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Tutorial 7: Incurred Cost Proposals and audits

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In this Tutorial, we are going to focus on Incurred Cost Proposals and Audits. This is one of the more important post-award audits. An Incurred Cost Proposal (ICP) is a report of your actual indirect expenses that you are required to submit annually when you have a Cost Reimbursable contract. Your actual incurred costs need to be submitted within six months of the end of your fiscal year. Therefore, if your fiscal year ends on December 31st, which many small businesses do, that means your incurred cost report is due on June 30th of the following year.

In this report you calculate what your actual expenses were on the contract or contracts, if you have more than one, to the government for the previous year. The government then compares these actual contract costs to those you billed using provisional billing rates from the approved provisional billing rate proposal.

Many times contractors have the belief that if their indirect rates are actually lower than what they proposed originally, that they’re making more money. That’s true for fixed-price contracts, but, that’s not the case for cost-reimbursable contracts, because the government is going to look at those actuals at the end of the year, and say, “Oh, I overpaid you, so we need to adjust that – meaning you need to pay back the government the additional money received.”

So, you need to really focus on managing your rates during the year to assure that you don’t have any of these large adjustments at the end of the year where you may have to give back money to the government. On the other hand, if your actual audited rates were higher than the approved provisional rates, the government may owe you money.

Due to the backlog of Incurred Cost audits, the DCAA is using a tiered risk approach to auditing Incurred Cost Proposals. If annual auditable costs are less than $1 million that is, all your cost-plus type contract costs are less than $1 million then you will not be selected for audit. There are exceptions to this, including government concerns if you had trouble passing an accounting system survey.

Those costs that come in over $1 million annually are put into a higher risk pool where audits are selected randomly. These risk pool tiers are always changing, and they may go away altogether. The point is everyone should be prepared to face at least one incurred cost audit.

Incurred cost audits are very rigorous, testing every operational facet of the accounting system. Documenting costs as they occur is critical, since audits may not be performed until years after the incurred cost proposal is submitted. You could very well be expected to produce verification and substantiation of every single transaction in an accounting year during the audit.

Another risk to avoid is including unallowable costs in the incurred cost calculations. These costs may incur penalties, impact the approval of your accounting system, and draw allegations of fraud from the government. In order to close out a contract, you have to have all contract years' of final costs audited by the government.

The ICP form itself can be a task to fill out. The DCAA suggests, but doesn’t require, that you use their ICP model which can be found on their website at It’s fair to say that the DCAA’s ICP model, also called the ICE model, is complex and can only be operated by those with above average Excel modeling skills. Also, in an effort to be a universal model, it’s designed to accommodate a vast array of indirect rate structures, from the most simple to the most complex. It requires a deep understanding of government contract accounting language and indirect rate design to navigate and provide an accurate result. In fact, on the DCAA ICE download page, they provide this advice: “If this is your first experience with the ICE Model, please contact your local DCAA Office to discuss the model and its requirements before preparing the proposal.”

In short, the first few sections of the ICP, called Schedules A through E, calculates your indirect rates using your accounting data as the source. Schedule H lists all your contracts, even commercial work, segregated by type – fixed price, cost-plus, and so on. Schedule H also lists your direct project costs for each project, then, using the indirect rates you calculated in Schedules A through E, calculates your total job cost including indirect rates. Schedule I focuses on only the cost-plus contract costs in Schedule H, comparing these costs to billed costs as was described earlier. Other schedules assist with reconciling accounting data to the ICP.

Another important post-award audit is an Accounting System Audit. The DCAA will review your entire accounting system to make sure it is operating as you said it would during the pre-award phase. The pre-award survey says, “This is how my accounting system is set up. This is how it’s going to operate. This is what it’s going to do.” When they come back to audit the Accounting System they will want to look at how you implemented your system. “Are you doing what you promised you said you were going to do during that pre-award survey?” Typically, they’ll want to do an audit at least once every four years. But, if there’s a red flag, or a presumed risk for whatever reason, they can put you on a shorter schedule than that.

While not typically seen on SBIR/STTR contracts, the government may audit for something called “defective pricing”. Defective pricing is shorthand for violating the Truth in Negotiations Act where contractors are required to certify that their pricing on new contracts or contract changes are “current, accurate, and complete”. Violations incur penalties in the form of reducing the negotiated amount of the contract. This defective pricing risk occurs for contracts and contract changes over $750,000 who are not otherwise exempt from providing certified cost and pricing data.

We could spend another few hours digging into the details of this subject. Some familiarity is warranted on this subject since you may be asked to sign a certificate of current cost and pricing data for SBIR/STTR Phase II contracts. For most small businesses, this will not be a concern since pricing during this phase is relatively simple and transparent and the government does a thorough job analyzing pricing data.

Contract changes occur from time to time, although rarely on SBIR/STTR contracts. Those that require a cost proposal will likely have those reviewed by the DCAA or other government agency. The same audit and review principles apply as if they were a new contract.

All the audits discussed previously require the DCAA to notify the contractor. The Labor Floor Check is the exception to that rule.

The DoD considers labor accounting the most critical element of cost accounting for the following reasons: 1) Labor is difficult to quantify. The only reliable measure of labor is by time. 2) Time keeping methods are difficult to enforce. 3) Labor accounting can be easily manipulated in the accounting records, as evidenced by a long list of violations discovered by the DCAA.

A DCAA Labor Floor Check is like a pop quiz. This audit is typically performed along with a current audit. However, the DCAA is allowed to appear unannounced. They’ll show up at the beginning of the day, or in the morning, and say, “I’m here to do a floor check.” They will ask for a list of employees and randomly select those they wish to audit. The audit consists of reviewing actual timesheets or timesheet data, if generated electronically. The subject of proper timekeeping is beyond the scope of this tutorial, but let’s just say its rules are detailed and some employees have difficulty with compliance. The DCAA will also conduct interviews, making sure employees understand the procedures.

Besides failing a pre-award accounting system survey, doing poorly on a labor floor check audit can jeopardize your standing with the government. If you don’t have a fool-proof and tamper-proof way of measuring time and distributing labor, the government’s going to get upset. Failure will expose you to a certain amount of financial risk, or the risk of allegations of fraud. They can do a number of nasty things, like withhold a certain amount of costs from billings, or they can even recommend monetary penalties. Ultimately, they can enforce the False Claims Act, having criminal penalties.

Tutorial 7
Incurred Cost Proposals and audits


(1) Which of the following staements is/are accurate?

(2) True/False? If annual auditable costs are more than $1 million annually, you are put into a higher risk pool where audits are more likely.

(3) True/False? The DCAA will want to review your entire accounting system at least once every four years.

(4) True/False? Contract changes rarely occur on SBIR/STTR contracts.

(5) True/False? The DCAA will always make an appointment with you prior to an audit.

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