Contract Financing: Audit Requirements and Quality Control

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Table of Contents

Introduction
Contract Financing Approaches
Appropriate Contract Financing Approaches
The Defense Contract Audit Agency (DCAA) Requirements
Quality Assurance
References

Introduction

Contract financing is a funding package that is tailor-made for a particular government contract or business (Defense Contract Audit Agency [DCAA]). Contract financing depends on the nature of the contractor’s business (services, supply) or project (infrastructure, civil). It offers financial support for every phase of a project as specified in the contract. When selecting a contractor, the client (government) must evaluate the financial strength of the potential contractors based on the scope of the project. While a contractor is obligated to reveal the project’s details, including the financial resources required, the client must assess the contractor’s financial strength before entering into a contract.

For commercial acquisitions, the contractor is often responsible for financing the entire project. However, in some commercial contracts, the government is responsible for contract financing. In contrast, for non-commercial projects, as a standard practice, financing is the responsibility of the contractor (DCAA). Such projects have unique requirements; hence, their financing must be both reliable and long-term.

The Federal Acquisition Regulation (FAR) provides a set of rules that govern contract financing under customary market conditions. It specifies the financing choices available to organizations. Each contract financing option is governed by specific terms and conditions that are drawn from customary market practices. Thus, it is important for a contractor (organization) to understand the contracting environment and analyze the customary market practices before selecting an appropriate financing option.

Contract Financing Approaches

Several contract financing options are available for commercial and non-commercial acquisitions. For non-commercial acquisitions, the payment methods include installment, commercial interim, and commercial advance payments (FAR). The FAR stipulates that contractors must meet certain conditions before they can use advance and commercial interim financing. It dictates that the project must involve a commercial service, and its contract price should meet the simplified acquisition threshold (SAT). Moreover, the contract must have security, be approved by the contracting officer, and cost below 15% of the contract price (FAR, Para. 3).

Installment contract financing refers to the “purchase of retail installment contracts from factoring companies that offer terms to their customers” (FAR, Para. 14). This approach not only provides value-added and accounting services to organizations, but it also eliminates contract-related overhead costs. Installment contract financing generates a reliable working capital (cash flow) for financing the project, which eliminates the need to sell account receivables (FAR). Installment contract financing also serves as a tool for generating funds for financing urgent project needs. It requires a business owner to contact a potential contract buyer, negotiate the price with a customer, and seek the buyer’s approval before the organization can enter into an installment contract. The contract buyer then channels funds to the customer’s account.

Installment contract financing can greatly increase sales, as it allows organizations to offer better payment terms (installments) to clients. However, installment payments spread over a long time have many administrative challenges to organizations compared to lump-sum payments. These challenges prevent firms from reaching their full profit potential. Nevertheless, this approach allows customers to purchase more products and pay in installments. This may give an organization a competitive advantage, especially if the rival companies do not use installment contract financing.

Commercial interim and advance payments are the other types of contract financing approaches for commercial acquisitions. An interim contract financing, payments are made to the contractor after a specified proportion of the project has been completed (FAR). In contrast, advance payment contracts dictate that the company pays the contractor upfront before any work, as specified in the contract, is done. The FAR stipulates that interim and advance payment can be used when the financed project involves a commercial service, the contract price is higher than the SAT, and the advance payments are less than 15% of the contract price (Para. 7). These payments are excluded from the interest penalty stipulated in the Prompt Payment Act (FAR). The liquidation of these payments is achieved through the deductions made on delivery payments, which is the amount paid for the supplies or services delivered.

Although interim and advance payments provide efficient contract financing options for commercial items, the risks involved can affect an organization. For the contracting approaches, the delivery terms are not clear, which exposes the contractor to financial risks. Furthermore, the contractor may be unable to mitigate these risks, as they arise from industry-wide fluctuations in prices. For instance, the cost of labor and supplies may fall in the course of the project. As a result, the contractor may incur extra costs due to unstable prices.

Noncommercial acquisitions involve different contract financing approaches. These methods help contractors undertaking large government projects. However, the FAR has stipulated certain regulations that contractors must follow when using these methods. For non-commercial contracts, the government shoulders the risks associated with non-performance and repayment (FAR). The financing approaches available for non-commercial acquisitions include advance payments, loan guarantees, progress payments, and performance-based financing (FAR). For this approach, organizations can only provide finance up to the maximum amount needed.

Moreover, the government can monitor the financial strength of the contractor during the project. Performance-based payments are suited for government agencies because they focus on outcomes, not the process. They also have fewer risks, enhance competition, and allow for meaningful contractor surveillance.

Appropriate Contract Financing Approaches

Contractors prefer contract-financing approaches that enhance accountability, increase returns, and minimize risks. They consider several factors when selecting a contract financing approach to engage the government. An appropriate contract financing approach should facilitate the item acquisition, avoid a monetary loss to the organization or government, allow monitoring of the contractor’s financial condition, and ensure that the financial conditions are in the government’s best interests (FAR).

