Accountants’ Handbook Special Industries and Special Topics 10th Edition_11

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• 34 48 FORMAT A— FORMAT B—UNCONSOLIDATED CONSOLIDATED PRESENTATION (STANDALONE ) PRESENTATION Note C. Contingencies Note C. Contingencies In addition to the general liability and malpractice insurance No disclosures related to medical malpractice would be in- carried by the individual physicians, GoodDocs is insured with cluded in the financial statements. The discussion of the busi- respect to general liability and medical malpractice risks on a ness contained in the Form 10-K filed by GoodDocs would claims-made basis. Management is not aware of any claims probably contain a statement similar to the following: against the company. In addition, GoodDocs has not accrued a “The provision of medical services by the physician group with loss for unreported incidents or for losses in excess of insur- which GoodDocs contracts entails an inherent risk of profes- ance coverage, as the amount, if any, cannot be reasonably sional liability claims. GoodDocs does not control the practice estimated and the probability of an adverse outcome cannot be of medicine by physicians or the compliance with certain determined at this time. It is the opinion of management that regulatory and other requirements directly applicable to physi- the ultimate resolution of any unasserted claims will not have a cians and physician groups.” material adverse effect on GoodDocs’ financial position or re- sults of operations. Exhibit 34.1 Continued.
34.4 SPECIAL ACCOUNTING PROBLEMS OF SPECIFIC TYPES OF PROVIDERS 34 49 • recently consummated, a signiﬁcant management agreement generally are not required in an IPO ﬁling if the PPM does not consolidate the practice and does not guarantee any minimum practice income, extend unusual credit terms, or fund operating losses. However, if the PPM is expected to have a material dependence on the PC, separate ﬁnancial in- formation about the practice would be material to investors. For example, if the management fee from the practice is expected to generate more than 20% of the PPM’s revenues in the next 12 months, the SEC has requested audited ﬁnancial statements of the practice. However, the SEC has accepted only unaudited summary ﬁnancial information about the practice for the three most recent ﬁscal years if audited ﬁnancial statements are not readily available and its owners are not promoters of the offering being registered. Historical information about the practice for any period before its ownership by the current own- ers would not be requested unless the PPM is of the view that a change in an owner does not funda- mentally change the underlying business. If the owners of a practice generating 20% or more of the PPM’s revenues own 10% or more of the PPM at the time of its IPO or are promoters of the offering, audited ﬁnancial statements of that practice for at least its most recent ﬁscal year ordinarily would be required, unless effects of providing the management services to the practice have been included in the PPM’s audited ﬁnancial statements for at least nine months. If ﬁnancial information of a man- aged practice is presented, care should be taken to avoid the impression that an investor is obtaining an interest in the practice or that the historical results are indicative of future results under the altered incentive structure and management afﬁliates established with the PPM. Disclosure Issues. The SEC staff expects PPM registrants to clearly and accurately describe their business and contractual relationships. Financial statement disclosures should address the following: WHAT IS THE NATURE OF THE PPM’S BUSINESS? • Describe the contractual relationship among the PPM and the medical practices. Describe the PPM’s rights and limitations under the contracts. • Disclose how the PPM’s fees are determined. If the fees are based on a percentage of certain items, what are those percentages, or what is the range of the percentages? What items affect the calculation? • Even if the PPM combines the operations of the medical practice group for ﬁnancial statement purposes or has consolidated subsidiaries that provide the medical services, the PPM must clearly distinguish the services it provides from the practice of medicine. WHAT IS THE PPM’S RELATIONSHIP WITH MANAGED CARE PROVIDERS? • Disclose whether the PPM (or an assignee) enters into direct contracts with managed care companies or whether the physician groups contract directly with the managed care compa- nies. • Identify the party who assumes the risk under managed care contracts (i.e., the PPM or the physician group). If the PPM assumes the contracts, are there any issues relating to medical li- censing? • Who assumes the risk associated with capitated payment contracts? If the PPM assumes the risk, does this subject it to regulation as an insurance company? IS THE PPM SUBJECT TO ANY STATE OR FEDERAL REGULATIONS? • Describe any state prohibitions on the corporate practice of medicine, and discuss the impact upon the PPM. • Is the PPM subject to regulation as an insurer? • What is the effect of federal antikickback and self-referral restrictions?
34 50 PROVIDERS OF HEALTH CARE SERVICES • 34.5 FINANCIAL REPORTING PRACTICES (a) USERS OF FINANCIAL STATEMENTS. The primary users of health care companies’ general purpose ﬁnancial statements are providers of capital who make rating and investment decisions in competitive capital markets (including investors in tax-exempt debt securities); suppliers of goods and services to the industry with whom health care companies maintain credit relationships; stock- holders and other owners; the Securities and Exchange Commission; and regulators such as state De- partments of Insurance and other oversight groups. (b) BASIC FINANCIAL STATEMENTS. Investor-owned and not-for-proﬁt health care pro- viders generally prepare four ﬁnancial statements: 1. Balance sheet 2. Income statement/statement of operations 3. Statement of changes in stockholders’ equity/statement of changes in net assets 4. Statement of cash ﬂows Not-for-proﬁt health care entities are required to follow the ﬁnancial reporting requirements con- tained in FAS No. 117, Financial Statements of Not-for-Proﬁt Organizations, as modiﬁed by certain requirements contained in Health Care Organizations. Generally speaking, FAS No. 117 provides broad standards of ﬁnancial reporting with which all not-for-proﬁt organizations (including not-for- proﬁt health care organizations) must comply. However, the FASB permitted the AICPA to provide industry-speciﬁc implementing guidance for FAS No. 117 through its audit and accounting guides. Although technically the guidance in Health Care Organizations stands lower in the GAAP hierar- chy than does the FASB guidance, the FASB expects not-for-proﬁt health care organizations to apply the requirements of FAS No. 117 in the manner speciﬁed by the Audit Guide. Generally speaking, those modiﬁcations are intended to keep the ﬁnancial statements of not-for-proﬁt providers compa- rable to those of investor-owned providers. Governmental health care entities are required to follow the ﬁnancial reporting require- ments prescribed by GASB No. 34, “Basic Financial Statements—and Management’s Discus- sion and Analysis—for State and Local Governments.” (GASB No. 34’s phased-in effective date is discussed at Section 32.11.) For purposes of applying GASB No. 34, the governmental health care organizations included within the scope of the AICPA audit and accounting guide Health Care Organizations are considered “special purpose governments engagement in business-type activities.” Those entities should present ﬁnancial statements required for enterprise funds, which consist of: • Management’s Discussion and Analysis (as RSI) • Statement of net assets (balance sheet) • Statement of revenues, expenses, and changes in net assets • Statement of cash ﬂows • Notes to ﬁnancial statements • RSI other than MD&A (if applicable) Although GASB No. 34 establishes eight required elements of MD&A, many of those ele- ments are not applicable to governmental health care entities. Consequently, MD&A discussion should be limited to only the elements that are applicable. Health Care Organizations provides illustrative ﬁnancial statements for investor-owned, tax- exempt, and governmental health care organizations. Those statements illustrate the application of the reporting practices contained in the Guide. Speciﬁc types of health care organizations are presented, but only to illustrate a wide diversity of reporting practices. It is not intended that these illustrations represent either the only types of disclosure nor the only statement formats that would be appropriate. More or less detail should appear in the ﬁnancial statements or notes, de- pending on the circumstances.
