Defense Contract Audits: Actions Needed to Improve DCAA's Access to and Use of Defense Company Internal Audit Reports
Published: 2011-12-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Defense Contract Audit Agency (DCAA) has a critical role in contract oversight. DCAA audits are intended to help provide reasonable assurance that defense company policies for safeguarding assets and complying with contractual requirements are fulfilled. Defense companies also maintain their own internal audit departments to monitor policies, procedures, and business systems related to their government contracts. GAO was asked to assess the role of defense companies' internal audit departments and their ability to provide DCAA with information on their internal controls. GAO assessed (1) selected defense companies' adherence to standards for internal audits, (2) the extent to which those companies' internal audit reports address defense contract management internal controls, and (3) DCAA's ability to examine internal audits and use information from these audits. GAO reviewed a nongeneralizable sample of seven major defense companies including the five largest defense contractors and two smaller contractors; analyzed information on their 2008 and 2009 internal audits, which were the latest available when GAO began its assessment; and reviewed DCAA's ability to examine and use the audits in carrying out its oversight.
section_title: What GAO Found
paragraphs: The seven internal audit departments GAO reviewed generally adhered to Institute of Internal Auditors standards for organizing their internal audit departments. These standards include maintaining independence and having a proficient workforce. For example, all seven companies are organized so that the internal audit department is independent of company management. For performing individual audits, the majority of the companies followed the standards in areas such as planning the audit work and obtaining evidence. In its examination of evidentiary workpapers, GAO found documentation of the internal auditors' testing to show the level of compliance with company policies. The selected companies' internal audit reports cover a broad spectrum of policies, business systems, and programs that are relevant to DCAA audits. Each company performs audits with scope and objectives specific to that company and its individual businesses, such as audits about defense programs or audits that review a company's accounting system. In addition, some audits are common across companies, such as reviews of purchase card transactions or controls over information technology. In 2008 and 2009, the seven companies conducted 1,125 internal audits. GAO determined that of these, 520 were related to the defense contract control environment and one or more areas reviewed by DCAA, such as overall internal control functions and specific business systems. DCAA's access to and use of internal audit information from reports and workpapers is limited, in part, because of company interpretations of court decisions concerning DCAA's access to documents. Consequently, the seven companies GAO reviewed have developed differing policies and procedures for providing internal audit information to DCAA but ultimately provide DCAA access to internal audit reports and workpapers on a case-by-case basis. (1) Six of the companies have policies that provide for DCAA access to at least some internal audits reports upon request. Of the six, four have policies for providing access to supporting workpapers for their internal audits upon request. The other two companies have policies of not providing DCAA with access to supporting workpapers. (2) One company has a policy of not providing DCAA with access to internal audits or workpapers. DCAA's use of its access authority has been addressed in two court decisions. The courts held that DCAA does not have unlimited power to demand access to all internal company materials, but they also held that DCAA may demand access to materials relevant to its audit responsibilities. However, DCAA does not generally track its requests or denials for internal audit reports. GAO found that the number of DCAA requests for internal audit reports is small relative to the number of internal audits GAO identified as relevant to defense contract oversight. In explaining why few reports are requested, DCAA auditors noted obstacles such as not being able to identify internal audits relevant to their work and uncertainty as to how useful those reports could be. By not routinely obtaining access to relevant company internal audits, DCAA auditors are hindered in their ability to effectively plan work and meet auditing standards for evaluating internal controls.
section_title: What GAO Recommends
paragraphs: GAO recommends that DCAA take steps to facilitate access to internal audits and assess periodically whether other actions are needed. DOD generally agreed to implement GAO's recommendations but expressed skepticism that this alone would fully ensure access to internal audits.

section_title: Letter
paragraphs: The Department of Defense (DOD) relies extensively on private  companies to obtain billions of dollars of goods and services annually.  This reliance underscores the importance of overseeing contractor  operations and contract costs, particularly in an era of constrained  budgets. The Defense Contract Audit Agency (DCAA) plays a critical role  in helping to ensure that contract costs are reasonable. As part of its  efforts, DCAA performs audits of companies’ overall internal controls,  which are intended to provide reasonable assurance that company  policies for safeguarding assets and complying with contractual  requirements are being carried out. In addition, major defense companies  have internal audit departments to monitor policies and procedures  established by their management to ensure the integrity of their business  systems, including those related to their government contracts. Taken  together, DCAA and the internal audit departments measure company  performance against quality and reliability standards in support of  government contracts as part of the overall internal controls.
You requested that we assess the role of defense company internal audit  departments and their ability to provide DCAA with information on  company internal controls, business systems, and policies affecting  government contracts. In response, we assessed (1) the adherence of  selected major defense companies to internal auditing standards for  organizations and individual audits, (2) the extent to which the internal  audit reports of those companies address internal controls for the  management of defense contracts and associated business systems, and  (3) DCAA’s ability to examine and use those reports in carrying out its  oversight responsibilities.
We used the following methodologies to address our objectives:
To assess defense company adherence to internal audit standards,  we selected a nongeneralizable sample of seven major defense  companies. We selected major defense companies, based on DOD  contract obligations, that had over $1 billion in DOD contracts in 2009.
These include five companies with at least $15 billion in DOD  contracts and two smaller companies that still qualify as major  defense companies. For each company, we interviewed company  executives and obtained documents pertaining to the internal audit  organizational structure, policies, and procedures. We then assessed  whether their organizations, reports, and engagements conform to  standards established by the Institute of Internal Auditors.
