Preparing Architectural/Engineering Firms for FAR (Overhead Rate) Audits

By Andrew Henderson, CPA, CVA Audit Manager, Thompson Greenspon

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS Introduction When architectural and engineering (A/E) firms propose or work on government contracts, they are often asked to provide overhead rates prepared in accordance with the Federal Acquisition Regulation (FAR). Many government agencies also request that the overhead rates be audited by a CPA. States and local governments are increasingly requesting these types of audits, better known as FAR audits.

FAR audits are unique engagements tailored for A/E firms and are not the same as financial statement audits. The purpose of this article is to inform A/E firms about these audits, and the things they should consider if they are thinking about obtaining a FAR audit.

Understanding the FAR and AASHTO Audit Guide The Federal Acquisition Regulation, Part 31 (FAR) is the primary regulation governing the acquisition of supplies and services with Federal funds. It sets the criteria for determining costs eligible for reimbursement on Federally funded agreements. Most States have bidding and contract requirements similar to Federal rules because states pay for the construction of highways and other projects using a mix of state and Federal funds.

The FAR spells out specific rules and procedures that must be followed when A/E firms calculate their overhead rates. A valuable resource for summarizing the FAR rules is the AASHTO (American Association of State Highway and Transportation Officials) audit guide, which was issued as a tool for state DOT auditors, A/E firms, and public accounting firms that perform audits of A/E firms. The latest version of the guide was released in 2012, but an updated version was released in 2015 and is expected to be finalized in 2016. The updated version includes new emphasis on the accounting for uncompensated overtime, overtime premiums, reasonableness of compensation, The AASHTO audit guide was developed making legal expenses allowable and providing best specifically for A/E firms and auditors. It is an practices for bonus plans. excellent resource for firms to review and can be downloaded for free at:

http://audit.transportation.org/Pages/default.aspx Audit Requirements While many government agencies may request FAR audits, they do not always require them. Small firms may be exempt from an audit if the home state DOT does a risk assessment and ensures rates are established in accordance with FAR. In addition, there are other possible exemptions; for example, the Virginia DOT (VDOT) requires FAR audits when a firm’s charges to VDOT will be equal to or greater than $100,000. However, a new or small consulting firm dong work for VDOT may be eligible for a provisional indirect cost rate of 110% and/or a field rate of 75% for one year. Some state or local governments may also accept internally prepared (unaudited) rates.

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 1 FAR audits include an examination and tests of an A/E firm’s accounting system and internal controls. Audits include tests of indirect expenses for potentially unallowable costs that may not have been segregated as unallowable, and tests of payroll and timesheets to verify proper processing of direct and indirect labor through the job cost system.

Most states require FAR audits to be completed on an annual basis no later than 180 days after year- end. While some states have specific restrictions and caps on costs, it is not necessary or appropriate to have a CPA prepare separate FAR audits for each state. The CPA will simply disclose any state specific adjustments within the audit footnotes. State DOTs are permitted to, and frequently do, inspect the work of auditors prior to issuing a letter to firms stating that the rates have been accepted.

Costs The cost of FAR compliance and audits include the hours spent by internal staff and dollars paid to external consultants and CPA firms. A/E firms may need to spend considerable time in order to design and maintain their accounting system to be FAR compliant.

CPAs must perform FAR audits in accordance with Generally Accepted Government Audit Standards (“GAGAS”), which are different than Generally Accepted Auditing Standards (“GAAS”), and require specialized training. A typical FAR audit may take a CPA firm 100-150 hours for small to mid-sized A/E firms, with additional time needed for larger or more complex entities and/or initial audits. In addition to the cost of the audit, A/E firms will need to spend time responding to auditor requests.

Benefits Performing services for government entities can be a profitable opportunity for A/E firms, and obtaining FAR audits is the only way to become eligible to work on many of these contracts. Not having these audits can result in lost bid opportunities and lower potential job profitability if you settle for estimated or provisional rates.