34.5 FINANCIAL REPORTING PRACTICES 34 51 • (c) BALANCE SHEET. All health care organizations must prepare classiﬁed balance sheets which segregate assets and liabilities between current and noncurrent categories.22 Special considerations related to balance sheet reporting of not-for-proﬁt and governmental providers are discussed below. (i) Not-for-Proﬁt Providers. Restricted assets and liabilities should not be carved out and pre- sented separately in the balance sheet. Because donor restrictions generally relate to limitations on the use of net assets rather than speciﬁc assets (i.e., the provider normally is not required to physi- cally maintain restricted resources separately from unrestricted resources), “cash is cash” regardless of whether it was received as a speciﬁc-purpose gift or generated through operations. As a result, the provider’s obligation to use unexpended donor-restricted contributions in accordance with the donor’s wishes is reﬂected by structuring the equity section of the balance sheet into three broad classes: unrestricted net assets, temporarily restricted net assets, and permanently restricted net as- sets. If the amount of unexpended donor-restricted contributions is material, the nature of restrictions should be disclosed in the notes to the ﬁnancial statements. The accounting and reporting require- ments for donor-restricted contributions is discussed at Subsection 34.3. Limitations on the use of assets arising from sources other than donor restrictions are high- lighted by using the balance sheet caption “assets whose use is limited.” These are discussed at Subsection 34.3(b)(i). (ii) Governmental Providers. A governmental provider’s balance sheet may be prepared using either the traditional balance sheet format or a net assets format (assets less liabilities equal net as- sets). The equity section of the balance sheet is structured into three broad classes of net assets: un- restricted; invested in capital assets, net of related debt (i.e., capital assets reduced by accumulated depreciation and by any outstanding debt incurred to acquire, construct or improve those assets); and restricted (differentiated between expendable and nonexpendable). The provider’s obligations to use certain resources for speciﬁc purposes is reﬂected in the balance sheet by (1) presenting those assets separately and (2) reporting any difference between those assets and their related liabilities as “re- stricted net assets.” The word “restricted” is not required to be used in labeling the assets themselves; however, the descriptions used on the face of the balance sheet should make it clear that such assets cannot be used to satisfy the organization’s current liabilities (other than any current liabilities that are intended to be satisﬁed with the restricted assets). Under GASB No. 34, assets are reported as re- stricted when limitations on their use is externally imposed (e.g., by creditors, grantors, contributors, or the laws or regulations of other governments). Restricted assets should be presented separately in the balance sheet. Internally imposed limitations (such as speciﬁc-purpose designations imposed management or the board) are included in unrestricted net assets. (d) OPERATING STATEMENT. Appendix A of the Guide provides illustrative income state- ments for investor-owned, not-for-proﬁt, and governmental health care organizations. These statements are not intended to establish standards but merely to illustrate the reporting conven- tions discussed in the Guide. Although income statement reporting requirements differ signiﬁ- cantly based on whether a provider is investor owned, not-for-proﬁt, or governmental, all allow ﬂexibility in the amount of detail that is provided. Some providers choose to present a great deal of detail; others present statements that are highly condensed with details, if any, provided in the notes. The Guide allows each provider to determine the level of detail that provides the most meaningful disclosure within the broad parameters established by GAAP. 22 For not-for-proﬁt providers, this is a modiﬁcation of the guidance provided in FAS No. 117, which requires in- formation about liquidity of assets and liabilities be provided in “some fashion” (e.g., by sequential ranking) within the balance sheet.
34 52 PROVIDERS OF HEALTH CARE SERVICES • Signiﬁcant differences exist in the presentation of extraordinary items, discontinued operations, and cumulative effect of changes in accounting principles depending on whether a provider is investor owned, not-for-proﬁt, or governmental, as follows. Presentation of Type of Provider Extraordinary Items Discontinued Operations Cumulative Effect Investor-owned Just before net income Just before net income Just before net income Not-for-proﬁt Just before change in Just before change in Just before change in unrestricted net assets, unrestricted net assets, unrestricted net assets, with subtotal with subtotal with subtotal Governmental Below nonoperating revenue See discussion Adjustment of beginning fund balance GASB No. 34 is silent on how discontinued operations should be reported. Based on informal dis- cussions with GASB staff, the author believes that reporting of discontinued operations would be part of the detail required by GASB No. 34 for the “Operating revenue” and “Operating expense” sections of the statement of changes in revenues, expenses, and changes in net assets, because both continuing and discontinued operations are part of a health care organizations operating activity. The “Operating rev- enues” section would contain one or more lines identiﬁed as “revenue from discontinued operations,” with a similar presentation of “expenses from discontinued operations” provided in the “Operating ex- penses” section. Any gain or loss on disposal of an operation would be reﬂected as nonoperating revenue or expense (similar to the treatment of other types of gains/losses under GASB No. 34). (i) Requirements for Investor-Owned Providers. The income statement reporting requirements for investor-owned health care providers are similar to those for other types of investor-owned ser- vice providers. Providers that are SEC registrants sometimes will receive comment letters from the SEC requesting that their income statements display operating expenses at a level of detail “consis- tent with the AICPA audit guide for health care providers.” As stated previously, the sample ﬁnancial statements included in the Guide are illustrative and are not intended to establish a practice that would require a certain level of disclosure. (ii) Requirements for Not-for-Proﬁt Providers. The income statement requirements for not-for- proﬁt health care entities were established by FAS No. 117, as modiﬁed by certain requirements con- tained in Health Care Organizations. Those modiﬁcations are as follows: Modiﬁcation provided in FAS No. 117 Requirement Health Care Organizations Presentation of a “statement of activity” that Subdivides “statement of activity” into two combines the information traditionally required statements: a “statement of operations” presented in an income statement with the (i.e., income statement) and a “statement of information traditionally reported in the changes in net assets.” statement of changes in net assets. Reporting of results of operations (i.e., net Must provide “performance indicator” subtotal23 within the statement of operations. income) is permitted but not required. Such contributions should be reported below Contributions of property, plant, and equipment the “performance indicator” (i.e., excluded from (or of funds expended to purchase such assets) net income) in the statement of operations. are reported as increases in unrestricted net assets in the statement of activities. 23 The FASB has objected to use of the term “net income” to refer to the results of operations of not-for-proﬁt health care organizations. Therefore, Health Care Organizations uses the generic term “performance indicator” to describe the operating measure.