We obtained the titles, objectives, and scope of all internal audit  reports completed in 2008 and 2009—the latest audits completed  when we began our assessment—by the seven selected companies.  We analyzed the information and determined that 520 internal audits  were related to contracting with the federal government. We then  asked to examine all 520 reports. Six of the seven companies agreed  to provide us their audit reports. We reviewed 470 reports to  determine the findings, corrective actions, and any connection to a  DCAA audit. We also requested that each company provide us with  workpaper sets from five internal audits, which we selected based on  a nongeneralizable random sample. Five of the seven companies  agreed to provide us access to their workpaper sets. We examined  the 25 sets of documents to verify that the workpapers contained  evidence for the findings and corrective actions identified in the  internal audit reports. The seven companies we reviewed are listed in  our full scope and methodology in appendix I, together with details on  the extent to which the companies provided us with the information we  requested. When materials were not provided for our review, we  obtained the company’s rationale for documenting purposes. These  rationales include the limitations on access to company internal  documents discussed in two court cases and ownership of the  workpapers by a third party. We do not regard the company decisions  as a limitation of our scope since we were fully able to address our  audit objectives based on examination of the vast majority of  documents we requested.
In evaluating DCAA’s access to and use of internal audit reports, we  reviewed DCAA’s statutory and regulatory authority to access  contractor records. We also reviewed DCAA’s audit manual to  determine the agency’s requirements for obtaining audit reports, as  well as the seven selected companies’ policies and procedures for  providing internal audit information to DCAA. We requested data from  DCAA and the selected companies on the number of company  internal audit reports DCAA had requested in 2008 and 2009, the  number of reports the companies provided, and rationale for not  providing requested reports. We interviewed DCAA officials, including  those who conduct audits at the seven selected companies, and  reviewed documentation to determine how DCAA auditors ask for and  track their requests and use of internal audit information.
The results of our review cannot be generalized across major defense  companies. Instead, they provide insights into how the selected  companies have organized their internal audit function, conduct internal  audits, and interact with DCAA.
We conducted this performance audit from September 2010 through  December 2011 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: For purposes of this report, we define the
Control environment—positive and supportive attitude toward internal  controls, conscientious management, and ethics standards.
Risk assessment—identification and assessment of risks from internal  and external sources and establishment of controls to mitigate them.
Control activities—policies, procedures, techniques, and mechanisms  that ensure management’s directives to mitigate risk are carried out.
Information and communication systems—assurance that information  is recorded and communicated to management and others in a form  and within a time frame that enables them to carry out internal  controls and operational responsibilities.
Monitoring—activities that assess the quality of performance over time  and ensure that audit and review findings are promptly resolved.
As part of their overall governance and control, many companies  establish internal audit departments to monitor adherence to  management policies and controls, report exceptions to policies and  procedures, and track corrective actions. One of the principal authorities  on the standards and practices of internal auditing is the Institute of  Internal Auditors (the Institute). The Institute is a non-profit professional  organization that provides guidance on assessing, maintaining, and  improving the quality of internal auditing within the profession.  Importantly, the Institute provides guidance for the profession through its  International Standards for the Professional Practice of Internal Auditing.  These standards include requirements at the organizational level such as  independence and objectivity, as well as for conducting audits, including  planning, performing fieldwork, communicating results, and following up  on corrective actions. The Institute also conducts training and administers  the Certified Internal Auditor (CIA) testing and certification program. The  CIA certification is acknowledged by auditing professionals as a standard  by which individuals demonstrate their competence in internal auditing.
In addition to a company’s own internal audit department, companies that  provide goods and services to DOD may be audited by DCAA. As  required by the Federal Acquisition Regulation (FAR) and the Defense  Federal Acquisition Regulation Supplement (DFARS), DCAA’s audits  examine internal controls, incurred costs, and business systems used in  the execution of government contracts. DCAA’s contract audit services  are intended to be a key control that helps ensure that prices paid by the  government are fair and reasonable and that companies are charging the  government in accordance with applicable laws, regulations, cost  accounting standards, and contract terms. At the completion of an audit,  DCAA provides the contracting officer with a report to assist in  negotiations or in assessing contract costs, as well as in determining  compliance with regulations and contractual requirements.
DCAA, which employs approximately 4,000 auditors, consists of a  headquarters office at Ft. Belvoir, Virginia and six major organizational  components—five regional offices across the United States that direct  and administer audits for assigned geographical areas and a field  detachment office that audits classified contracting activity. The five  regional offices manage about 300 field audit offices. Field audit offices  can be categorized as branch offices, resident offices, or suboffices.
Branch offices are located within each region and have responsibility  for all contract audit services within the assigned geographical area.
Resident offices are established at company locations where the audit  workload justifies assignment of a permanent staff of auditors.
Suboffices are established by regional directors as extensions of  branch or resident offices when required to furnish audit services. A  suboffice depends on its parent field office for release of reports.
For larger companies with operations at multiple locations, DCAA assigns  a Contract Audit Coordinator (CAC) who serves as a central point of  communication between DCAA auditors and company representatives.
DCAA audits are governed by generally accepted government auditing  standards (GAGAS). These standards require evaluation and testing of  the overall internal controls including the work of the contractor’s internal  audit activity, specific controls, and business systems. These standards  and associated principles govern the audit planning and evidence  required to conduct a GAGAS-compliant audit. DCAA’s procedures for  adhering to GAGAS in conducting different types of audits, such as audits  of internal controls or company business systems, are contained in its  Contract Audit Manual (CAM). According to the CAM, DCAA is required  periodically to examine the contractor’s internal controls, as well as  contractor policies and procedures. It also states that in the process of  planning an audit, auditors should consider the company’s self  governance programs when assessing the adequacy of the internal  controls to determine the scope of their audit. Further, the CAM states  that audits of individual business systems are to include an evaluation of  the internal control activities applicable to that system.guidance for audit procedures states that auditors should consider a  company’s internal audit activities to determine the adequacy of its  internal controls when performing an audit of the company’s control  environment and accounting system.