Even if A/E firms do not currently work on government contracts, it may be beneficial to establish a FAR compliant accounting system and have it audited in order to be ready if future government contracts require it. It can take some A/E firms months to establish a FAR compliant accounting system, so firms should start the process as soon as they think they may want to bid on government work with FAR audit requirements.

In addition, FAR audits can achieve the following benefits: • Accurate overhead rates are a key measure for profitability. The overhead rate is one of the most

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 2 critical performance factors for A/E firms. With an audited rate, your firm gains comfort that the rate is accurate and you can compare your firm’s rate to your peers. Industry ratios are widely available from sources such as the AIA, PSMJ, Zweig group, Deltek, Axium and others.

• A FAR audit will determine if your accounting systems and controls comply with Federal and state regulatory and contractual requirements; and whether or not your cost allocation methodology is proper.

• A FAR audit will identify whether or not all reimbursable costs are being recovered.

When state DOTs accept Audits can uncover items that are improperly treated as provisional or estimated rates unallowable. For example, firms may mistakenly disallow in lieu of audited rates, it is very all marketing salaries as part of advertising and promotion likely that the rate is conservative under FAR 31.205-1. However, direct sales type marketing, and will almost certainly be in including bid and proposal costs, are generally allowable favor of the state DOT. under FAR 31.205-18 and FAR 31.205-38.

What firms can do to prepare for FAR Audits The following steps can help firms calculate their overhead rates in accordance with FAR and prepare for a FAR audit: 1. Ensure that accounting records are kept on an accrual basis in accordance with generally accepted accounting principles.

2. Obtain a copy of the latest AASHTO audit guide and become familiar with the timekeeping requirements in Chapters 5 and 6. http://audit.transportation.org/Pages/default.aspx

3. Provide training for accounting personnel and key management on Part 31 of FAR.

4. Complete the Internal Control Questionnaire (ICQ) for Consulting Engineers (included in Appendix B of the AASHTO audit guide). If you are unsure of how to complete any questions, then this may be a sign that your firm is not compliant with FAR. You should obtain a sufficient understanding of FAR in order to complete the entire questionnaire.

5. After taking these initial steps, you should assess the adequacy of your firm’s current accounting system to determine whether you are in compliance with FAR. It may be necessary for firms to adopt new policies and procedures before they can be audited. Some firms may need to hire consultants to assist

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 3 them in setting up policies and procedures, job costing and accounting systems. Establishing a requisite accounting system can take months, and if certain procedures and controls are not in place during the period to be audited, then a FAR audit may not be feasible. At a minimum, the accounting system should include the following: • A written internal control policies and procedures manual.

• A timekeeping system, which includes the internal controls described in Chapter 6 of the AASHTO audit guide.

• A system to separate indirect costs and direct costs in the general ledger.

• A system to separate allowable and unallowable costs in the general ledger.

6. Compensation must be limited to a reasonable amount, as described in Chapter 7 of the audit guide. The AASHTO has issued a National Compensation Matrix that firms can use to document the reasonableness of compensation. In addition, there is a maximum allowable benchmark compensation amount. Owners of closely-held firms are subject to additional restriction – no payment that represents a distribution of profits may be submitted as a cost against a government contract. Bonuses paid to owners of closely- held corporations are subject to special scrutiny for potential distribution of profits when the firm does not have other mechanisms to provide a return on investment to owners, such as payment of dividends, distributions, or a separate bonus plan for profit distributions.