34.5 FINANCIAL REPORTING PRACTICES 34 53 • Other requirements imposed on not-for-proﬁt providers that differ from those of investor-owned and governmental providers are as follows: • Net assets released from restrictions (except those related to long-lived assets) are included in net income. • All expenses must be reported in the “unrestricted net assets” classiﬁcation. No expenses may be reported in the statement of changes in net assets for the temporarily or permanently re- stricted classiﬁcations. • FAS No. 117 requires reporting of expenses by functional categories such as “program,” “management,” and “fund raising.” Administrative allocations to the functional categories should be based on full cost allocations. Normally, providers report expenses classiﬁed along revenue/cost center lines (e.g., nursing services, other professional services, general services) or “natural” lines (e.g., salaries and wages, employee beneﬁts, supplies, purchased services). Health Care Organizations emphasizes the ﬂexibility allowed in FAS No. 117, which allows reporting the functional information in the notes to the ﬁnancial statements. Similarly, ﬂexi- bility is allowed in the degree to which details are presented with regard to functional infor- mation. Some providers may choose to present only two categories: “health services” and “general and administrative”; others may desire to report more detailed information. • APB No. 30 items must be reported below the performance indicator (see Subsection 34.5(d)(iv). The health care Guide does not require not-for-proﬁt providers to distinguish between operating and nonoperating activities. If an “income from operations” subtotal is presented and its use is not apparent from the details provided on the face of the statement, note disclosure should be made re- garding the nature of the measure or the types of items excluded from that measure. In June 2002, AcSEC issued an exposure draft of a proposed Statement of Position, “Accounting for Derivative Instruments and Hedging Activities by Not-for-Proﬁt Health Care Organizations, and Clariﬁ- cation of the Performance Indicator.” The proposed standard would amend the AICPA audit and ac- counting guide Health Care Organizations to clarify that the performance indicator reported by not-for-proﬁt health care organizations is analogous to income from continuing operations of a for-proﬁt enterprise. (The analogy is made to a for-proﬁt enterprise’s income from continuing operations, rather than net income, because FAS No. 117 requires “APB No. 30” type items—extraordinary items, cumu- lative effect of accounting changes, and discontinued operations—to be reported separately from mea- sures of operations such as the performance indicator. In order for the performance indicator to be comparable to net income, APB No. 30 items would need to be included within the performance indica- tor. See Subsection 34.5(d)(iv) for information on reporting APB No. 30 items.) This clariﬁcation also provides not-for-proﬁt providers with a clearer concept of “other comprehensive income” reporting. (Not-for-proﬁt organizations were excluded from the scope of FAS No. 130, “Reporting Comprehensive Income,” because FAS No. 117 already required them to display the equivalent of total comprehensive income in the Statement of Activities.) Gains and losses that FASB pronouncements classify as elements of other comprehensive income should be excluded from the performance indicator. (iii) Requirements for Governmental Providers. The operating statement prepared by govern- mental health care organizations is the “Statement of revenues, expenses, and changes in net assets.” The focus of this statement is “all-inclusive”—that is, it presents all changes in net assets, not just those that affect net income. Therefore, it contains all transactions that would be reported in an in- come statement plus a statement of changes in net assets, including changes in restricted resources. The statement must be prepared using a speciﬁcally sequenced format that distinguishes op- erating and nonoperating revenues and expenses, and provides an intermediate total for operat- ing income or loss. The prescribed sequence is as follows: • Operating revenues (detailed) • Total operating revenues (required subtotal)
34 54 PROVIDERS OF HEALTH CARE SERVICES • • Operating expenses (detailed) • Total operating expenses (required subtotal) • Operating income/loss (required subtotal) • Nonoperating revenues/expenses (detailed) • Income before other revenues, expenses, gains, losses, and transfers • Capital contributions • Additions to term and permanent endowments • “Special items” • Extraordinary items • Transfers • Increase (decrease) in net assets • Net assets—beginning of period • Net assets—end of period Because the focus of this statement is on the change in total net assets, rather than changes in classes of net assets, no reclassiﬁcations from restricted to unrestricted funds are reported when when restrictions are released. The use of restricted funds and expiration of time restrictions are ﬁnancial statement “nonevents” under GASB No. 34. Balance sheet reclassiﬁcations from “re- stricted” to “unrestricted” and vice versa are not reported anywhere in a governmental entity’s ﬁnancial statements. Revenues should be reported by major source, and entities are required to separately identify rev- enues that provide security for revenue bonds. GASB No. 34 links the determination of operating/nonoperating classiﬁcation to the classiﬁcation of transactions in the statement of cash ﬂows under GASB No. 9. Transactions related to cash ﬂows that are classiﬁed as noncapital ﬁnanc- ing, capital ﬁnancing, or investing in the statement of cash ﬂows typically are not classiﬁed as “op- erating” in the statement of revenues, expenses, and changes in net assets. Examples of items that are required to be classiﬁed as nonoperating using this approach are contributions received (ﬁnancing activity), interest expense (ﬁnancing activity), and interest income (investing activity). Under the all- inclusive format, restricted contributions (other than capital contributions) and restricted investment income are included in nonoperating revenues together with unrestricted contributions and unre- stricted investment income). Each organization must establish a policy that deﬁnes operating rev- enues and expenses based on the above parameters and disclose that policy in the notes to the ﬁnancial statements. GASB No. 34 established a new category of transaction called “special items.” A special item is a signiﬁcant transaction or other event that is within the control of management and that meets one (but not both) of the APB No. 30 criteria for classiﬁcation as an extraordinary item. Similar transac- tions that are beyond the control of management are not special items. Special items should be re- ported separately below nonoperating revenues (expenses). Although governmental health care entities generally are required to apply all FASB pro- nouncements that apply to for-proﬁt enterprises, the all-inclusive reporting format required by GASB No. 34 conﬂicts with FASB Statement No. 130, “Reporting Comprehensive Income.” Therefore, governmental entities do not have a concept of “other comprehensive income.” Gains and losses that FASB pronouncements classify as elements of other comprehensive income should be reported no differently from other gains and losses in the statement of revenues, ex- penses, and changes in net assets. (e) STATEMENT OF CHANGES IN NET ASSETS/EQUITY. A Statement of Changes in Net As- sets/Equity should report all changes that have occurred during the reporting period in all equity, net asset, and fund balance accounts maintained by a not-for-proﬁt provider. Governmental providers