Lastly, DCAA  To conduct its audits, DCAA relies on the examination of contractor  financial, accounting, and other data. DCAA’s authority to access and  audit contractor records in support of DOD contracting and contract  payment functions is described in sections 2313 and 2306a of title 10 of  the United States Code (U.S.C.) and in the FAR. DCAA’s use of its  authority has been addressed in two court decisions involving Newport  News Shipbuilding and Dry Dock Company. The decisions are generally  known as Newport News I and Newport News II, both decided in 1988. In  the first case (Newport News I), the court held that DCAA’s statutory  subpoena power could not be used to access internal audits not tied to a  specific contract or proposal. In the second case, (Newport News II), the  court held that DCAA could subpoena company tax returns and other  materials, which were directly relevant to an audit and would allow DCAA  to corroborate the company’s computation of direct and indirect costs.For additional information on DCAA’s access authorities and the Newport  News cases, see appendix IV.
section_title: Internal Audit Departments We Reviewed Generally Adhered to Institute Standards
paragraphs: All of the companies we reviewed generally followed the Institute’s  standards for organizing their internal audit departments. These  organizational standards include maintaining independence and  objectivity, constructing a risk-based audit plan, employing and  maintaining a skilled, professional audit staff, and completing an external  assessment. Similarly, based on our examination of internal audit reports  and audit documentation (generally referred to as workpapers), we found  that the majority of companies followed the standards for performing  individual audits. These standards include assessing risks during audit planning, including the risk of fraud, obtaining evidence for findings to  include testing and documenting evidence, and following up on audit  issues. However, some companies did not provide sufficient information  on how they conduct individual audits for us to determine if the standards  for performance were met. Figure 1 shows the applicable Institute  standards and the number of companies in our review that followed them.
Our analysis indicates that five of the seven companies we evaluated  generally conformed to five Institute standards for internal audit  organizations. The remaining two companies did not provide for an  external quality assurance review as required under the Institute’s  standards. The five standards are:  Independence and objectivity—According to the organizational charts  of the seven selected companies, their Vice Presidents of Internal  Audit, also called the Chief Audit Executives (CAE), report directly to  the Audit Committees of the Board of Directors for matters related to  internal audits. For administrative matters such as payroll and office  space, the internal audit departments can be linked to the Chief  Financial Officer or another department. This organizational feature  allows the internal audit activity to be independent of company  management, as called for under the Institute’s standards. To further  ensure independence and objectivity, most audit executives we met  with stated that they encourage an attitude of objectivity in their staff.  For example, one CAE said that if staff from other divisions of the  company are assigned to the internal audit department, those staff do  not audit their former division’s activities to mitigate conflict of interest  risks.
Risk-based audit plan—All seven companies we reviewed developed  audit plans using risk-based assessments consistent with the  Institute’s standards. Audit plans are used by companies’ internal  audit departments to schedule their audits throughout the year so that  the highest risk issues the company is facing are covered. According  to the Institute’s standards, internal audit departments should base  audit plans on an annual evaluation of multiple risk factors, prioritized  to ensure coverage of the highest risk areas. In reviewing how the  companies develop their audit plans, we found that they receive input  from management and the board of directors and consider a variety of  factors such as changes in government regulations, review of high- risk areas identified in previous risk assessments, the potential for  financial misstatement, and external factors facing the company.  Once the information is compiled, the seven internal audit  departments plan specific audits across company businesses and  product lines, taking into account the likelihood of the risk  materializing and the damage to the company should the risk  materialize. Sometimes companies conduct a follow-up audit for high- risk issues highlighted in a previous year. Follow-up audits allow the  internal audit department to track high-risk findings to ensure they are  corrected.
Proficiency—The Institute’s standards require that internal auditors  have sufficient expertise. We found that although internal audit  departments’ staff varies in number, the staff are comparable in  professional qualifications. Six of the company internal audit  departments are staffed by company employees, while the seventh  company contracts with an accounting firm to conduct its audits.  Based on information provided by the companies, we found that the  staff from six companies have a wide range of professional  credentials including certified public accountants, certified fraud  examiners, certified internal auditors, and certified information  systems auditors. In addition, more than half of the staff members  have advanced degrees, such as a masters of business  administration. Table 1 shows the audit staff experience and the  average number of auditors with certifications for six companies.
For the seventh company that retains an outside accounting firm to  perform its internal audits, the audit directors and the staff of the  accounting firm combined have a range of professional certifications  and advanced degrees comparable to the other companies. Company  officials informed us that their practice enhances the audit function’s  independence since the audit staff is not employed by the company  and ensures the availability of specialists, if needed. Another  company in our review previously outsourced its internal audit function  but stopped doing so, according to a senior internal audit official, to  save money, provide an in-house talent pool, and enhance the  connection between the auditors and the company.
Continuing professional development—The Institute’s standards  require certified internal auditors to complete 80 hours of continuing  professional education (CPE) every 2 years to ensure that they  maintain and update their knowledge and skills. We found that the  companies take a variety of measures to enhance auditors’  knowledge and skills. For example, one company provides 100 hours  of annual training, covers the cost of professional certifications,  provides financial incentives for their completion, and expects auditors  to obtain an additional 100 hours of training on their own. In addition  to CPE requirements and professional certifications, officials at three  companies stated they have training programs that allow staff from  other departments or business units to rotate through the internal  audit department for a limited time.
External assessments—Institute standards require that internal audit  departments must be subjected to external assessments at least once  every 5 years. Five of the selected companies have had external  quality assurance reviews of their organization and audit performance  within the previous 5 years. These assessments review a company’s  conformity with the Institute’s standards and provide comments on the  performance of the internal audit function. All five companies received  the highest possible rating of “generally conforms.” Officials from the  other two companies in our review stated that they do not have an  external assessment of their internal audit departments.
subsections: section_title: Internal Audits We Reviewed Followed Institute Standards
paragraphs: Our analysis found that five of the companies met the standards for  individual audits (see figure 1), including engagement planning,  conducting fieldwork and testing, reporting findings, and tracking  corrective actions. We were unable to completely assess two companies’  compliance with the standards because the companies did not provide  the information needed to do so. Specifically, we found that the 470 audit  reports provided by six companies and 25 sets of supporting workpapers  provided by five companies followed the Institute’s standards.
