.

-   The reviewing state should determine that the CPA's audit report
    format is in material compliance with the "Uniform Indirect Cost
    Rate Audit Report Format For Engineering Consulting Firms" prepared
    and adopted by the AASHTO Audit Subcommittee and the ACEC
    Transportation Committee.

-   The reviewing state should determine that the CPA audit was
    conducted in accordance with the General Standards, Field Work
    Standards and Reporting Standards for audits as described in
    Chapters 3,4 & 5 of the Yellow Book. The review should also
    determine compliance with Part 31 of the Federal Acquisition
    Regulations.

The following steps should be performed to make these determinations:

1.  Review of the audit report.

2.  Discussions with CPA auditor, if available.

3.  Review the CPA's working papers. CPA's must provide access to
    working papers.

4.  Request any additional supplemental tests the reviewing state deems
    necessary.

The reviewing state upon satisfactory completion of this review shall
issue a letter of concurrence with the CPA's indirect cost audit report
of the firm. The state auditor and audit manager who performed and
supervised the review shall sign the letter. Documentation to support
this review shall be retained by the reviewing state for a minimum of
three years from the date of the letter of concurrence. The letter of
concurrence shall be addressed to the audited firm.

# - Glossary of Terms

**[The following terms are used throughout this guide:]{.underline}**

**Actual Cost Agreement**

The term Actual Cost Agreement does not mean that a consultant will be
reimbursed for all actual costs incurred for performing a job. Costs are
reimbursed subject to the limitations described in the agreement,
contract, or specified criteria. These limitations can be very
restrictive. An example is interest on borrowed money. This is a cost of
doing business, yet it is not reimbursable as an actual cost of doing
business.

**Actual Costs**

Amounts determined on the basis of costs incurred and supported by
original source documentation, as compared to forecasted costs, or costs
thought to have been incurred, or costs based on historical averages.

**Advance Agreement**

An understanding included in an agreement by the contracting officer and
the consultant as to the treatment of special or unusual costs not
already included in FARs. The agreement must be in writing, executed by
both the contracting parties, and incorporated into applicable current
and future contracts. An advance agreement shall contain a statement of
its applicability and duration. See 48 CFR 31.109.

**Agreement**

A contract. A binding, legal, document which identifies the deliverable
goods and services being provided, under what conditions, and the method
of payment for such services. The document may include federal criteria
and state requirements which will have to be adhered to by the state and
the consultant. The document will usually indicate start and finish
dates, record retention requirements, and other pertinent information
relative to the actual work to be performed.

**All-Inclusive Hourly Rate Agreement**

An agreement using an hourly rate developed for billing purposes which
may include a firm's actual direct labor cost, overhead rate allowed or
negotiated, and negotiated profit margin. Provisional hourly rates
generally are temporary and will be adjusted by an audit. Negotiated
hourly rates may be used for the life of an agreement, or may be
adjusted from time to time depending on the agreement provisions.

**Allocable**

A cost is allocable (to an agreement or cost of work being performed for
the government) if it benefits both the agreement and other work of the
firm and the cost can be distributed in reasonable proportion to the
benefits of incurring that cost.

**Allowable (Cost)**

An item of cost that can be billed directly as a project cost or
indirectly as an overhead cost by the consultant.

**Audit Cycle**

The series of steps auditors go through in completing their assigned
work. The process includes a review of a firm's permanent file
maintained by the Audit Office, preliminary audit work including
scheduling of billed costs, arranging an appointment to conduct the
audit, entrance conference, field work, review of a firm's
documentation, exit conference, report write up, submittal of draft
report to auditee for comment, and issuance of the final report.

**Audit Resolution Process**

The process that SHA management and the auditee go through in resolving
audit findings. It may involve negotiation of a settlement, legal
counsel, and court procedures.

**Audit Trail**

The auditable record left by a transaction in a firm's accounting
records from original source document into subsidiary ledgers through
the general ledger and into financial statements and invoices.

**Billing Rate**

The billing rate generally refers to the hourly labor rate being charged
for work on an agreement. For a cost plus fixed fee agreement, the
billing rate will be the employee's actual payroll rate. For an
all-inclusive hourly rate agreement, the billing labor rate will include
the actual payroll rate plus an overhead percentage plus an amount for
fee.

**Cognizant Audit**

This concept was developed to assign primary responsibility for the
audit to one organization and to avoid duplication of audit work when
auditing the indirect cost schedule. The audit work may be done by the
home state auditors, a Federal audit agency, a CPA firm, or a non-home
state auditor designated by the home state auditor.