34.5 FINANCIAL REPORTING PRACTICES 34 55 • do not prepare this statement, due to the “all-inclusive” nature of their operating statement as discussed at Subsection 34.5(d)(iii). (f) STATEMENT OF CASH FLOWS. Standards for cash ﬂow reporting differ among investor- owned, not-for-proﬁt, and governmental health care entities, as follows: Source(s) of “Cash Flows from Type of Provider Authoritative Guidance Operations” Reconciles To Investor-owned FAS No. 95 Net income Not-for-proﬁt FAS No. 117/FAS No. 95 Change in net assets Governmental GAS No. 9 Income/loss from operations (i) Considerations for Not-for-Proﬁt Providers. Unique considerations for not-for-proﬁt providers include the following: • Because FAS No. 117 reconciles cash ﬂows from operations to change in total net assets, the reconciliation will have to accommodate certain equity items that are not dealt with in cash ﬂow statements prepared for investor-owned companies. These items include equity trans- fers, contributions of long-lived assets, unrealized gains and losses on certain investments, investment returns restricted by donor or law, and restricted contributions. • Unrealized gains and losses on investment other than trading securities and contributions of long-lived assets will need to be adjusted out as noncash items. • Equity transfers, restricted investment income, and restricted contributions (including contri- butions restricted for purchase of long-lived assets) will need to be “transferred” to the ﬁnanc- ing category by adjusting them out of operating cash ﬂows and increasing (or decreasing, as appropriate) the ﬁnancing category by that same amount. • Purchases, sales, and maturities of trading securities should be classiﬁed as cash ﬂows from op- erating activities; cash ﬂows from purchases, sales, and maturities of other than trading securi- ties should be classiﬁed as cash ﬂows from investing activities. • Cash and cash equivalents reported as “assets whose use is limited” should be excluded from “cash and cash equivalents” reported in the cash ﬂow statement. (ii) Considerations for Governmental Providers. Governmental providers follow the guidance in GASB Statement No. 9, Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds and Governmental Entities That Use Proprietary Fund Accounting, in preparing their statement of cash ﬂows. That statement’s requirements differ from those of FASB Statement Nos. 95 and 117 in the following ways: • The direct method of presenting operating cash ﬂows must be used, with a reconciliation pro- vided of operating cash ﬂows to operating income (loss). • The GASB cash ﬂow statement has four categories: operating, investing, capital ﬁnancing, and noncapital ﬁnancing. The capital ﬁnancing category is used for acquiring and disposing of cap- ital assets, borrowing money for acquiring capital assets, and repaying the amounts borrowed. All other ﬁnancing is classiﬁed as noncapital. • Some items are classiﬁed differently by the GASB than they are by the FASB. For example, ﬁxed assets are classiﬁed as capital ﬁnancing activities under GASB Statement No. 9, but are considered to be investing activities under FASB Statement No. 95. • GAS No. 9, par. 8 provides that a statement of cash ﬂows should explain the change in all cash and cash equivalents, regardless of any restrictions on their use. • The total amount of cash and cash equivalents should be easily traceable to similarly titled line items. If it is not, a reconciliation should be provided.
34 56 PROVIDERS OF HEALTH CARE SERVICES • 34.6 STATUTORY/REGULATORY REPORTING ISSUES (a) STATUTORY FINANCIAL STATEMENTS. Increasingly, HMOs and provider-sponsored net- works are coming under regulation by state departments of insurance. Generally speaking, regulated insurers are required by their state of domicile to submit annually a set of audited ﬁnancial state- ments that are prepared using that state’s prescribed regulatory accounting principles (“statutory ﬁ- nancial statements”). In 1999, the NAIC completed a process to codify statutory accounting practices (SAP) for managed care organizations, resulting in a revised Accounting Practices and Procedures Man- ual. Nine of the Statements of Statutory Accounting Principles (SSAPs) included in the Manual have been speciﬁcally modiﬁed or written to address issues related to managed care. These in- clude SSAP No. 25, “Accounting for and Disclosures about Transactions with Afﬁliates and Other Related Parties,” No. 35, “Guaranty Fund and Other Assessments,” No. 47, “Uninsured Plans,” No. 50, “Classiﬁcations and Deﬁnitions of Insurance or Managed Care Contracts in Force,” No. 54, “Individual and Group Accident and Health Contracts,” No. 55, “Unpaid Claims, Losses and Loss Adjustment Expenses,” No. 66, “Retrospectively Rated Insurance Contracts,” No. 73, “Health Care Delivery Assets—Supplies, Pharmaceuticals and Surgical Supplies, Durable Medical Equipment, Furniture, Medical Equipment and Fixtures, and Lease- hold Improvements in Health Care Facilities,” and No. 84, “Health Care Receivables.” All other SSAPs should be considered that are applicable to the particular managed care entity. The Manual is updated annually to reﬂect revisions or additions to SAP. It is expected that most states will require insurers to comply with most, if not all, provisions of the Manual. States may adopt the Manual in whole, or in part, as an element of prescribed SAP in those states. If, however, the requirements of state laws, regulations, and administrative rules differ from guid- ance provided in the Manual, those state laws, regulations, and administrative rules preempt the guidance in the Manual. (b) RISK-BASED CAPITAL FOR MANAGED CARE ORGANIZATIONS. State laws generally require insurers to maintain minimum levels of capital or surplus. The NAIC has implemented a “risk-based capital” (RBC) formula for managed care organizations under which affected managed care organizations must calculate and report to regulators its capital requirement and total adjusted capital. There are ﬁve principal elements to the RBC formula: afﬁliated investment risk, asset risk, underwriting risk, credit risk, and general business risk. Four action levels (in order of increasingly stringent level of regulatory response) are: company action level, regulatory action level, authorized control level, and mandatory control level. At a minimum, the company action-level event requires the ﬁling of an RBC plan that details conditions leading to the event and proposals of corrective ac- tion with the state insurance commissioner. (c) OMB CIRCULAR A-133. Health care organizations that receive ﬁnancial assistance from a governmental agency may be subject to audit requirements in accordance with the Single Audit Act of 1996 and Ofﬁce of Management and Budget (OMB) Circular A-133, Audits of Institutions of Higher Education and Other Nonproﬁt Organizations. Financial assistance may take the form of grants, contracts, loans, loan guarantees, property, cooperative agreements, interest subsidies, and in- surance or direct appropriations. 34.7 SOURCES AND SUGGESTED REFERENCES American Institute of Certiﬁed Public Accountants, “Health Care Organizations,” Industry Audit and Accounting Guide. New York, 1996. , “Checklists and Illustrative Financial Statements for Health Care Organizations,” 1996.