Planning the audit including assessing the risk of fraud—Workpapers  we examined from the five companies that provided them contained  documents showing planning steps for each objective consistent with  the Institute’s standards. Some companies completed an additional  step by noting in the workpapers the evidence associated with each  planning step. We also found that some workpapers contained  assessments of the fraud risks specific to the audit’s scope. For  example, one workpaper set we reviewed reported that the audit team  met with the legal department about fraud risks and ethics  considerations for that particular audit. Another set of workpapers  showed that a risk assessment chart was used to identify areas to be  included in the audit’s scope along with a rationale for its inclusion.
Conducting fieldwork including testing—The Institute’s standards  require internal auditors to conduct sufficient analysis and document  information to support the audit. The workpapers we reviewed  contained extensive documentation of the fieldwork, such as  interviews with company officials, and testing, such as comparing  company actions to policies and procedures to determine the extent of  compliance. The audit reports we reviewed from the six companies  showed evidence of substantive testing and provided analysis of the  testing showing the level of compliance with company policies,  procedures, business systems, and defense contracts. When testing  was conducted, it was cited in the reports as support for reportable  issues. Some testing relied on judgmental samples, but for certain  audits, such as audits of purchase card transactions, all of the  transactions were examined. In addition, we traced identified findings  through the workpapers to track the testing and the inclusion of the  work in the audit planning. By tracing the findings back to their origin  in the audit objectives, we verified that the findings reported were  supported by sufficient audit work.
Reporting findings—The audit reports we reviewed followed the  Institute’s standards for reporting results of the audit work by providing  reports to upper management and the audited party. The audit reports  provided the objectives and scope of the audit work and the findings  or issues discovered through the audit work. While the companies do  not follow GAGAS standards, the reports, although brief, contained a  clear explanation of the findings often citing criteria, condition, cause,  and effect as defined in GAGAS. Audit officials at one company  stated that they include only those findings they consider to be the  most important in their reports because that is what company  management has indicated has the most value to them. Officials said  that highlighting the most important issues allows them to prioritize  their resources and take appropriate actions to correct them. In  contrast, some companies include nearly every finding discovered  during the audit work. Illustrative of these different approaches, the  company that only reports on the highest risk issues routinely had 2 to  4 findings per report, while other companies had multiple reports with  more than 10 findings per report.
Tracking corrective actions—The Institute’s standards require that the  CAE establish a process for the internal audit department to track  corrective actions to ensure they have been implemented or that  management has accepted the risk of not taking the corrective action.  We found that five companies documented the corrective actions they  had taken or intended to take to fix the problems identified in the audit  reports. Usually, the responsibility and accountability for implementing  the corrective actions were assigned to specific individuals and were  generally required to be implemented within a certain time period.  According to officials at one company, if corrective actions are not  taken or completed in a timely manner internal audit management and  company management are notified. In addition to findings that require  corrective actions, some companies’ audit reports include suggestions  for process enhancements for improving operations, comments that  are notable business practices, and observed areas of excellence that  are exceptional practices that would benefit other business units  within the company.
section_title: Internal Audit Reports Contain Information Relevant to DCAA Audits
paragraphs: The internal audits conducted by the seven selected defense companies  cover a broad spectrum of policies, business systems, and programs. The  seven companies conducted 1,125 internal audits from January 1, 2008,  through December 31, 2009, with 520—slightly less than half—of these  audits relevant to the internal control for defense contracts.defense-related internal audit reports fell into one or more of the following  categories:
All 520 audits examined some aspect of the companies’ overall  control environment.
338 audits related to one or more of the six business systems that  DOD audits.
97 audits pertained to a specific DOD program and could include  reviews of an entire business system, such as the earned value  management system, or one component of a business system, such  as purchasing.
96 audits were associated with a company’s compliance with federal  laws and regulations, or company policies related to its management  and oversight of its defense contracts.
Of the 338 audits related to the business systems audited by DOD, we  found that most concerned some aspect of the company’s accounting  system. In addition, the audits reviewed a wide range of subjects,  including purchase cards or earned value management systems to  determine if they are compliant with FAR and DFARS standards, and  internal controls over accounts payable. For example, an audit from one  company assessed a division’s purchase card program and found several  issues of non-compliance with policies and procedures and identified  control weaknesses related to the administration of the purchase card  program. Another company’s audit reviewed the general controls,  including the accounting system, for a division within a company and  found that controls were not operating effectively to ensure consistent  classification of accounting transactions. Figure 2 shows the distribution  of internal audits among the six business systems.
section_title: DCAA’s Access to and Use of Company Internal Audits Are Limited
paragraphs: DCAA’s access to and use of internal audit information were generally  limited at the companies we reviewed. Company policies on providing  DCAA access to such information varied at the seven companies—from  allowing full access on a case-by-case basis to denying access. The  extent to which DCAA has requested or been denied access to internal  audits is difficult to determine because DCAA does not track its requests  or denials. Based on information provided to us by the seven companies,  we estimate that DCAA requested access to 115 of the 520 audits we  identified as being relevant to internal controls and oversight of defense  contracting. We identified a number of factors that affect how frequently  DCAA auditors request internal audits, including interpretations of prior  legal decisions on DCAA’s access and the limited details DCAA receives  from the companies about the contents of the internal audit reports.  However, GAGAS and DCAA’s audit manual require an evaluation of  internal control, which includes internal audits, to provide a basis for  efficiently and effectively planning an audit.
subsections: section_title: DCAA Obtains Limited Access to Internal Audit Reports and Workpapers
paragraphs: The seven companies that we reviewed do not have uniform policies  about providing DCAA with access to internal audit reports and  workpapers. Of the seven companies:
Six companies have policies that provide for DCAA access to at least  some internal audits reports upon request. Four of the six, however,  provide that access on a “view-only” or “read-only” basis, meaning  that DCAA auditors may not have physical or electronic copies of the  reports but may view them and take notes in the presence of  company staff. Company officials explained to us that they adopted  this policy because the reports are sensitive and proprietary. One  company provides copies only of the sections of the reports and  workpapers that company officials consider relevant to DCAA’s work.
