6-601 Introduction
This section presents audit guidance and procedures for the audit of indirect costs used in establishing final indirect cost rates for other than firm-fixed-price type contracts. Refer to Section 5-1000, Indirect/Other Direct Cost Systems, for guidance and procedures on the evaluation of the contractor's policies, procedures, and internal controls which affect indi
rect costs. The guidance is also to be used for the determination of allowable indirect costs under other circumstances such as audits of terminated contracts (12-304.15), audits of progress payment requests (14-200), and for interim evaluations of incurred costs.
a. An indirect cost is any cost that is not directly identified with a single final cost ob
jective, but is identified with two or more final cost objectives or an intermediate cost objective (FAR 31.203 (b)). Indirect costs are to be accumulated by logical groups and distributed on the basis of benefits accruing to the several cost objectives. The numbers and composition of cost groupings should be governed by practical considerations.
b. Procedures for settling final indirect cost rates are presented in 6-700. Guidance for audits of the base costs to which the rates apply is provided in this section.
6-602 Audit Objectives
a. The audit objectives are to evaluate and determine:
(1) the allowability, allocability, and reasonableness of the costs charged to Gov
ernment contracts;
(2) the propriety of the methods used to allocate indirect costs to Government con
tracts;
(3) the correctness of the bases used to apportion indirect costs;
(4) the appropriateness of the indirect cost period;
(5) the consistency of the application of policies and procedures to the Government and to other operations; and
(6) the mathematical accuracy of the computed final indirect cost rates.
b. The discovery of fraud or other unlawful/improper activity is not the primary audit objective, but the auditor must be attentive to any condition which suggests that such a situa
tion may exist. If such activity is suspected, the circumstances should be reported in accord
ance with 4-700.
6-603 Scope of Audit
a. The audit should provide for the accomplishment of MAARs (see 6-603.2 below) and should include:
(1) an evaluation of the contractor's system of internal control, including the means by which all echelons of management control the level of indirect costs (see 5-1000);
(2) an evaluation of the composition and suitability of the allocation bases;
(3) an evaluation of the composition of the various indirect cost pools to ascertain whether they are logical and bear a reasonable relationship to the bases used for apportion
ing expenses to operations;
(4) an evaluation of selected indirect cost accounts;
(5) a verification to the financial records; and
(6) a verification of the mathematical accuracy of the rate computation.
b. The extent of audit effort should be influenced by:
(1) the adequacy of the contractor's policies, procedures, and internal controls, in
cluding the contractor's monitoring and testing efforts (see 5-1000);
(2) the mandatory annual audit requirements (MAARs);
(3) the types of Government contracts and the percentage of participation (the total dollar value of the indirect costs allocated to Government contracts);
(4) the adequacy of the records based on past experience and the impact of changed conditions; and
(5) the contract terms.
6-603.1 Types of Contracts and Government Participation
a. For discussion, contracts other than firm-fixed-price, time-and-materials, or labor-hour are referred to as cost-reimbursable. The various types of contracts are more fully defined in FAR Part 16. Audits of incurred indirect costs are performed only at contractors with cost-reimbursable contracts. The higher the value and percentage of reimbursable costs, the greater the need to analyze management decisions and internal controls over costs and the greater the depth of evaluation of selected accounts. The higher the percent
age of firm-fixed-price or commercial work, the greater the need to evaluate the allocation of costs between Government and other contracts. An analysis of participation may result in reduced scope for the whole audit or only certain pools. For instance, pools with high Government participation may require detailed account analysis, whereas pools with no Government participation may require only a determination that the allocation base is appropriate to assure absorption of all allocable costs.
b. The scope of audit may also be affected by the percentage and amount of subcon
tract or interdivisional work performed. Prime contractors have a responsibility to audit their subcontractors. The auditor cognizant of the prime or higher tier contractor is respon
sible for obtaining adequate audit coverage of subcontracts, either from the prime contrac
tor or from the cognizant Government auditor (MAAR 12) (see 6-310.4 for guidance on subcontract coverage by the prime auditor).
c. Contractors may have both DoD and non-DoD contracts which may affect the scope of audit because of differences in procurement regulations. Some non-DoD agencies re
quest and reimburse DCAA for audit services; others do not. The requirement for our ser
vices on non-DoD contracts should be confirmed by a review of the contract terms or dis
cussion with the appropriate contracting officer or Office of the Inspector General (see 1
300 and 15-100 for guidance on audit services for non-DoD agencies).
6-603.2 Mandatory Annual Audit Requirements (MAARs)
a. MAARs represent basic core audit requirements which should be accomplished along with the other procedures discussed in this section to complete the audit of incurred costs. MAARs must be performed at all contractors when warranted by materiality and/or significance. At major contractors it should always be presumed that materiality necessi
tates accomplishment of all MAARs. At nonmajor contractors, auditors are expected to independently make such judgments on the basis of specific circumstances in each audit.