34.7 SOURCES AND SUGGESTED REFERENCES 34 57 • , “Providers of Health Care Services (Section 6400).” Technical Practice Aids, 1997. Healthcare Financial Management Association, (P&P Board Statements and Issue Analyses are available from HFMA at 1-800-252-4362, ext. 420.) “Accounting and Reporting for Agency Relationships,” Principles and Practices Board Statement No. 5. Westchester, IL, 1983. , “Accounting and Reporting by Institutional Health Care Providers for Risk Contracts,” Principles and Practices Board Statement No. 11, 1989. , “Valuation and Financial Statement Presentation of Charity Service and Bad Debts by Institutional Health Care Providers.” Principles and Practices Board Statement No. 15, 1993. , “Classifying, Valuing, and Analyzing Accounts Receivable Related to Patient Services.” Principles and Practices Board Statement No. 16, 1993. , “Assessments and Arrangements Similar to Taxes on Tax-Exempt Institutional Health Care Providers,” Principles and Practices Board Statement No. 17, 1994. , “Public Disclosure of Financial and Operating Information by Health Care Providers,” Principles and Practices Board Statement No. 18, 1994. , “Transactions Among Afﬁliated Entities Comprising an Integrated Delivery System,” Principles and Practices Board Statement No. 19, 1995. , “Healthcare Mergers, Acquisitions, and Collaborations,” Principles and Practices Board Statement No. 20, 1997. , “Acquisitions of Physician Practices,” Principles and Practices Board Issue Analysis No. 95-1, 1995. , “Assessing Managed Care Contracting Risk,” Principles and Practices Board Issue Analysis No. 97- 1, 1997. Financial Accounting Standards Board, “Application of FASB Statement No. 94, Consolidation of All Majority- Owned Subsidiaries, and APB Opinion No. 16, Business Combinations, to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements,” EITF Issue No. 97-2. Nor- walk, CT, 1997. , “Accounting for Contributions Received and Contributions Made,” Statement of Financial Accounting Standards No. 116, 1993. , “Financial Statements of Not-for-Proﬁt Organizations,” Statement of Financial Accounting Standards No. 117, 1993. , “Accounting for Certain Investments Held by Not-for-Proﬁt Organizations,” Statement of Financial Ac- counting Standards No. 124, 1995.
35 CHAPTER ACCOUNTING FOR GOVERNMENT CONTRACTS Margaret M. Worthington, CPA 35.1 UNIQUE ACCOUNTING 35.3 SPECIFIC ACCOUNTING REQUIREMENTS FOR FEDERAL REQUIREMENTS 10 CONTRACTORS 1 (a) Effects on Contractors 10 (b) Cost Principles 10 (i) Advance Agreements on 35.2 MANAGEMENT INFORMATION Particular Cost Items SYSTEM REQUIREMENTS 2 (FAR 31.109) 11 (a) Cost Accounting Systems 2 (ii) Composition of Total (b) Cost Estimating Systems 4 Allowable Costs 12 (c) Material Management and (iii) Factors Affecting Accounting Systems 5 Allowability (FAR 31.201) 12 (d) Project Management (c) Cost Accounting Standards 13 Systems 7 (i) Contract Coverage 15 (e) Billing Systems 8 (ii) Price Adjustments 17 (i) Cost-Reimbursement (iii) Disclosure Statements 18 Contracts 8 (iv) The Standards 20 (ii) Fixed-Price Contracts 9 (d) Contract Changes and (f) Record-Retention Terminations 26 Requirements 9 (i) Contract Changes 26 (ii) Contract Terminations 27 35.1 UNIQUE ACCOUNTING REQUIREMENTS FOR FEDERAL CONTRACTORS The federal government operates within a formalized statutory and regulatory framework when it acquires products and services. That process was signiﬁcantly streamlined and simpliﬁed in the 1990s for acquisitions of commercial products and services or awards that are competed among qualiﬁed suppliers. For contracts awarded in these circumstances, negotiations are based on prices submitted by offerors in response to government solicitation notices. However, when products or services are custom made and/or awards are not competed, the estimated or actual cost of performance becomes a dominant factor in setting prices. Consequently, systems used by federal contractors in this latter environment must not only maintain information that is necessary to effectively price contracts and control contract incurred costs but also must com- ply with special cost estimating, cost accounting, billing and project management requirements. 35 1 •
35 2 ACCOUNTING FOR GOVERNMENT CONTRACTS • This chapter is designed to provide a practical discussion of those unique federal contracting re- quirements, which include: • Cost Principles. Federal cost principles contained in Part 31 of the Federal Acquisition Regula- tion (FAR) provide speciﬁc criteria as to the costs that may be included in contract proposals, claims and billings submitted to the government. • Cost Accounting Standards. Nineteen cost accounting standards (CAS) and disclosure state- ment ﬁling requirements address disclosure of cost accounting practices and measurement and assignment and allocation of costs. • Defective Pricing. The Truth in Negotiations Act is designed to ensure that the government has the opportunity to review all signiﬁcant and relevant cost or pricing data available to the con- tractor when contract prices are being negotiated on the basis of estimated costs of perfor- mance. If, after the negotiation, it is determined that current, complete, and accurate data were not submitted, the contract price is subject to downward adjustment for any price increase re- sulting from the failure to disclose the relevant data. 35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS To compete effectively in any market, management must have the information necessary to plan and control its business. In the complex federal acquisition environment, companies must have systems and controls that provide adequate accounting, estimating, and project management in- formation. The planning phase begins when a contract proposal is prepared. During that process, contract performance is broken down into meaningful work packages with cost esti- mates, performance schedules, and performance responsibility assigned to appropriate cost cen- ters. When the contract is awarded, such data should be used to establish the performance and cost baseline for monitoring actual performance. During performance, comparisons of actual and budgeted costs and schedule permit a contractor to take prompt corrective action as unfa- vorable variances occur. (a) COST ACCOUNTING SYSTEMS. Most negotiated federal contracts contain the FAR 52.215-2 clause, “Audit and Records—Negotiation,” which provides that “the Contractor shall maintain . . . records and other evidence sufﬁcient to reﬂect properly all costs claimed to have been incurred or anticipated to be incurred directly or indirectly in performance of this contract.” Con- tractors performing contracts for which cost or pricing data were submitted before contract award must have cost accounting systems that comply with FAR (and perhaps CAS) requirements. Allow- able costs form the basis for requests for reimbursement of costs incurred under cost-reimbursement contract billings and ﬁxed-price contract progress payments. For ﬁrm-ﬁxed-price contracts requiring submission of cost or pricing data prior to contract award, an adequate cost accounting system is re- quired even though costs incurred on the contract do not affect the remuneration ultimately paid to the contractor upon contract completion. Rather, the cost accounting system is critical for providing data for follow-on contract cost pricing, providing a basis for tracking contract performance and sup- porting cost-based progress payment requests. To price follow-on contracts, information on the rate of improvement in performing repetitive tasks on subsequent production (i.e., learning curves) is im- portant. Well-designed cost accounting systems can enable estimators to identify the costs or hours incurred on prior contracts or production lots. The ability to segregate nonrecurring costs from re- curring costs is also critical for follow-on pricing. Clearly, the design of the accounting system is all- important in providing valuable input for the estimating or planning process for contract costs. The regulations do not specify that the contractor maintain any speciﬁc type of accounting system. Rather, FAR 31.201-1 states that “any generally accepted method of determining or es- timating costs that is equitable and is consistently applied may be used, including standard costs properly adjusted for applicable variances.” Cost ledgers can be designed in a variety of
