United States: A Wolf In Sheep's Clothing: The Final FAR Contract Closeout Rule

On June 30, 2011 the final FAR contract closeout rule will go into effect.¹ Although the Federal Register notice accompanying the final rule states that it sets forth "procedures for closing out contract files," the real impact of the rule will be on a contractor's annual incurred cost proposal. The final rule is a significant victory for the Defense Contract Audit Agency (DCAA) insofar as it authorizes the positions DCAA has advanced for years without previously having a regulatory basis to do so.

A regulatory definition of what constitutes an "adequate" incurred cost proposal

All cost-type contracts are required to include FAR 52.216-7, "Allowable Cost and Payment." The clause sets out the process for preparing indirect cost rates and requires that contractors submit their annual incurred cost proposal within six months of the close of their fiscal year. DCAA then audits that proposal and eventually the contractor and the government reach an agreement on final indirect cost rates that are used for, among other purposes, closing out cost-type contracts.

DCAA, however, will only audit an "adequate" incurred cost proposal. Prior to the issuance of this rule, what constituted an "adequate" incurred cost proposal was not defined in the Allowable Cost and Payment Clause. The only insight into what the word "adequate" meant was provided by FAR 42.705-1(b)(1), which explained that:

Although there was no regulatory definition of what constituted an "adequate" incurred cost proposal, DCAA often held contractors to the standards articulated in the above referenced pamphlet and its Incurred Cost Electronically (ICE) Model, which is essentially the electronic version of the pamphlet. In recent years, as DCAA itself has come under increasing scrutiny from Congress and the government Accountability Office, DCAA's propensity to reject incurred cost proposals — sometimes multiple times — has only grown. Application of DCAA's "standard" often results in the rejection of contractor incurred cost proposals, which in turn necessitates expensive and time consuming efforts to either conform the proposal to what DCAA wants or persuade DCAA why its "standard" should not apply.

The final rule deletes the FAR 42.705-1(b)(1) language cited above, which had made it clear that the DCAA pamphlet and ICE Model were only guidance, and replaces it with text providing that the definition of an "adequate incurred cost proposal" is set forth in the Allowable Cost and Payment Clause. That clause was itself modified by adding a new section (d)(iii), which provides a list of 15 schedules that are taken directly from the ICE Model.² Thus, DCAA has now gained the regulatory authority that it had previously been lacking to force contractors to prepare their incurred cost proposals in a manner consistent with the ICE Model. As a result, the final rule is likely to make the rejection of incurred cost proposals even more prevalent and concomitantly make it increasingly difficult for contractors to persuade DCAA that it should accept submissions that vary from the DCAA pamphlet and ICE Model.

This is a considerable victory for DCAA and potentially a significant headache for contractors. Although the FAR will continue to contain language providing that the "required content of the proposal and supporting data will vary depending on such factors as business type, size, and accounting system capabilities," that flexibility is effectively undercut by the new definition of what is adequate.³

Broader DCAA access to records

In addition to defining the elements of an adequate incurred cost proposal, the rule also amends the Allowable Cost and Payment Clause by adding a second list of 15 categories of information that, although not required for the purposes of determining adequacy, "may be required during the audit process."⁴ Included in this supplemental data are items that DCAA has frequently requested and that contractors have frequently resisted providing on the basis of, among other reasons, relevancy grounds. For example, DCAA may now request:

• management letters from external accounting firms addressing any control weaknesses
  
• a list of the actions that have been or will be taken to correct any internal control issues identified in the management letter
  
• a list of all internal audit reports issued since the last disclosure of such reports to the government
  
• the contractor's internal audit plan
  
• federal and state income tax returns
  
• minutes from meetings of the board of directors

A secondary byproduct of DCAA's new authority to request supplemental data is that it may result in DCAA pushing contractors to create records not kept in the ordinary course of business.⁵ For example, one category of supplemental data (for contractors who do not have a CAS Disclosure Statement) is a description of their accounting system. Non-CAS covered contractors may not maintain such a description. Contract briefings are another category of supplemental data. The new Allowable Cost and Payment Clause explains what such briefings "generally" include. Although it would be unreasonable, DCAA may take the position that contract briefings must include the components specifically identified. Contractors who try to resist DCAA requests for supplemental data may now run an even greater risk of receiving a denial of access to records notice from DCAA and all of the potential sanctions that come along with the receipt of such a notice (e.g., suspension of costs).

Mandatory fee withholds

The rule revises FAR 52.216-8, "Fixed Fee;" FAR 52.216-9, "Fixed Fee-Construction;" and FAR 52.216-10, "Incentive Fee," by removing language that had given contracting officers the option of imposing fee withholds for reasons related to the submission of a certified incurred cost proposal and replacing it with mandatory withholds tied to the submission of an adequate incurred cost proposal. Coming on the heels of the recently promulgated Business Systems Rule,⁶ this change provides the government with yet another regulatory basis to withhold contractor funds.

Contract close out

Although the final rule primarily affects the submission of incurred cost proposals, it does address contract closeout. It revises FAR 42.708 in a way that is likely to reduce the instances when the contracting officer can take advantage of the "quick closeout" option. Prior to the final rule, a quick closeout was available when the amount of unsettled costs was "relatively insignificant," which was defined as less than US$1 million of indirect costs. Now relative insignificance is the lesser of US$1 million of indirect and direct costs or 10 percent of the total contract, task order, or delivery order value. In addition, before using the quick closeout procedure, the contracting officer must conduct a risk assessment that must address (a) consideration of the contractor's accounting, estimating, and purchasing systems; (b) concerns of the cognizant auditors (i.e., DCAA); and (c) "other pertinent information," which could include volatility of rate fluctuations, corporate transactions, and/or changes to the contractor's rate structure. By effectively requiring contracting officers to consult with the cognizant auditor before utilizing the quick closeout option, DCAA has achieved yet another regulatory victory.

Footnotes

1 See 76 Fed. Reg. 31,402 (May 31, 2011).
2 FAR 52.216-7(d)(2)(iii), Allowable Cost and Payment (June 2011).
3 FAR 42.705-1(b)(i).
4 FAR 52.216-7(d)(2)(iv), Allowable Cost and Payment (June 2011).
5 Putting contractors in that position would be contrary to FAR 52.215-2(d)(2), which expressly states that access to records should not be construed to require contractors to maintain or create records.
6 See 76 Fed. Reg. 28,856 (May 18, 2011).

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