**Common Control**

Exists in related party transactions when business is conducted at less
than arm's length between businesses and/or persons that have a family
or business relationship. Examples are transactions between family
members, transactions between subsidiaries of the same parent company,
or transactions between companies owned by the same person or persons.

**Contracting Officer**

A title sometimes used in private and public sectors to indicate the
person having authority to enter into a contract or agreement for goods
and services.

**Corporation (C-Corp)**

A business structure where stock is made available for purchase. The
firm may have a president, vice president, treasurer, and secretary.
Anyone working for the corporation is usually paid an hourly wage rate
or is salaried. In theory, the liabilities of the individual stockowners
are limited in this type of business structure.

Other forms of business organizations include: Limited Liability
Corporations (LLC), Limited Liability Partnerships (LLP) and Sub-Chapter
S Corporations. Each has varying levels of liability for owners and each
has different Federal Income Tax provisions.

**Cost Accounting Standards**

Cost Accounting Standards (CAS) are the rules, regulations and
standards, which are promulgated by the Cost Accounting Standards Board
(CASB). The CASB is located within the Office of Federal Procurement
Policy, which is under the direction of the Office of Management and
Budget (OMB) of the Federal government.

**Cost Center**

Cost centers are used to accumulate and segregate costs.

**Cost Objective**

An agreement, contract, function or organizational subdivision for which
cost data are desired and for which provision is made to accumulate and
measure the cost of processes, products, jobs, capitalized projects,
etc.

**Cost of Money**

Facilities capital cost of money in an imputed cost determined by
applying a cost-of-money rate to facilities capital employed in contract
performance.

**Cost Plus Fixed Fee Agreement**

An agreement in which all the cost factors except fee are actual cost.
The fixed fee is a set dollar amount in the agreement.

**Cost Principles**

The underlying basis for determining how costs should be recorded when
they are allowable or unallowable, and the specific basis for treating
various costs as either allowable or unallowable.

**Courtesy Audit**

An audit performed for another state, another state agency, or city or
county government. The audit could be a preaward, interim or post, with
the requesting agency paying for the cost of the audit.

**Direct Cost**

Any cost that can be identified specifically with a particular final
cost objective, i.e., a project related cost. Direct costs would include
labor, materials, and reimbursables incurred specifically for an
agreement. It is irrelevant whether or not the costs are actually
billed. All direct labor costs must be included in the direct labor
base. All costs for lump sum agreements must be included in direct
costs.

**Entrance Conference**

A meeting between the auditor and the auditee, at which time the purpose
and scope of the audit are discussed.

**Exit Conference**

A meeting held after the auditor completes field work at the auditee's
place of business. Topics of discussion are preliminary findings of the
audit, which are subject to change and revision during the supervisory
workpaper review process, and/or a formal request for the auditee's
response to the draft audit report.

**Federal Acquisition Regulations (FARs) Code of Federal Regulations No.
48**

Sets the criteria for allowable and unallowable costs for federally
funded agreements. The FARs are also used as a guideline for other
government contracting such as State contracts. Part 31.2 is the primary
section pertaining to State Highway Agencies.

**Finding**

A statement of noncompliance with the terms of an agreement. A finding
includes the condition, criteria, cause, effect, and a recommendation
for correction.

**General and Administrative Expenses**

Any management, financial, and other expense which is incurred by or
allocated to a business unit, and which is for the general management
and administration of the business as a whole.

**Generally Accepted Auditing Standards (GAAS)**

These are standards for financial statement audits set forth by the
American Institute of Certified Public Accountants. The standards
pertain to auditors' professional qualifications, the quality of audit
effort, and the characteristics of professional and meaningful audit
reports.

**Generally Accepted Governmental Auditing Standards (GAGAS)**

These are standards for audits of government organizations, programs,
activities, and functions, and of government assistance received by
contractors, nonprofit organizations, and other non-government
organizations. These standards also incorporate GAAS for
financial-related audits.

**Indirect Cost**

Any cost not directly identified with a single, final cost objective,
but identified with two or more final cost objectives or an intermediate
cost objective. Consultants recover their indirect costs in their
overhead rate.

**Interim Audit**

An audit, which may be of limited scope, during the life of an
agreement. The purpose is to determine the actual allowable costs to
date, review and adjust a firm's overhead rate, and audit a prime
consultant's subcontracts. This audit follows a standard audit plan.

**Internal Control**

The plan of organization and methods and procedures adopted by
management to ensure that its goals and objectives are met; that
resources are used consistent with laws, regulations, and policies; that
resources are safeguarded against waste, loss, and misuse; and that
reliable data are obtained, maintained, and fairly disclosed in reports.