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35 3 • ways to permit efﬁcient accumulation of costs for billing purposes. In practice, these records vary considerably, based on the individual company’s need for information and the complexity of the contract requirements. A key requirement is the existence of adequate audit trails. An ac- counting system provides satisfactory audit trails if: (1) every transaction is traceable from its origin to its ﬁnal posting in the books of account; (2) every posting to accounts is susceptible to breakdown into identiﬁable transactions; and (3) adequate documentation (e.g., time cards or vendors’ invoices) is available and accessible to support the accuracy and validity of indi- vidual transactions. In a job-order costing system, costs are collected using a work-order process. Contractors, particularly in a production environment, are not required by the regulations to account for costs by contract (e.g., maintain a job-order cost accounting system). A cost accounting system in a production environment is generally driven by the contractor’s products and/or production processes. The cost accounting system should be deemed adequate if production costs are ap- propriately, equitably, and consistently allocated to all ﬁnal cost objectives. The obvious neces- sity is to capture and accumulate costs in a manner that reﬂects the cost of performance in individual government contracts. To do this, certain costs that can be identiﬁed speciﬁcally with contracts and/or products are treated as direct costs and are charged in that manner. Typically, direct costs include material, subcontracts, and labor, but they are by no means limited to these. FAR 31.201-4 requires that costs charged directly to contracts be allocated “on a basis of the relative beneﬁts received or other equitable relationship.” Indirect costs, or other costs that beneﬁt more than one contract, must be pooled and allo- cated to contracts on some equitable basis. According to FAR 31.203(b), the general criteria for establishing indirect cost pools are: Indirect costs shall be accumulated by logical cost groupings with due consideration of the reasons for incurring such costs. Each grouping should be determined so as to permit the distribution of the grouping on the basis of the beneﬁts accruing to the several cost objectives. Commonly, manufac- turing overhead, selling expenses, and general and administrative (G&A) expenses are separately grouped. Similarly, the particular case may require subdivision of these groupings, e.g., building occupancy costs might be separable from those of personnel administration within the manufactur- ing overhead group. . . . When substantially the same results can be achieved through less precise methods, the number and composition of cost groupings should be governed by practical consider- ations and should not unduly complicate the allocation. FAR 31.203(b) and (c) similarly provide ﬂexibility in determining what allocation base to use in distributing costs from the indirect cost pools to contracts: This necessitates selecting a distribution base common to all cost objectives to which the grouping is to be allocated. The base should be selected so as to permit allocation of the grouping on the basis of the beneﬁts accruing to the several cost objectives. . . . Once an appropriate base for distributing indirect costs has been accepted, it shall not be frag- mented by the removal of individual elements. All items properly includable in an indirect cost base should bear a pro-rata share of indirect costs irrespective of their acceptance as Government con- tract costs. For example, when a cost input base is used for the distribution of general and adminis- trative (G&A) costs, all items that would properly be part of the cost input base, whether allowable or unallowable, shall be included in the base and bear their pro-rata share of G&A costs. Accounting for indirect costs presents a challenge to those uninitiated in government contracting. The government has promulgated speciﬁc rules in FAR Part 31 and CAS governing the allocability of indirect costs. However, these rules still permit considerable ﬂexibility in the number and types of pools that can be selected and the methods used for allocating indirect costs. The allocation of indirect costs in a highly automated environment presents an even greater challenge, since typical overhead allocation bases, such as direct labor, may represent only a minor component of total factory costs. In this environment, the need for multiple cost pools al-
35 4 ACCOUNTING FOR GOVERNMENT CONTRACTS • located over nonlabor bases, such as machine usage, may be required. This requirement is evi- dent in activity-based costing or advanced cost management systems that have been imple- mented by some government contractors. In an automated environment, requirements for audit trails still exist; however, additional controls over input to the system and program logic are es- sential to validate the accuracy of such systems. For cost-reimbursement, time-and-material, and ﬁxed-price incentive contracts, accurate labor charging by contract is imperative. To make sure of the reliability of recorded labor hours and costs, a contractor must have an adequate internal control system for collecting and distrib- uting labor costs. Accurate labor charging also encompasses accounting for all hours worked. If salaried employees work a signiﬁcant number of hours in excess of 40 hours per week, a risk of labor mischarging to the government may be asserted if all hours worked are not accounted for. Although no speciﬁc regulatory provisions mandate the use of total time accounting, govern- ment auditors have long asserted that accounting for all hours worked is a basic requirement of FAR 31.201-4 and CAS 418, which provide that costs should be charged to contracts on the basis of relative beneﬁts received. Proposals for professional or technical services that are ac- quired on the basis of the number of hours to be provided must identify both uncompensated hours and the uncompensated overtime rate (described in FAR 52.237-10) for direct charge ex- empt personnel included in the proposal. The accounting practices used to estimate uncompen- sated overtime must be consistent with the cost accounting practices used to accumulate and report uncompensated overtime hours. (b) COST ESTIMATING SYSTEMS. Pursuant to the requirements of FAR Subpart 15.4, cost or pricing data generally must be submitted prior to award of a contract of $550,000 or more unless: • The prices agreed upon are based on adequate price competition. • The prices agreed upon are based on prices set by law or regulation. • Commercial item are being acquired or a contract for commercial items is being modiﬁed. • A waiver has been granted. In estimating the costs to be incurred on government contracts, contractors’ cost estimating systems must incorporate large amounts of data generated from a myriad of sources and departments. These data often include historical data, vendor quotations, projections based on changes in production methods, changes in technology, volume changes, management decisions, and estimates of future costs. FAR 15.407-5 addresses the beneﬁts to both the government and the contractor of using an ac- ceptable estimating system for proposal preparation. The Department of Defense (DOD) FAR Sup- plement (DFARS), 215-407-5-70(d), applicable to defense contracts and subcontracts, outlines the following characteristics of an acceptable estimating system: • Clear responsibilities for preparation, review, and approval of cost estimates • Written description of the organization and duties of personnel responsible for preparing, re- viewing, and approving cost estimates • Sufﬁcient personnel training, experience, and guidance to perform estimating tasks in accor- dance with established procedures • Identiﬁcation of the sources of data, estimating methods, and rationale used in developing cost estimates • Appropriate supervision throughout the estimating process • Consistent application of estimating techniques • Detection and timely correction of errors • Protection against cost duplication and omissions • Use of historical experience, where appropriate