Of those six, four companies have policies that provide for DCAA  access to the supporting workpapers for their internal audits upon  request. Again, one company’s policy is to provide only workpapers  for the sections of internal audit reports the company deems relevant  to DCAA’s work. The other two companies have policies to not  provide DCAA with access to supporting workpapers.
One company adopted a policy of not providing DCAA with access to  its internal audits or workpapers.
Each of the six companies that have policies for providing access to their  internal audit reports require approval for specific requests for access on  a case-by-case basis, and most require that the requested internal audit  information directly relate to a DCAA audit of a specific contract or  proposal. When companies determined that such a request is not  relevant, the companies have denied DCAA’s requests. For example, one  company denied DCAA access to two requested audits because  company officials determined that the audits were related to commercial  or other activities the company believed were not subject to DCAA’s  review. Another company official said that the company would not provide  DCAA with access to internal audits related to internal controls for  information technology due to the potential threat of unauthorized  individuals getting access to networks, critical applications, and  confidential company or client data.
For the company with the policy of not providing DCAA with access to  internal audit reports, DCAA has cited the lack of access as preventing it  from obtaining an understanding of the company’s internal controls and  reported this as a deficiency in the audit of the company’s overall  accounting system. DCAA concluded that without access to the  company’s internal audit reports, DCAA could not determine if the  company’s monitoring function was operating effectively and whether  deficiencies were corrected. The company’s response cited the Newport  News I decision to support its position that contractors are not required to  provide DCAA with access to internal audit reports that are not tied to a  specific DCAA audit. While the company provided DCAA with lists of  planned audits as requested by DCAA and a summary of the three  requested audits, DCAA noted in its 2010 report that this was not enough  information to establish that the company’s internal controls were  effective.
In another instance, DCAA reported a deficiency in another company’s  control environment, citing the company’s policy of limiting access to  sections of internal audit reports the company deemed relevant to  contract oversight and not providing adequate and timely disclosure of  audit reports that identified unallowable costs. The company changed its  policy and agreed to provide DCAA with access to all audit reports the  company determines to include findings related to government costs.  However, auditors at one DCAA office who have requested internal audit  reports from the company said that the company has not adhered to the  revised policy and has continued to deny DCAA access to reports.
Another company we reviewed also changed its policy in recent years in  response to discussions with DCAA officials or as the result of DCAA  reporting the lack of access as contributing to a control environment  deficiency. The company previously had a policy of providing DCAA with  no access to internal audit reports, citing the Newport News I court case  as support for restricting DCAA’s access. After the CAC sent a letter in  2009 challenging this access policy and discussed the access issue with  company officials, the company changed its policy to provide DCAA with  read-only access to internal audit reports.
section_title: DCAA Does Not Generally Track Requests and Company Responses Related to Internal Audits
paragraphs: DCAA audit teams generally do not coordinate their requests for audit  reports among their field audit offices, which limits DCAA’s insight into the  extent to which audit teams are requesting or are being denied access to  internal audit reports. Within DCAA, one of the responsibilities of the CAC  assigned to a company is to serve as a contact point for discussions  related to access to contractor information, such as internal audit reports.  However, we found only one DCAA audit team that has implemented a  system in which the CAC serves as a focal point for all internal audit  report requests by all the field offices. For the other companies, the  corporate and field offices submit requests directly to the company. As a  result, the CAC does not necessarily know how frequently or what type of  internal audit information field audit offices are requesting. One of these  CACs noted that the CAC is informed when DCAA teams are denied  access, but otherwise the CAC does not track requests or company  responses. In the case of the one company that has multiple locations but  does not have a CAC, the DCAA audit team does not coordinate internal  audit requests to the company. As a result, the audit team does not know  how many requests for internal audit information are made to company,  what type of information is being requested, or whether the requests are  fulfilled or denied.
Although DCAA does not generally track requests or denials for internal  audit reports and, therefore, cannot say how many audit reports it asks for  or receives, the companies we reviewed maintain such information with  varying degrees of specificity. Based primarily on information from these  companies, we determined that for the most part, DCAA audit teams  request a small number of company internal audits, even though a  significant number of internal audits pertain to internal controls and  systems that are subject to DCAA audits. The companies provided us  with estimates or specific counts of how many internal audits were  requested by DCAA since 2008. In most cases, the number of reports  requested was significantly fewer than the number of reports we  determined were related to DOD contract oversight. The companies  estimated that DCAA requested 115 audit reports over the 2-year period  while we determined that 520 audit reports were related to some aspect  of oversight of DOD contracts. Information on the number of reports  requested from each of the companies and the number of reports we  determined to be related to oversight of government contracts is  summarized in table 2.
DCAA auditors we spoke with identified several factors that could affect  the number of internal audits they request.
Auditors from four DCAA audit teams told us they have difficulty  determining which internal audit reports are relevant to their own  audit work because descriptions of internal audits they receive from  the companies are often too brief to assess the relevancy to ongoing  or planned DCAA audits. Our review of the lists of audits provided to  DCAA confirmed that five of the companies provide only brief titles of  audits, while two provide more detailed summaries that included the  purpose, potential risks, and scope.
DCAA auditors stated when they request an internal audit report, the  company usually requires them to justify their request by linking it to a  planned or ongoing DCAA audit of a particular contract or proposal.
As a result, DCAA auditors believe they are limited to requesting only  those reports related to a specific planned or ongoing DCAA audit,  even if the company has other internal audit reports related to  another system or program that DCAA is responsible for auditing.
Auditors from three DCAA audit teams stated that they did not believe  that access to contractor internal audit information is critical to their  own audit work and that the internal audit reports do not have enough  detail to be helpful. They also stated that they are restricted by  auditing standards in relying on the work of others. However, auditing  standards do not restrict auditors from relying on the work of other  auditors, including internal audit functions. While not reducing the  level of work to be performed by DCAA auditors, consideration of  relevant internal audit reports in planning related DCAA audits and  performing risk assessments can provide useful information for  planning DCAA’s scope of work and audit procedures.