It should also allow the government to evaluate the contractor’s financial strength as the project progresses (FAR). The conditions for contract financing also differ depending on the size of the business. The contract value is usually $100,000 for small businesses and $2.5 million for large businesses with a lead-time of four and six months respectively (FAR, Para. 10). Performance-based payment (PBP), unlike other customary contracting approaches, has minimal risks, which makes it suited for organizations.

Performance-based financing brings about changes in the assignment of roles among different stakeholders, accountability, and verification of performance (FAR, Para. 4), as it requires new structures and mechanisms to facilitate organizational operations. In this approach, payment is made based on the results or outcomes of the project. In PBP, contractors are paid based on two factors: attainment of specified measurable objectives and performance. This approach enhances an organization’s focus on the schedule of the project, strengthens the duties of stakeholders, and promotes oversight, which may reduce costs.

PBP has three main benefits to the contractor: it enhances cash flow to the company; cuts down costs associated with oversight; and ensures that the project progresses according to the agreed schedule. Moreover, often, the government assumes the risks associated with damage or loss of property.

The Defense Contract Audit Agency (DCAA) Requirements

The DCAA focuses on the following five main aspects of organizational performance when evaluating contractors: “(1) management procedures; (2) business systems; (3) accuracy of the contractor’s pricing and incurred costs; (4) reliability of the accounting systems; and (5) contractor compliance with FAR regulations” (Para. 8). The DCAA audits an organization’s financial status and pricing of the contract, as specified under the FAR regulations, to identify any signs of financial distress. To comply with the DCAA’s requirements, organizations must implement policies that entrench quality standards and quality in their operations and processes.

One of the systems that the DCAA evaluates is the organization’s accounting systems. The aim is to determine the contractor’s financial capacity to undertake the contract. Besides the accounting systems, the DCAA evaluates an organization’s quality assurance and technical systems and furnishes the evaluation report to the government. In light of this, an organization should implement policies that enhance information access by the agencies such as the DCAA. It should provide detailed information about its accounting procedures and practices electronically to help DCAA to audit the contract. Online submissions of information are fast, accurate, and allow easy retrieval of data.

The DCAA also evaluates an organization’s accounting system to determine its capability to accumulate costs in the entire life of the contract. Therefore, the contractor (organization) should implement an accounting system that can track cost information as specified under the contract. Furthermore, organizations should ensure that their accounting system is operable concerning ledger control procedures that are characteristic of government contracts. It should distinguish costs that are directly related to the contract from those that are not. Under the FAR regulations, direct costs refer to the expenses that can be directly linked to the contract, such as labor (FAR, Para. 2). Thus, the organization’s accounting system must distinguish between direct and indirect costs to facilitate auditing.

DCAA’s Defense Contract Management Agency (DCMA) also performs a risk assessment to determine the nonperformance contingencies associated with the project (Para. 14). As such, the organization must adopt risk mitigation policies because if there are risks associated with the contract, the DCAA will consider the contractor unable to perform on the project. A labor charging system is another method a prospective contractor should implement. The DCAA lays strong emphasis on labor costs and working procedures. Thus, a prospective contractor should implement a policy that requires employees to record their charges on an internal labor charging system. This internal control mechanism would allow stakeholders (creditors, managers, and customers) to protect the company from losses associated with ineffective labor charging systems.

The organization can also adopt timekeeping policies, which minimize costs and waste associated with employee absenteeism or inefficiency. In such a policy, employees are required to complete a timesheet indicating their work hours or charges and return it to a supervisor (DCAA, Para. 11). The nature of the contract determines each employee’s responsibilities and roles. Supervisors use employee worksheets to ensure that each employee is present at his or her workstation. They also ensure that each worker is performing the assigned tasks, and the charges reflect the employee’s job classification.

Quality Assurance

The government requires contractors to provide services that meet particular quality standards as part of the contract agreement. Often, the government relies on industry-specific quality standards to assess the quality of the contractor’s services or supplies. A quality control system is one of the approaches a business organization can use to improve the quality of its services (DCAA, Para. 8). A good quality control system improves a company’s reputation, attracts more customers, and reduces operational costs. Industry-specific ISO certification is an international quality assurance program, which a company can use to bolster its reputation.

A quality control program also enhances the reliability of a company’s products or services in the market. Firms that enter into contractual agreements with the government often have strong quality control systems, which enhance the reliability of their supplies. Reliability is essential since the government often requires assurances for the products bought. Moreover, a quality control system will ensure that the supplies or products meet the minimum standards set.

They ensure that the contractor’s suppliers meet high-quality standards as they allow the government to evaluate the quality control program and inspect the contractor’s systems to determine whether the company complies with the contract demands. Thus, the contractor is obligated to provide supplies that meet high-quality standards, as stipulated in the contract agreement. The common approaches that contractors employ to ensure the quality of commercial items include quality assurance system, contractor inspection, standard inspection (safety), and international quality standards such as ISO and ANSI.

References

Defense Contract Audit Agency [DCAA]. (2012). Information for Contractors. Web.

Federal Acquisition Regulation [FAR]. (2009). Part 32 – Contract Financing. Web.

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