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35 5 • • Use of appropriate analytical methods • Integration of information available from other management systems, where appropriate • Management review, including review of company estimating policies, procedures, and practices • Internal review of and accountability for the acceptability of the estimating system, including comparisons of projected and actual results and analyses of variances • Procedures for timely updates of cost estimates throughout the negotiation process • Responsibility for review and analysis of the reasonableness of subcontractor prices The accuracy of the contractor’s cost estimating system is critical, since estimating mistakes can only harm the contractor. If the estimate understates costs, the contractor may end up with a loss on the contract. If the proposed costs are overstated, the company may be vulnerable to a downward price adjustment as a result of defective pricing. Cost proposals must be compatible with the cost accounting system that will be use to mea- sure and accumulate costs during contract performance. To comply with government require- ments for most contracts, the cost accounting system must be able to produce information on the speciﬁc cost elements and in the same detail as proposed. FAR 15.408 Table 15-2, “Instructions for Submitting Cost/Price Proposals When Cost or Pricing Data Are Required,” outlines the doc- umentation needed to support the proposed costs by cost element and contract line item. Table 15-2, Section I—General Instructions, includes a discussion of the requirement for submission of current, complete, and accurate cost or pricing data. Table 15-2, Section II—Cost Elements, iden- tiﬁes speciﬁc requirements for presenting and supporting the following elements of cost: • Materials and services • Direct labor • Indirect costs • Other costs • Royalties • Facilities’ capital cost of money Relevant information that becomes available after submitting the proposal must be provided to the contracting ofﬁcer before ﬁnal contract negotiation. Contractors should maintain a record of all data provided, the date and to whom provided, and, if feasible, copies of all data provided to the contracting ofﬁcer and/or the auditor. (c) MATERIAL MANAGEMENT AND ACCOUNTING SYSTEMS. While no speciﬁc cost accounting requirements relating to material costs are contained in FAR, DFARS clause 252.242-7004, “Material Management and Accounting Systems” (MMAS), addresses “systems for planning, controlling, and accounting for the acquisition, use, issuing, and disposition of material.” The clause is included in all defense contracts and subcontracts over $100,00 that are not for the acquisition of commercial items. The clause contains 10 standards that are used in determining whether systems are adequate: • Adequate system description including policies, procedures, and operating instructions • Costs of purchased and fabricated material charged or allocated to a contract based on valid time phased requirements as impacted by minimum/economic order quantity restrictions (desired ac- curacy levels of 98% for the bill of material and 95% for the master production schedule) • Mechanism to identify, report and resolve system control weaknesses and manual overrides and identify operational exceptions such as excess/residual inventory as soon as known
35 6 ACCOUNTING FOR GOVERNMENT CONTRACTS • • Audit trails and records (maintained for the prescribed record retention periods) necessary to evaluate system logic and to verify through transaction testing that the system is operat- ing as desired • Adequate levels of record accuracy (desired accuracy level of 95%); reconciliation of recorded inventory quantities to physical inventory by part number on a periodic basis; and detailed descriptions of circumstances that will result in manual or system generated trans- fers of parts • Consistent, equitable, and unbiased logic for costing of material transactions. With regard allo- cations from common inventory accounts, controls to ensure that: (i) reallocations and credits due are processed no less frequently than the routine billing cycle; (ii) inventories retained for requirements that are not under contract are not allocated to contracts; (iii) algorithms are maintained based on valid and current data • Adequate controls to ensure that physically commingled inventories that may include material for which costs are charged or allocated to ﬁxed-price, cost-reimbursement, and commercial contracts do not compromise requirements of any of the above standards • Periodic internal audits to ensure compliance with established policies and procedures The accuracy requirements of 98% for the bill of materials and 95% for the master produc- tion schedule are intended to ensure that the right materials are assigned to contracts based on the time-phased requirements. Difﬁculties arise when the bill of materials and/or production schedule are not updated, thus raising doubt as to whether the materials being procured are ac- tually required and are only procured when they are needed for current production. The 95% ac- curacy standard for physical inventory is intended to ensure that the number of parts reported in the system for government contracts actually is in inventory and that the inventories allocated to defense contracts and included in requests for progress payments have actually been used on those contracts. However, accuracy levels for physical inventories may be difﬁcult to achieve using the gross numbers of items in the inventory. During these periodic counts of physical in- ventories, defense contractors can stratify inventories based on the value of the items and estab- lish differing accuracy levels for various strata. For example, a high-cost, specialized electronic component may be put in a stratum that requires 100% accuracy, whereas an inexpensive bolt may be in a stratum that requires 60% accuracy. A potential result of using multiple strata is that inaccuracy in one strata may cause the accuracy of the entire inventory to fall below the 95% level; however, using multiple strata may make it easier to demonstrate that DOD has not been harmed due to the lower accuracy in low-value parts. If systems have an accuracy level below 95%, the contractor must demonstrate that (1) there is no material harm to the government due to lower accuracy level, and/or (2) the cost to meet the accuracy goal is excessive in relation to the impact on the government. Because transfers of parts between contracts transfers can affect billings based on cost, trans- fers must be well documented, consistently applied, and use appropriate and equitable pricing methodologies. Contractors must maintain and disclose a written policy describing the transfer methodologies. The costing methodology may be standard or actual cost, or any of the inventory costing methods permitted under CAS 411, which is discussed in Section 35.3(c)(iv). Consis- tency must be maintained across all contract and customer types and from accounting period to accounting period for initial charging and transfer charging. Loan/payback systems use the prin- ciple that contracts that receive transfers of parts due to changed requirements should bear the cost of the parts purchased to replace the items transferred; such systems are permitted only when the loan and the payback are accomplished in the same billing period or, with govern- ments approval, when billings are adjusted to mitigate any overbilling. Where it may not be ap- propriate to transfer parts and associated costs within the same billing period, use of a “loan/payback” technique must be approved by the administrative contracting ofﬁcer (ACO). Controls must be in place to ensure that parts are paid back expeditiously; procedures and con- trols are in place to correct any overbilling that might occur; at a minimum, the borrowing con-
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35 7 • tract and the date the part was borrowed are identiﬁed monthly; and the cost of the replacement part is charged to the borrowing contract. System programming and records must be maintained in machine-readable form for the record retention period outlined in Section 35.2(f). This requirement goes beyond the scope of normal record retention provisions, which require manual or “hard” copies to be retained. This require- ment also points out the government’s changing view of what constitutes an adequate audit trail. (d) PROJECT MANAGEMENT SYSTEMS. The ability to monitor and project costs on gov- ernment contracts is critical. The government is particularly concerned about overpaying cost- based progress payments and not being forewarned about potential cost overruns. The preparation of a comprehensive estimate of contract costs at completion is key to as- sessing progress and determining if problems exist. These estimates should be prepared at least quarterly to ensure the reliability of interim ﬁnancial statements and to avoid surprises that come too late for effective corrective action. Management must be informed promptly and peri- odically of the key facts concerning contract performance. Inherent in such systems is a conﬁg- uration management function that tracks changes to the technical “baseline” of a product. The project management system needs to timely provide information needed, which includes: • Actual cost to date • Budgeted cost for work scheduled • Budgeted cost for work performed • Estimated cost to complete • Estimated cost at completion • Contract amount (including changes) • Projected overrun or underrun • Contract scheduled completion date • Expected completion date • Projected slippage To ensure effective monitoring of a contractor’s progress on major procurements, DOD in- serts the “Earned Value