Renewed Focus on Contractor Business System Reviews

Sara N. Gerber

According to a recent U.S. Government Accountability Office (“GAO”) report, the Defense Contract Audit Agency (“DCAA”) and the Defense Contract Management Agency (“DCMA”) have taken certain steps to improve the contractor business system (“CBS”) review process and are forecasting that CBS reviews will increase significantly over the next four years. Contractor business systems include a contractor’s accounting, earned value management, estimating, purchasing, material management, and property management systems. These systems require contractors to maintain internal controls that, as GAO noted, “act as the first line of defense against fraud, waste and abuse of federal funding.” Given their importance, the renewed focus on ensuring CBS reviews are conducted in a timely and consistent manner is not surprising, and contractors should prepare for a new wave of audit activity.

Past Challenges to Completing CBS Reviews

In its report, GAO identified persistent challenges that have prevented DCAA and DCMA from performing consistent and timely CBS reviews. One key factor for DCAA is its focus on eliminating the backlog of incurred cost audits, which determine whether contractor costs are allowable prior to closing out the contract. GAO found that as a result of prioritizing incurred cost audits, Contracting Officers maintained CBS determinations as adequate even though the systems had not been audited in many years. GAO further found that lacking a mechanism to track CBS audits, DCMA and DCAA did not always comply with requirements to report CBS deficiencies or did not report the deficiencies within required timeframes.

Congress took notice. In an effort to improve the CBS review process, Congress enacted certain provisions in the National Defense Authorization Acts for fiscal years 2011, 2017, and 2018. Together, these provisions:

  1. require the Department of Defense (“DoD”) to establish criteria for each system, a process for identifying deficiencies within systems, and the significant deficiencies that would result in disapproval of a system;
  2. authorize DoD to withhold up to 10 percent of payment to contractors whose systems are disapproved;
  3. define a “covered contractor” to mean those with government contracts subject to the cost accounting standards accounting for more than one percent of the contractor’s total gross revenue; and
  4. direct DoD to use qualified public accounting firms to perform incurred cost audits to eliminate the backlog by October 1, 2020.

Improvements in the CBS Review Process

As GAO reported, DoD has made progress in implementing the legislative changes enacted in the National Defense Authorization Acts. DCMA and DCAA issued revised instructions and guidance for CBS audits that clarified the procedures for conducting and reporting each system review. The revised processes divided review obligations evenly between DCMA and DCAA so that each is responsible for three systems, and assigned responsibility for making the final approval determination to the DCMA Administrative Contracting Officer (“ACO”). DCMA and DCAA further clarified that CBS reviews should generally be conducted on each system every three years, and DCMA established timeframes in which ACOs are required to make final approval determinations. DCMA reported that in fiscal year 2017, 80 percent of ACO final determination letters were issued within required timeframes.

DoD also revised the Defense Federal Acquisition Regulation Supplement (“DFARS”) to include individual clauses that define the criteria each system must meet and to implement mandatory payment withholds. DCMA and DCAA officials reported to GAO that mandatory payment withholds—of 5 percent for one or more significant deficiencies in any single business system and 10 percent for significant deficiencies in multiple business systems—have been an effective tool for motivating contractors to promptly respond to significant deficiencies. Although DoD does not retain historical data on withholds, GAO found that a snapshot of July 2018 showed that DoD was withholding payments from 11 contractors with a total value of $238 million.

Despite DoD’s progress, GAO noted that there are still issues to be addressed. For example, GAO found that the review and corrective action process can be lengthy, ranging in the reviews GAO sampled from 15 months to five years. The delays were attributable to different factors, including lack of contractor responsiveness and submission of inadequate corrective action plans, the identification of new deficiencies in follow-up reviews, and ACO departures or re-assignments. GAO also noted that DoD has not yet implemented recent legislative provisions to change the definition of a “covered contractor” or to enable the use of public accounting firms.

Contractors Should Prepare for Business Systems Audits

GAO recommended that DCMA and DCAA develop a mechanism to formally monitor CBS reviews so that they have accurate information on the number of reviews that are outstanding, the risk level assigned to systems, and the resources available to conduct reviews. This information should help DoD assess whether it is able to meet its goals to increase the number of CBS reviews in the near term and to conduct CBS reviews on a timely and consistent basis going forward.

While DoD’s goals are ambitious, contractors should be prepared for CBS audits. Business system reviews have been the subject of ongoing and recent Congressional and DoD attention, which is not likely to abate. For the Government, the reviews are an important means of managing billions of dollars in federal spending. For contractors, disapproved systems also have consequences, from precluding use of a particular contract type, to necessitating additional government oversight of subcontracts, to increasing the scope of review of individual proposals. To avoid a protracted audit, contractors should review and ensure compliance with system requirements in advance. In addition, in our experience, DoD is using payment withholds aggressively when reviews result in system disapproval. Therefore, contractors should be highly engaged and responsive if significant system deficiencies are identified and should expeditiously develop corrective action plans that adequately address those deficiencies.