6-603 General guidance on MAARs is provided in 6-105. Descriptions of the MAARs are pro
vided in 6-1S1.
b. The extent of audit necessary to accomplish any MAAR is a matter of auditor judg
ment, subject to supervisory review. Because of the dollar value of cost reimbursable work at major contractor locations, all MAARs will be accomplished for each year. Considera
tions of materiality, based on Government participation and other factors, may result in a decision to perform minimal transaction testing.
6-603.3 Procedures and Internal Controls
The adequacy of the contractor's policies, procedures, and internal controls increases the auditor's reliance on cost representations and reduces the extent of testing and veri
fication which might otherwise be required to express an opinion on the acceptability of indirect costs. Refer to section 5-1000 for guidance on auditing contractor indirect/other direct cost systems and related internal controls. The permanent files should also pro
vide information on the contractor's internal controls and problem areas disclosed dur
ing ongoing audits and should be reviewed during determinations of audit scope.
6-603.4 Past Experience and Changed Conditions
a. Past experience can be a significant determinant of scope. Reviews of prior audits not only provide the accounts where costs have been questioned in the past, but also the accounts where costs have been voluntarily deleted. If past experience indicates good in
ternal control over unallowable costs and minimum costs questioned, transaction testing can be reduced if the auditor can determine that the controls are still in place. A compara
tive analysis of cost accounts by year provides an indication of significant changes in cost account activity or changes in methods of allocation.
b. Changed conditions (MAAR 7) affect the reasonableness of costs and the equitable distribution of indirect costs. Changes in conditions may significantly affect the develop
ment of indirect cost rates. These changes may include the award of a significant cost-reimbursement contract when prior Government contracts were primarily of the firm-fixed-price type; a shift in emphasis from research to production, which may require re
classifying indirect costs into different departments; or changing the method of allocating and distributing indirect costs. Further, significant variations in levels of production and technological modernization of manufacturing facilities (14-800) may require an evalua
tion to determine the effect on facilities, labor, and indirect costs.
6-603.5 Contract Terms
a. As discussed in 6-603.1(c) above, a mixture of DoD and non-DoD contracts may result in increased scope to accommodate the differences in procurement regulations. The contract briefs state the procurement regulations which are applicable and they may also indicate special contract terms or conditions on cost allowability or allocability which may increase scope. The contract briefs may indicate advance agreements made by the contracting officer affecting allowability or allocability, the most common of which are IR&D/B&P agreements and precontract costs (see FAR 31.109 for a discussion of advance agreements).
b. The auditor must identify the contractor's status with respect to CAS; i.e., not cov
ered; subject to modified coverage (CAS 401, 402, 405 and 406); or fully covered and
required to file a disclosure statement. DMIS CAS Compliance Testing Reports main
tained for each CAS-covered contractor (see 8-305) identify the status of a contractor's compliance with CAS and pinpoint specific areas requiring consideration in establishing the audit scope.
6-603.6 Multi-Year Auditing
a. The auditor should consider multi-year audit techniques when establishing the audit scope. Auditors should use their professional judgment to determine if more than one fis
cal year should be audited on a multi-year basis. Multi-year audit techniques can be used at any contractor location, regardless of ADV, assuming the auditor has determined it is appropriate in their specific circumstances as discussed in the following paragraph.
b. To enable an auditor to appropriately and effectively plan a multi-year audit it is essential the auditor have a clear and documented understanding of the contractor’s inter
nal controls that are material for the fiscal years under review. An environment of dynam
ic change in contrast to a stable one may result in unbalanced audit risk among the fiscal years under consideration for multi-year auditing. Multi-year auditing may only be em
ployed where the auditor has determined and documented that the contractor’s business and organizational structure for the years being audited has been relatively stable and con
sistent. Some of key elements to be considered include changes in the following areas:
Contract type mix, sales, customer base;
Profitability, financial position;
Business product line, services;
Organizational structure and operations;
Business acquisitions, loss or mergers;
Employee turnover, key management positions and accounting staff turnover;
Number of employees;
Accounting practices, policies and procedures;
Business software, i.e. timekeeping systems or accounting software etc;
Plant and transportation facilities; and
Business systems and internal control environment.
c. Multi-year auditing techniques should be based on the following guidelines:
(1) Perform all MAARs for each year being audited, if appropriate, based on mate
riality and assessed risk.
(2) Tests of details must be performed in all years in order to obtain sufficient ap
propriate evidence to provide a reasonable basis for the conclusions and opinion stated in the report (i.e. opinion on all indirect and direct costs for each audited year).
(3) The audit approach for each year should be risk-based and based on the audi
tor’s documented risk assessment and understanding of the contractors systems/internal controls. For example, the auditor may select an account in one year for the initial detailed testing and then adjust (expand or limit) the level of testing required for that account in the remaining years based on the results for the one year of testing. Alternatively, the auditor may sample a homogeneous population of like transactions across all years for detailed testing. Auditor should clearly document their rationale and judgments used for determin
ing the nature, timing and extent of the audit procedures performed.
6-604