Management System” (EVMS) clause (DFARS 252.234-7001) into cer- tain large contracts requiring compliance with the criteria provided in DOD 5000.2-R, “Mandatory Procedures for Major Defense Acquisitions Programs and Major Automatic Infor- mation System Acquisition Programs. Basically, an EVMS or other type of cost/schedule con- trol system breaks down the contract into work packages, identiﬁes organizations and managers responsible, develops a schedule, and budgets the costs by those work packages. The “Limitation of Cost” clause (FAR 52.232-20), inserted in fully funded cost-reimburse- ment contracts, and the “Limitation of Funds” clause (FAR 52.232-22), inserted in incremen- tally funded cost-reimbursement contracts, obligate the contractor to notify the government when the contractor has reason to believe that within the next 60 days the cumulative cost in- curred to date in performing the contract will exceed 75% of the estimated cost of, or funds al- lotted to, the contract. The contractor must also notify the government anytime the total contract cost is expected to be substantially more or less than the estimated cost or allotted funds. The government is not obligated to reimburse the contractor for any cost in excess of the contract es- timated cost or funds allotted to the contract. Nor is the contractor obligated to continue perfor- mance or incur any costs in excess of the contract estimated costs or funds allotted. The limitation of cost or funds clauses are designed to give the government an opportunity to decide whether it can and will provide additional funds necessary to complete the work. Because of the reporting requirements of these clauses, companies contracting with the government must have an adequate project management system to allow for timely notiﬁcation of potential cost over- runs. Boards of contract appeals and the courts have ruled in numerous instances that inadequate
35 8 ACCOUNTING FOR GOVERNMENT CONTRACTS • accounting or project management systems are not valid excuses for not providing the notice required by the clauses. (e) BILLING SYSTEMS (i) Cost-Reimbursement Contracts. The “Allowable Cost and Payment” clause (FAR 52.216-7) provides for reimbursement costs incurred in contract performance that are deemed “allowable” by the contracting ofﬁcer, in accordance with procurement regulation cost principles and contract terms. The clause provides cost reimbursement of allowable, recorded incurred costs for: • Items or services purchased directly for the contract and associated ﬁnancing payments to sub- contractors, provided payments are made on a timely basis • Materials issued from the contractor’s stored inventory • Direct labor • Direct travel • Other direct in-house costs • Properly allocable and allowable indirect costs, except that pension plan contributions must be funded no less frequently that on a quarterly basis When pension plan contributions are funded less frequently than quarterly, the accrued cost must be excluded from claimed indirect expenses until actually paid. The contractor’s cost ac- counting system is used to determine properly allocable costs. As discussed in Section 35.3(c) the allocation of costs to a government contract may be subject to some or all of the provisions of the CASB’s rules, regulations, and standards. In establishing the allowable indirect costs under a contract, indirect cost rates are ap- plied to allowable contract base costs. Since indirect cost rates can be definitively deter- mined only at the completion of a contractor’s fiscal year, estimated rates are required to reimburse contractors on an interim basis. These rates, referred to as billing rates, are based on the anticipated final annual rates. To prevent substantial overpayment or underpayment, the billing rates should be adjusted as needed during the year. The contractor must determine the continued appropriateness of previously established billing rates given the passage of time and experience. The ACO or auditor responsible for determining the final indirect cost rates is usually responsible for establishing the billing rates to be used. Final indirect cost rates, which are generally determined after the contractor’s fiscal period ends, are used to determine indirect expenses applicable to cost reimbursement–type contracts, as well as fixed-price redeterminable and incentive-type contracts. The contractor is required to submit an adequate final indirect cost rate proposal to the ACO and auditor within six months after expiration of the fiscal year. For guidance on what constitutes an adequate proposal, FAR 42.705-1(b)(1) refers contractors to the Model Indirect Cost Proposal contained in Chapter 5 of the Defense Contract Audit Agency Pamphlet (DCAAP) No. 7641.90, “Information for Contractors.” 1 FAR 42.703-2 and “Certiﬁcation of Final Indirect Costs” clause (FAR 52.242-4) require ex- ecution of the following certiﬁcation when ﬁnal indirect cost rate proposals are submitted: This is to certify that I have reviewed this proposal to establish ﬁnal indirect cost rates and to the best of my knowledge and belief: 1. All costs included in this proposal (identify proposal and date) to establish ﬁnal indirect cost rates for (identify period covered by rate) are allowable in accordance with the cost principles of 1 Defense Contract Audit Agency Pamphlet No. 7641.90 can be obtained by contacting Internet ad- dress www.dtic.mil/dcaa/chap5.html.
35.2 MANAGEMENT INFORMATION SYSTEM REQUIREMENTS 35 9 • the Federal Acquisition Regulation (FAR) and its supplements applicable to the contracts to which the ﬁnal indirect cost rates will apply; and 2. This proposal does not include any costs which are expressly unallowable under applicable cost principles of the FAR or its supplements. The certiﬁcation must be signed by a senior management ofﬁcial at a level no lower than vice president or chief ﬁnancial ofﬁcer. The certiﬁcation requirements should not be taken lightly. Contractors should ensure that effective internal controls exist to properly screen unallowable costs from indirect expense proposals. Including expressly unallowable costs in ﬁnal indirect cost rate proposals subjects the con- tractor to certain monetary penalties prescribed in FAR 42.709-1 and the “Penalties for Unal- lowable Costs” clause (FAR 52.242-3). (ii) Fixed-Price Contracts. Pursuant to the “Progress Payments” clause (FAR 52.232-16), ﬁxed-price contracts requiring the use of signiﬁcant contractor working capital for extended pe- riods generally provide for progress payments if the contractor is reliable, is in satisfactory ﬁnan- cial condition, and has an adequate accounting and control system. Payments are made as work progresses, as measured by eligible costs incurred, except for construction-type contracts or ship- building, conversion, alteration, or repair contracts, which are based on percentage of completion or other measure of the speciﬁc stages of physical completion. Progress payments based on eligi- ble costs incurred provide reimbursement of a speciﬁed percentage of total allowable costs in- curred in performance of the contract, provided that payments for supplies and services purchased directly for the contract are paid on a timely basis. Accrued costs of allowable pension plan contributions must be funded on a quarterly basis. (f) RECORD-RETENTION REQUIREMENTS. The audit-negotiation clause (FAR 52.215- 2), inserted in negotiated contracts, and the audit-sealed bidding clause (FAR 52.214-26), in- serted in contracts awarded under sealed bidding, form the basis of the government’s access to contractor records, and require contractors to provide the contracting ofﬁcer, or a representa- tive of the contracting ofﬁcer who is a government employee, with access to certain records whenever: cost or pricing data is required; a cost reimbursement or ﬂexibly priced contract is used; or cost, funding, or performance reports are required by the contract. The audit clauses must be ﬂowed down to all the subcontracts over $10,000. In these situations, contractors must make available, in their original form, relevant books, records, documents, and other data or evidence, and accounting procedures and practices. The data must be maintained for three years after ﬁnal payment, except where shorter retention periods are prescribed in FAR 4.705 for certain speciﬁed types of data, as summarized below: TWO-YEAR RETENTION REQUIREMENT • Labor cost distribution cards or equivalent documents • Petty cash records • Time and attendance cards • Payroll checks • Material and supply requisitions FOUR-YEAR RETENTION REQUIREMENT • Accounts receivable invoices and supporting data • Material, work order, or service order ﬁles • Cash advance recapitulations • Paid, canceled, and voided checks other than payroll checks • Maintenance work orders