DCAA has issued significantly fewer audit reports since 2008. The  annual number of DCAA audits of the seven companies selected for  this review decreased by almost 50 percent from 2008 to 2010. The  number of internal control audits DCAA performed on the companies  decreased from 128 to 62 in the same period. A DCAA policy official  noted that DCAA decreased its number of control environment audits  because it was waiting for a regulatory change that would redefine  critical business systems for contractors. As a result of this  decrease, the number of internal audits necessary to supplement  DCAA’s audit work also decreased during this time period.
Auditors from the DCAA audit teams we spoke with confirmed that while  they request relatively few internal audits, when they are provided access  to the audit reports, they use them primarily to help assess the  companies’ internal controls and to determine whether companies took  corrective action to address reported issues. Other uses of internal audits  that DCAA auditors identified included: assessing the risk associated with a given DCAA audit, identifying the amount of testing needed for a given area, and determining whether company audit report findings identify  unallowable costs that affect government contracts.
DCAA officials have acknowledged that getting access to internal audit  information has been an issue with some of the major defense  contractors and, at best, they have access on a case-by-case basis. They  also acknowledge that they have not used their subpoena authority to get  access to internal audits or other company documents since the Newport  News decisions were issued in 1988 in part because the Fourth Circuit  Court of Appeals held that the language in the statutes did not generally  include internal audit reports unrelated to a specific contract or proposal.They also stated that the court’s decisions may have resulted in some  DCAA auditors limiting their requests for internal audit information. A  DCAA official noted that they have implemented a pilot program with one  major defense contractor that could be a model for how the agency  disseminates and coordinates internal information. The pilot program  consolidates authority and communication among various field offices  throughout the country that are responsible for auditing the contractor into  one regional audit team. DCAA auditors and company representatives  told us that the pilot provided enhanced communications and efficiency  between DCAA and the company. While the pilot does not specifically  address requests for internal audits, a senior DCAA official suggested  that the model could be applied to the process of requesting and  distributing company internal audit information as well.
section_title: Conclusions
paragraphs: The internal audits conducted by the seven companies we reviewed  generally were conducted in accordance with recognized professional  organizational standards. For individual company audits, the audit reports  and workpapers from five companies demonstrate that they likewise  adhere to recognized professional standards. The audit reports assess  the controls and systems for managing defense contracts that DCAA is  charged with auditing and contain information and analysis that DCAA  could find useful as it conducts its own work. However, DCAA is not  making full use of internal audits to help accomplish its critical oversight  role. This is attributable, in part, to company limits on access to internal  audit information based on their interpretations of DCAA’s access  authority and related court cases. While the courts have held that DCAA  does not have unlimited power to demand access to all internal company  materials, the courts have also made it clear that DCAA may demand  access to materials that are relevant to carrying out its audit  responsibilities. There are other issues that also account for DCAA’s  limited use of internal audit reports. Specifically, DCAA auditors do not  routinely request access to the reports due to limited visibility into the  scope and objectives of internal audits and uncertainty as to how relevant  internal audits can be used. DCAA management lacks insight into the  limited access and use of internal audits because DCAA does not  centrally track requests and denials for access to documents that could  improve its ability to carry out its mission.
When companies do not provide DCAA with access to internal audits or  DCAA auditors do not request them, DCAA auditors do not have  information that may be relevant for audit planning and risk assessment.  Conversely, greater access to internal audit information could improve  DCAA’s efficiency. DCAA auditors could either conduct a full audit of all  components of internal control, or in instances in which internal auditors  have conducted related work, DCAA auditors could examine the audit  reports and workpapers, if needed, and adjust their planning accordingly.  Moreover, we believe that by not routinely obtaining access to relevant  company internal audits that can inform their audits of the companies’  control environments, as well as audits of specific business systems and  contracts, DCAA auditors are hindered in their ability to meet the GAGAS  requirement for assessing internal controls. The work of the internal  auditors by no means replaces the work of DCAA auditors, but it could  provide DCAA auditors with a basis for making a judgment about a  company’s internal controls and help inform their audit planning, thereby  making more effective and efficient use of DCAA audits.
section_title: Recommendations for Executive Action
paragraphs: To increase DCAA’s access to and use of internal audits, we recommend  that the Secretary of Defense direct that the Director of DCAA take the  following three actions:
Ensure that DCAA’s central point of contact for each company  coordinates issues pertaining to internal audits. For some companies,  this would be the Contract Audit Coordinator. For companies without  a Contract Audit Coordinator, a point of contact would need to be  designated except when DCAA officials have determined that a  company does not have an internal audit function that produces  reports that may be relevant to DCAA’s audit responsibilities.  Coordination responsibilities should include obtaining sufficient information from the companies on their  internal audit reports so DCAA auditors can better identify and  request relevant audit reports and workpapers and  tracking DCAA auditors’ requests for access to internal audit  reports and workpapers and the companies’ disposition of those  requests.
Periodically assess information compiled by the central points of  contact regarding the number of requests for internal audits and their  disposition to determine whether additional actions are needed. Such  additional actions could include senior level engagement with  company officials to change company access policies or, as  warranted, the issuance of subpoenas.
Reaffirm with DCAA staff through guidance and training how and  under what circumstances company internal audit reports can be  accessed and used to improve the efficiency of audit planning and  execution.
section_title: Agency and Third- Party Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from DOD. In its written  comments, reproduced in appendix II, DOD concurred with two of the  recommendations and partially concurred with the recommendation  regarding DCAA central points of contact for issues pertaining to internal  audits. In its partial concurrence, DOD explained that DCAA would  implement the recommendation to establish central points of contact for  larger companies to attempt to obtain internal audit information from them  and establish processes for tracking auditor’s requests for internal audit  reports and workpapers. DOD stated, however, that doing so for smaller  companies may not be feasible or beneficial, as some smaller contractors  may not have sophisticated internal audit functions. DOD further  expressed skepticism that implementing the recommended actions alone  would fully ensure that DCAA would have complete and full access to  contractor internal audits, citing the limits that companies have placed on  DCAA’s access to internal audits and prior legal precedence.
