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New World: The Future of Government Contracting
Buyers and Sellers Must Be Aware of Risks in Today’s Market
By Mark Burroughs, CPA and partner, Government Contracting Consulting Group, Dixon Hughes Goodman LLP
With the U.S. government’s spending budgets continuing to decline in the foreseeable future, it is expected that the government contracting industry may go through another round of consolidations as companies once again look for ways of increasing revenue in the declining market. However, in addition to the "normal" risks associated with this industry, today’s marketplace has several new risk areas. Buyers and sellers alike need to be aware of these areas and take appropriate consideration when planning a transaction:
Outside Buyers Beware
In times of market growth, it is common for companies or investors who are not traditional government contractors to become active in the government marketplace. As with any marketplace, buying in a period of growth vastly improves the odds of buying into a stable, if not growing, organization. However in a period of downturn, and dare we say, investors must be very cautious as to how the company, service, technology, etc. may fare. This risk is amplified if the target is a subcontractor. A prime contractor has some level of control of its own destiny when it comes to existing, funded contracts; unfortunately this control often comes at the expense of subcontractors. As primes look to increase revenue, efforts that normally may have been subcontracted are brought in house. Therefore it is important that subcontractors have established themselves as critical to the project either through relationships or having the all-important niche expertise.
ALL Buyers Beware
Government contractors operating in a cost-based/government unique environment bear the unique risk of having government auditors review their books and records to ensure costs are reasonable, appropriately allocated to contracts and allowable per the Federal Acquisition Regulations. Part of the diligence process for government contractors is to attempt to assess this risk and to evaluate appropriate methods to account for that risk through price adjustment and/or escrow reserves. The current environment adds to these complexities in a number of ways:
§ Open Years: Government contractors with cost-reimbursable contracts often have six or more years where final direct costs and indirect expense rates have not been agreed to. These years are either in negotiation or awaiting audit. Not only does the risk of contract adjustments compound arithmetically with each open year, they also increase incrementally as time goes by. Defense Contract Audit Agency (DCAA) auditors are more aggressively questioning costs which complicates the challenge of trying to explain or defend a transaction that occurred six or more years ago, if you are able to locate supporting documents in the first place. Imagine how difficult this task would be if you lose the knowledge of the history of the acquired company.
In addition to the complexities of determining risk, the number of open years raises questions as to how to account for that risk as part of the transaction, particularly when escrows are being considered. If the establishment of final costs and rates are fairly current one could establish a three-year escrow and have certain comfort that some, if not all, of the open years would be addressed during that period. The same cannot be said for the current audit backlog and the time it is taking to complete each open year. Fortunately, the DCAA has increased the number of small/low risk contractors. On Dec. 18, 2012, the Government Accountability Office issued an audit report on DCAA’s backlog and identified that the DCAA has increased its threshold that triggers an automatic audit of a contractor’s incurred cost submission from $15 million to $250 million and significantly increased the number of low risk audits that may be randomly sampled. Unfortunately, while the risk is reduced for some companies – it is not eliminated.
§ Is History Representative: In order to evaluate risk, buyers often analyze a company’s audit and negotiation history to establish a baseline of findings, yet today’s environment raises the question as to how valid that is. This is not only because of the challenge of tracking down supporting documentation but also because we have entered into a "brave new world" with regards to both the audit process and negotiations. Since 2008 there have been a number of reports by both the GAO and various inspector generals raising concerns as to the quality of the audits being performed and the negotiation positions taken by the government. As a result, transactions and issues which may have been acceptable or negotiable in years past may now be questioned. It is difficult, if not impossible, to identify the nature or costs associated with these areas.
While it may not be possible to estimate a dollar amount associated with this new risk environment, there are steps that can be taken to mitigate these risks. One critical process is to ensure that a well-defined system exists related to document retention. This should include policies and procedures related to the identification, indexing and storage of these materials, either electronically or in paper form. The ability to quickly and accurately provide supporting documentation to auditors greatly increases the likelihood that these costs may not be questioned. Consideration should also be given to retaining appropriate knowledge of corporate history to assist in the audit process. In addition, having an organized, proactive, compliance team mitigates risks associated with government audits by continuously evaluating a company’s risks and not waiting for an issue to arise. In this way risks can be addressed before an auditor raises them or responds appropriately when concerns.
For more information, please contact your Dixon Hughes Goodman advisor or Mark Burroughs, partner at (703)970-0519 or email@example.com.
About Dixon Hughes Goodman LLP: With more than 1,800 people in 11 states, Dixon Hughes Goodman is the largest certified public accounting firm based in the Southern U.S. and the 15th largest in the nation. Visit www.dhgllp.com for more information.