Common Deficiencies Noted During Our Audits:

• Missing timesheet approvals • Failure to keep mileage logs to document whether vehicle costs are direct or indirect • Estimates for personal use of vehicle use are not sufficient • Rent paid to related parties • Failure to keep bonus policy that documents eligibility requirements and provides details on how bonus payments are determined

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 4 Common Unallowable Expenses:

• Idle Facilities • Sub-consultants/outside consultants not properly identified as direct costs • Advertising • Trade Show Expenses • Trade Show Labor • Brochures and Other Promotional Material • Souvenirs/Imprinted Clothing Provided to Public • Membership in Civic and Community Organizations • Bad Debts • Collection Costs – including legal costs related to collections • Personal Use of Company Vehicles • Contributions or Donations • Employee Gifts and Recreation • Membership in Social, Dining, and Country Clubs • Social Activities • Fines, Penalties, and Mischarging Costs Related to Violation of Laws • Life Insurance on Key Employees • Costs to Correct Defects in Materials and Workmanship • Interest Expense • Lobbying and Political Activity Costs • Organization/Reorganization Legal Fees, accounting fees, incorporation fees, labor • Capital Raising (Equity or Long-Term Debt) Legal & Accounting Fees, Lender Fees • Patent Costs • Retainer Agreements (unless properly supported) • Relocation Costs (in certain circumstances) • Travel Costs in Excess of FTR Rates • Goodwill • Alcoholic Beverages

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 5 Selection of a CPA Firm for a FAR Audit Chapter 2 of the AASHTO audit guide provides the following factors to consider in selecting a CPA. The firm should: • Meet all GAGAS requirements, including requirements for adequate continuing professional education (CPE) in governmental auditing

• Have received favorable peer review reports

• Be well versed in GAGAS, the provisions of FAR Part 31 (including the FAR Subpart 31.2 cost principles), Cost Accounting Standards, related laws and regulations (e.g., the Internal Revenue Code, the Federal Travel Regulation, and 23 U.S.C. 112), and the guidelines and recommendations set forth in this guide

• Have adequate experience in applying GAGAS

• Have a working knowledge of the A/E industry, including common operating practices, trends, and risk factors

• Be well versed in job-cost accounting practices and systems used by A/E firms

• Assign direct supervisory staff to the engagement who have prior experience performing overhead audits in compliance with FAR Part 31

• Have experience performing FAR-compliant audits and have knowledge of Government procurement with regard to various types of contracts and contract payments terms affecting the development and/or application of an allowable overhead rate

• Design and execute an audit program that meets the AICPA’s professional standards, as well as the specific testing recommendations described in the sample CPA Workpaper Review Program provided in Appendix A of the guide

FAR audits are not the same as financial statement audits. FAR audits are unique engagements for A/E firms and must be conducted under government auditing standards (GAGAS), which are not the same as generally accepted auditing standards (GAAS). You may already have your accounting records reviewed or audited by a CPA, but if your existing CPA does not have this experience, then it will be necessary to hire a CPA with the requisite expertise.

PREPARING ARCHITECTURAL/ENGINEERING FIRMS FOR FAR (OVERHEAD RATE) AUDITS 6 Conclusion If a FAR audit is desired or one day may be required, then it is critical that your firm review the AASHTO audit guide and obtain a basic knowledge and understanding of the FAR. Firms may need to seek assistance from an outside consultant in order to assess the adequacy of their current accounting system and make any necessary improvements for the system to be in compliance with FAR.

Key Take-Aways 1. Don’t wait and miss out on your chance to bid on government work. Implementing a FAR compliant accounting system can take months and last minute audits are not always feasible. 2. Accepting a provisional rate can cost you. Provisional rates (or unaudited rates that a state chooses to allow) will almost always be in favor of the state. 3. Training is key. Accounting and HR staff need to be trained on the basics of FAR and how to maintain a compliant accounting system. Management should not wait until the end of the year to prepare their overhead rate or rely on their CPA to prepare the overhead rate schedule as part of their audit.

Questions? If you have questions regarding FAR audits, or would like more information on this topic, please contact our office at 703.385.8888 or [email protected].

ABOUT THOMPSON GREENSPON: Thompson Greenspon is a certified public accounting firm providing financial reporting, tax and advisory services for businesses and individuals in the United States. Located in Fairfax, VA, the firm has been serving the Washington, DC metropolitan area for 60 years. For more information about Thompson Greenspon, visit www.tgccpa.com or call 703.385.8888.

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