**Lump Sum (Fixed Price) Agreement**

An agreement where the method of payment for delivery of goods and
services is one set amount that includes salaries, overhead, and profit
with no adjustments. Once the lump sum amount is agreed upon, the
services or goods must be provided regardless of the actual cost to the
consultant.

**Negotiated Hourly Rate Agreement**

An agreement in which hourly billing rates that include labor, overhead,
and fee are negotiated in advance and are listed for a 12-month period
or more.

**Overhead Expenses**

All allowable general administrative expenses and fringe benefit costs
(sometimes called payroll additives). Depending on the size of the firm,
these costs may or may not be separately identified on a schedule of
overhead costs.

**Overhead Rate**

A computed rate usually developed by adding together all of a firm's
costs that cannot be associated with a single cost objective, including
general and administrative costs, fringe benefit costs, then dividing by
a base value, usually direct labor dollars, to get a percentage. This
rate is applied to direct labor to allow a firm to recover the share of
indirect costs allowable to the agreement.

**Overtime Compensation**

Compensation paid to employees who work more then a certain amount of
hours within a pay period, usually 40 hours. The pay rate may be based
on the normal salary rate or may include "premium overtime" such as time
and a half, or double time. In most cases, premium overtime is required
for hourly workers and is optional for certain salaried employees.

**Partnership**

A business with two or more co-owners, who may or may not have
established salaries. The liabilities of the firm are the owners'
responsibility. Owners may be treated the same as sole proprietors by
the auditors regarding the establishment of a salary rate.

**Post Audit**

An audit done after the completion of all work by a consultant. Its
scope may include all billed costs by the prime consultant and/or any
sub consultants providing services. This audit follows a standard audit
plan.

**Pre-Award Review**

An audit conducted on behalf of SHA management for the purpose of
validating financial information supplied by a potential contractor. The
audit may require an on site visit or information may be reviewed at the
Audit Office. Upon completion, the information is provided to the SHA
contracting officer in an audit report for use during agreement
negotiations. This audit follows a special pre-award audit plan.

**Provisional Hourly Rate Agreement**

An agreement in which hourly billing rates that include labor, overhead,
and fee are negotiated in advance, but are subject to adjustment after
an audit determines actual labor and overhead rates.

**Reasonable Cost**

A cost, if in its nature and amount, does not exceed that which would be
incurred by a prudent person in the conduct of competitive business.

**Record of Negotiation**

A summary memorandum prepared by the SHA contracting officer regarding
the reconciliation between the consultant's proposal and the SHA
estimate. It includes contract rate negotiations, disposition of
significant matters in the pre-award audit report, and reasons why audit
recommendations were not followed. It is required by 48 CFR 42.706(b).

**Single Audit**

In theory, an audit, which satisfies the needs of all parties, involved
with funding or doing business with an organization, either private or
public.

**Sole Proprietorship**

A business with one owner. From an audit standpoint, this person may not
have an established salary, but instead may rely on draws from the
profits of the firm to obtain their payment for services.

**Source Documentation**

Original documents, including but not limited to time sheets, invoices,
hotel receipts, rental slips, gasoline tickets, canceled checks, tax
returns, insurance policies, minutes of corporate meetings, etc., which
support the costs recorded in the firm's accounting ledgers and which
may be used for billing purposes to the government or for income tax
purposes.

**Task Assignment Agreements**

An agreement without a definite description of work, but with a
specified time period. Tasks which require the consultant's expertise
are assigned as needed. Each task will have its own maximum payable
amount. The total amount paid on all of the tasks cannot exceed the
total amount of the agreement.

**Unallowable (Cost)**

An item of cost which cannot be billed directly or indirectly by a
consultant. These types of costs, if found during an audit will be
purged from the costs billed directly, or from those billed indirectly
via an overhead rate or cost center. When an unallowable cost is
incurred, its directly associated costs are also unallowable.

#  - Listing of Resource Materials

This section provides a listing of resource materials that are commonly
used as guides by auditors in performing government contract audits. The
listing is not all-inclusive but attempts to highlight the most
frequently used materials. While paper copies are available most of the
publications are now also available on CD ROM disks or via the Internet.
These are especially useful because of the built-in search features that
enable the users to quickly find specific information.

## Government Auditing Standards - 2003 Revision ("Yellow Book")

#### [Published by:]{.underline} United States General Accounting Office (GAO),By the Comptroller General

#### Current version available at: http://www.gao.gov/govaud/ybk01.htm

#### [Purpose: (quote from introduction)]{.underline}

"Government Auditing Standards (the \"Yellow Book\") contains standards
for audits of government organizations, programs, activities, and
functions, and of government assistance received by contractors,
nonprofit organizations, and other nongovernment organizations. These
standards, often referred to as generally accepted government auditing
standards (GAGAS), are to be followed by auditors and audit
organizations when required by law, regulation, agreement, contract, or
policy. These standards pertain to auditors\' professional
qualifications, the quality of audit effort, and the characteristics of
professional and meaningful audit reports." 

