Reprinted with permission from the Professional Aerospace Contractors Association.

Last winter, the Defense Contract Audit Agency (DCAA) issued two memorandums for regional directors (MRDs), 14-PAC-021(R) and 14-PAC-022(R), to guide regional directors in identifying expressly unallowable costs. These expressly unallowable costs are an important consideration for federal contractors, because contracting officers are obligated to assess penalties for their inclusion under Federal Acquisition Regulation (FAR) Part 42.709-3.

The issuance of these memorandums is significant because these audit alerts are often an indication of the current focus of contract audits. Together, they provide a 32-page matrix of cost principles used to identify expressly unallowable costs and rationale for these items based on two types of considerations: cost principles stated in direct terms and cost principles not stated in direct terms.

FAR Part 31.001 defines expressly unallowable cost as “a particular item or type of cost which, under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable.” Expressly unallowable costs stated in direct terms are straightforward and therefore difficult to dispute, because language in the contract terms or federal law specifically states the cost is unallowable. However, other costs can be inferred as expressly unallowable even if they aren’t stated in direct terms—and this is where expressly unallowable costs get tricky.

The first memorandum, MRD 14-PAC-022(R), refers to an Armed Services Board of Contract Appeals (ASBCA) opinion dated November 19, 1986, titled Emerson Electric Co. (ASBCA No. 30090, 87-1, BCA para 19,478). In the opinion, the board found that “the word ‘expressly’ in the phrase ‘expressly unallowable cost’ [is] to be understood in the ‘broad dictionary sense,’ rather than as a term of art having some special, subtle meaning,” and that although no regulation stated the subject costs were unallowable, the only logical interpretation was that they were in fact expressly unallowable. As such, costs can be reported as expressly unallowable in a DCAA audit report even though the cost principle doesn’t explicitly state it. Further, these costs are subject to penalty.

One thing to consider is that unallowable costs are generally reported in an incurred cost audit report. As we know, DCAA is currently working to catch up on the backlog of incurred cost audits and can apply this guidance to prior fiscal years that haven’t yet been subject to audit. This means findings from previous fiscal years can have a snowball effect if the finding can be applied to all unaudited fiscal years.

For example, if DCAA reports a significant expressly unallowable cost in the overhead pool in the incurred cost audit of a particular year and recommends the cost be removed from the pool, this could cause a significant reduction in the overhead rate for the year. Further, if this cost is included in the overhead pool for all subsequent fiscal years, each of those years can be affected, causing the contractor to owe money to the government. If these costs are considered expressly unallowable, the contractor may also owe a penalty on these costs. Because the statute of limitations is seven years, there may be contractors with seven fiscal years of expressly unallowable costs subject to penalty!

The good news is that contracting officers can waive penalties in certain circumstances stated in FAR Part 42.709-5:

• The contractor withdraws the proposal (certified incurred cost submission) before the government initiates an audit. In this case, the contractor has the opportunity to be proactive. If DCAA has already issued a report from a previous year with expressly unallowable costs, the contractor can withdraw previous submissions and resubmit unaudited years’ costs. While voluntary removal of expressly unallowable costs may still result in lower indirect rates or overall cost reimbursement, it could avoid penalties on expressly unallowable costs. However, if costs are found to be expressly unallowable in a multiyear incurred cost audit, all years included in the audit will be reported simultaneously and penalties will be assessed on the amount reported.
• The expressly unallowable cost isn’t material. If the cost subject to penalty is $10,000 or less, the contracting officer can opt for waiver of the penalty.
• Corrective policies have been implemented. If expressly unallowable costs are found prior to the submission of the certified incurred cost proposal, the penalty may be waived if the contractor can demonstrate that it has established policies that assure that expressly unallowable costs aren’t included in the final incurred cost proposal.
• Inclusion was unintentional. If the proposal has already been submitted, the penalty may be waived if the contractor can demonstrate that inclusion of the expressly unallowable costs resulted from an unintentional error.

We Can Help

The release of two memorandums on expressly unallowable costs in quick succession indicates that DCAA may focus audit effort in this area. Important to note is that DCAA’s determination of expressly unallowable costs subject to penalty can be subjective in nature, and there’s potential for financial and legal consequences for federal contractors. However, FAR provides options for corrective action and penalty waivers apply in many circumstances.

If you have questions about expressly unallowable costs or other topics related to DCAA audits, contact your Moss Adams professional.