We agree that for companies without internal audit functions that produce  reports that may be relevant to DCAA’s audit responsibilities, designated  coordinators would not be necessary. We, therefore, revised our original  recommendation to provide for such an exception. We agree that  implementing these recommendations alone may not be sufficient to  provide DCAA with full and complete access to internal audit reports in all  instances. However, implementation of the recommendations is a  necessary step for DCAA to obtain the information needed to determine  the extent to which DCAA is or is not getting access and how that is  affecting DCAA’s ability to fulfill efficiently its oversight responsibilities.  After taking such steps, DOD may be in a better position to identify and  pursue other remedies for ensuring DCAA’s access to internal audit  reports.
We also provided a draft of the report to the Chief Audit Executives of the  seven selected companies for their review and comment. In its written  comments on the draft, which are reproduced in appendix III, Lockheed  Martin Corporation expressed support for providing DCAA with internal  audit reports to the extent they can be used by DCAA to satisfy internal  control reviews. Lockheed Martin also noted, with regard to the  recommendation for DCAA central points of contact, that all DCAA audit  requests are already centrally coordinated through the DCAA CAC, which  has allowed the company to be responsive to DCAA request for internal  audit reports. The other six companies declined to provide official  comments, but two provided technical comments, which we incorporated  into the final report as appropriate.
We are sending copies of this report to the Secretary of Defense, the  Director of the Defense Contract Audit Agency, the Director of the Office  of Management and Budget, appropriate congressional committees, and  other interested parties. We will make this report available to the public at  no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-4841 or at woodsw@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. Key contributors to this report are listed in  appendix V.
section_title: Appendix I: Scope and Methodology
paragraphs: In response to a congressional request to assess the role of defense  companies’ internal audit departments and their ability to provide the  Defense Contract Audit Agency (DCAA) with information on their control  environments, business systems, and policies affecting government  contracts, we examined (1) the adherence of selected major defense  companies to internal auditing standards for organizations and individual  audits, (2) the extent to which the internal audit reports of those  companies address internal controls for the management of defense  contracts and associated business systems, and (3) DCAA’s ability to  examine and use those reports in carrying out its oversight  responsibilities.
Our review focused on seven selected major defense companies. For  purposes of our review we defined a major defense company as having at  least $500 million in contracts with the Department of Defense (DOD) and  at least $100 million in cost reimbursable contracts. The companies we  selected had at least $1 billion in DOD contracts and derived at least  25 percent of their revenue from DOD contracts in fiscal year 2009. We  selected the top five major defense companies based on fiscal year 2009  DOD contract obligations—The Boeing Company, Lockheed Martin  Corporation, Raytheon Company, Northrop Grumman Corporation, and  General Dynamics Corporation. We then judgmentally selected URS  Corporation and KBR, Incorporated to obtain insights on how smaller  major defense companies carry out their internal audit functions.  Collectively these seven companies represent about $106.7 billion  (57 percent) of the value of all contracts awarded by DOD to all major  defense companies in fiscal year 2009. The results of our review cannot  be generalized across major defense companies; instead, they provide  insights into how companies have organized their internal audit function,  conduct audits, and interact with DCAA.
To provide a framework for our assessment of the seven companies’  internal audit organization and engagement performance, we interviewed  officials with the Institute of Internal Auditors and reviewed standards  promulgated by the Institute for characteristics used in their peer review  assessment of internal audit organizations as well as the standards for  engagement performance. We also interviewed officials and reviewed  documentation pertaining to the Institute’s Certified Internal Auditor  examination and its training programs and conferences available to the  auditing profession.
To develop information on companies’ organizational characteristics, we  reviewed documents related to the organization and reporting structure of  companies’ internal audit departments. We conducted an initial interview  and obtained documents from officials from all seven companies to  determine the internal audit department’s organizational standards,  including its reporting structure, qualifications of staff, and whether the  company participated in a peer review of its organization and  engagement performance. We compared company policies, standards,  and practices to standards set by the Institute regarding the organization  and activities of company internal audit departments and to the standards  for engagements.
Our work in examining the audit reports was conducted in two phases.  First, we requested a list of all audit reports completed by the companies  from January 1, 2008, through December 31, 2009—the latest audits  completed when we began our assessment. We asked that the lists  contain the titles, objectives, and scope of the audits. In total, the seven  companies provided information on 1,125 audits. Second, we analyzed  the information provided on the 1,125 audits and identified reports that  pertained to the oversight of government contracts. We categorized the  report as defense-related if the audit report’s scope and objectives  identified one or more of the following aspects of company operations that  are related to execution of government contracts:
The audit’s scope and objectives included review of some aspect of  the overall internal control system.
The audit’s scope and objectives included review of one of the six  business systems DOD is charged with reviewing—accounting  system, earned value management system, estimating system,  purchasing system, material management and accounting system,  and property management system.
The audit’s scope and objectives covered one or more DOD  programs.
The audit’s scope and objectives covered some aspect of the Federal  Acquisition Regulation (FAR), Defense Federal Acquisition Regulation  Supplement (DFARS), or company policies related to defense  contract oversight.
In total, we identified 520 audit reports as defense-related and requested  those reports from the companies. We also selected a nongeneralizable  random sample of five sets of workpapers from each company’s audit  reports in order to assess how individual audits adhere to the Institute’s  standards for conducting audits.
The companies provided us with 470 audit reports and 25 sets of  workpapers. Lockheed Martin Corporation, Northrop Grumman  Corporation, The Boeing Company, Raytheon Company, and URS  Corporation provided us with both audit reports and workpapers for  review. General Dynamics Corporation provided only audit reports for  review. KBR, Incorporated did not provide audit reports or workpapers for  our review. When companies did not provide us with requested audit  reports or workpapers, we obtained the rationale for not providing the  materials from company officials for documenting purposes. These  rationales included the limitations on access to company internal  documents discussed in two court cases and ownership of the  workpapers by a third party. We do not regard the company decisions as  a limitation of our scope since we examined the vast majority of the  documents we requested and were fully able to address our audit  objectives.