## Federal Acquisition Regulations (FARs)

#### [Published jointly by:]{.underline} 

United States Department of Defense (DOD), General Services
Administration (GSA) and National Aeronautics and Space Administration
(NASA)

#### [Format:]{.underline}

Available in paper, CD ROM and on the Internet at
[**www.arnet.gov/far.**]{.underline} Another way to access the web site
is at the Federal Government main home page
**[www.firstgov.gov]{.underline}**, then search for "Federal Acquisition
Regulations."

#### [Contained in:]{.underline}

Code of Federal Regulations at 48 CFR Chapter 1

#### [Relevant Part:]{.underline}

Part 31 - Contract Cost Principles and Procedures

#### [Purpose:]{.underline}

Provides primary authoritative guidelines for acquisition of supplies
and services by government agencies. Provides detailed explanations of
specific rules for allowable and unallowable costs.

## DCAA Contract Audit Manual

#### Published by:

United States Department of Defense, Contract Audit Agency (DCAA)

#### Formats:

Two-volume set of paper manuals published twice per year

Available on CD ROM called "Defense Acquisition Deskbook"

Available on the Internet via the Acquisition Knowledge Sharing System
(AKSS) at: http://www.dcaa.mil/cam.htm

#### Purpose: (quote per manual)

"This manual is issued to provide technical audit guidance, audit
techniques, audit standards, and technical policies and procedures to be
followed by DCAA personnel in the execution of the contract audit
mission."

## American Institute of Certified Public Accountants (AICPA)

#### [Published by:]{.underline}

The AICPA is the premier national professional association for CPAs in
the United States. This organization produces numerous publications to
assist accountants and auditors in following accounting principles and
auditing standards.

#### [Formats:]{.underline}

1.  AICPA materials are generally available in hard-copy form in a
    variety of formats including Audit & Accounting Guides, Audit
    Guides, Professional Standards Binders, Statements of Position,
    Newsletters, Exposure Drafts and others.

2.  All of the AICPA's professional literature is available on CD-ROM
    with built in search capabilities.

3.  Many of the materials are available on the Internet at the AICPA
    website which is: http://www.aicpa.org

#### [Partial Listing of Helpful Materials:]{.underline}

1.  AICPA Professional Standards (Two Volume Set)

2.  Audits of Federal Government Contractors - Audit and Accounting
    Guide

3.  Auditing Recipients of Federal Awards: Practical Guidance for
    Applying OMB Circular A-133, Audits of States, Local Governments and
    Non-Profit Organizations

4.  Codification of Statements on Auditing Standards

5.  Accounting Trends and Techniques -CD-ROM

6.  Audit Sampling - Auditing Practice Release

7.  Auditing in Common Computer Environments - Auditing Practice Release

8.  Codification of Statements on Standards for Attestation Engagements

## Accounting Standards - Current Text

#### [Published by:]{.underline}

Financial Accounting Standards Board

#### [Format:]{.underline}

Hard-copy 3 volume set

Website address: http://www.fasb.org/

#### [Purpose:]{.underline}

This guide is an integration of currently effective accounting and
reporting standards. Material is drawn from AICPA Accounting Research
Bulletins, APB Opinions, FASB Statements of Financial Accounting
Standards, and FASB Interpretations. While its focus is primarily
publicly-traded corporations, some of the material may be helpful for
government auditors.

## Federal Travel Regulation

Provides information on travel guidelines for Federal government rates,
etc.

Website: http://www.fedtraveler.com/

#  - Other General Information

### Acknowledgements:

The concept of developing an audit guide to assist engineering
consultants, CPA's and State auditors with the preparation of Schedules
of Indirect Costs originally started at the State and regional levels.
Discussions at the regional level and at annual AASHTO meetings lead to
the first edition of the national audit guide released in December 2001.
Over the years many people have contributed to the "Uniform Audit &
Accounting Guide" by providing input, conducting research, attending
working sessions, facilitating meetings, editing, desktop publishing,
proofreading and other support activities. Representatives from State
Highway Agencies, FHWA, ACEC and AASHTO staff participated. Their
knowledge, time, travel money and supplies are greatly appreciated in
the nationwide team efforts that lead to the 2005 update.

### State Contacts:

For questions, comments and input for future updates the audit
representative from the local State Highway Agency should be contacted.
An updated listing of contacts can be found at:

<http://audit.transportation.org/community/audit/directory.nsf/Map?openform>