To assess how internal auditors applied the standards in conducting their  audits, we reviewed 470 audit reports and 25 sets of workpapers. For the  audit reports we determined the issues raised by the auditors, distribution  of audit findings as well as evidence in the reports of testing conducted  and follow-up of corrective actions. For our examination of the  workpapers, we looked for evidence of planning for the engagement, risk  assessments to include the risk of fraud, testing of company policies and  procedures to determine if they are being followed, and whether the work  performed supported the findings. For the workpaper reviews, we traced  a finding from the conclusion back through the evidentiary materials  including testing to the planning and risk evaluation to ascertain whether  the finding was supported by the audit evidence and planning. To  determine whether the audit finding was followed until it was corrected,  we examined documentation in the audit workpapers to identify the  person responsible for taking the action, what action was taken, and the  date corrective action was completed.
To assess DCAA’s access and use of company internal audits, we  reviewed DCAA’s audit manual and its audit programs for control  environment audits as well as for audits of business systems and incurred  costs. We interviewed DCAA officials responsible for audit policy. At the  seven companies we selected, we also interviewed the DCAA audit staff  to determine their experience in examining internal audit reports. We  obtained DCAA documents requesting audit reports and copies of  material provided by the companies in response to requests. We  discussed actions taken by DCAA to gain material requested and  reviewed reports of internal control deficiencies citing a lack of access to  company audit reports. We interviewed staff to review their rationale for  requesting company audit reports as well as the materiality of those  reports to DCAA’s work.
We reviewed sections 2313 and 2306a of title 10 of the United States  Code concerning DCAA access to records and FAR and DFARS  provisions governing DCAA’s responsibilities. We also reviewed two key  court decisions regarding DCAA’s ability to enforce a subpoena for  company records including internal audits.
We conducted this performance audit from September 2010 through  December 2011 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Department of Defense
section_title: Appendix III: Comments from Lockheed Martin Corporation
section_title: Appendix IV: DCAA Access Authority and Associated Court Cases
paragraphs: The Defense Contract Audit Agency’s (DCAA) authority to access and  audit contractor records in support of Department of Defense (DOD)  contracting and contract payment functions is described in sections 2313  and 2306a of title 10 of the United States Code (U.S. Code) and in the  Federal Acquisition Regulation (FAR).
Section 2313 of title 10 of the U.S. Code gives the head of an agency,  acting through DCAA as its authorized representative, the authority to  inspect the plant and audit the records of a contractor performing a  cost-reimbursement, incentive, time and materials, labor hour, or price  redeterminable contract for agency. Records are defined as including  both documents and data (among other things) whether written or in  electronic form. The statute also provides that records may be  subpoenaed if not provided by the contractor.
Section 2313(i) of title 10 of the U.S. Code defines records to include  books, documents, accounting procedures and practices, and other  data, regardless of type and regardless of whether such items are in  written form, in the form of computer data, or in any other form.
Section 2306a of title 10 of the U.S. Code gives the head of an  agency, acting through the contracting officer, the authority to require  offerors, contractors, and subcontractors to make available cost or  pricing data to the government. It also provides the head of an  agency, acting through the contracting officer and DCAA, with the  authority to review the records provided by the offerors, contractors,  and subcontractors for the purpose of evaluating its accuracy,  completeness, and currency.
The FAR describes the auditor’s contract audit responsibilities such  as submitting information and advice to the requesting activity based  on the auditor’s analysis of contractor’s financial and accounting  records or other related data as to the acceptability of the contractor’s  incurred and estimated costs. In addition, the auditor is responsible for  reviewing the financial and accounting aspects of contractor cost  control systems and performing other analyses and reviews that  require access to contractor financial and accounting records  supporting proposed and incurred costs. The FAR also provides  specific language regarding DCAA role as the responsible  government audit agency.
DCAA’s use of its access authority has been addressed in at least two  court decisions, generally known as Newport News I and Newport News  II, both decided in 1988. In both cases, DCAA sought to enforce  subpoenas for access to internal documents of Newport News  Shipbuilding and Dry Dock Company. In the first case (Newport News I),  Newport News challenged the scope of DCAA’s subpoena power as it  related to Newport News’ internal audits. The court held that the  statutory subpoena power of DCAA extends to cost information related to  government contracts but that DCAA does not have unlimited power to  demand access to all internal corporate materials of companies  performing cost type contracts for the government. Because the materials  sought by DCAA were not within the scope of its statutory authority, the  court affirmed the district court’s order denying enforcement of the  subpoena.
In the second case (Newport News II), DCAA subpoenaed the company’s  tax returns, financial statements, and supporting schedules.decided to uphold enforcement of the subpoena, concluding that the  requested material was relevant to an audit and provided evidence of the  consistency of costing methods and the reconciliation of costs claimed for  tax purposes. Further, the court decided that access to the documents  would allow DCAA to corroborate the company’s computation of direct  and indirect costs. The court contrasted the two cases, stating that the  subpoena at issue in the first case did not extend to internal audits, which  contain the subjective assessments of Newport News’ internal audit staff.  In the second case, DCAA requested production of objective financial and  cost data and summaries, not the subjective work product of Newport  News’ internal auditors. To the extent that the materials subpoenaed  would assist DCAA in verifying and evaluating the cost claims of the  contractor, the court determined they were within DCAA’s statutory  subpoena authority.
section_title: Appendix V: GAO Contact and Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: Principal contributors to this report were Johana R. Ayers, Assistant  Director; James Ashley; Lisa M. Brownson; John W. Crawford; Gayle L.  Fischer; Laura S. Greifner; Carolyn R. Kirby; John Krump; Jean L.  McSween; Carol T. Mebane; John Needham; Matthew M. Shaffer; Robert  A. Sharpe; and Roxanna T. Sun.