By Peter Alfele, CPA & Melanie Burgess, CPA
Cherry, Bekaert & Holland
The recent economic downturn combined with the expansion of government stimulus spending has encouraged many small businesses to seek revenue streams from the federal government. Although government work typically yields lower profit margins and increased oversight, the reliability of a stable customer found in the federal government is often a safe haven for small businesses during tough economic times.
The federal government enlists the private sector to provide a variety of goods and services ranging from off the shelf products and routine maintenance/support functions to specialized military equipment, highly technical research and development and information technology. Companies that choose to do business with the federal government face a complex web of regulation that reaches all aspects of business operations including marketing, pricing, procurement, billing and reporting. This article examines some of the effects that dealing with the federal government has on a company’s accounting practices.
Methods of doing business
The federal government typically transacts business with the private sector by contracting with an enterprise to perform a scope of work. The contract type is important because it determines the amount of risk each individual party is willing to accept. The federal procurement system is based on the premise that the greater the risk assumed by the contractor, the greater the earnings potential. Therefore, selection of the appropriate contract type for a given procurement is important to achieve a proper balance between risk and profit. In general, federal contracts are generally classified as either fixed-price or cost-reimbursement.
Fixed-price contracts provide for the contractor to be paid a predetermined fixed amount for a specified scope of work and have full responsibility for the performance costs and resulting profit or loss. This contract type is used primarily when the scope of work is known and a fair and reasonable price can be established based on competition or on reasonable price comparisons.
Cost contracts permit the contractor to be reimbursed for allowable incurred costs with no provision to give the contractor any profit or fee. Cost contracts obligate the contractor only to use its best efforts to accomplish the scope of work within a specified time and stated dollar limitation; the contractor can legally stop work when all of the contract funds are spent. Many cost contracts include provisions for profit or fee as fixed amounts or dependant on performance (award or incentive).
The government has also devised a variety of other contract methods to meet certain needs. Other common arrangements include:
Time and materials (T&M) and labor hour contracts provide for the contractor to be paid fixed hourly rates for direct-labor hours expended under specified labor categories. The labor rates include direct-labor costs, indirect expenses, and profit. Materials or other specified costs are usually reimbursed at actual costs plus allocable indirect costs. A labor hour contract is similar to a T&M contract except that materials are not supplied by the contractor.
Indefinite delivery, indefinite quantity contracts (IDIQ) are used when the exact time of delivery or the quantities to be delivered are unknown at the time the contract is executed. This type of contract is used when the government does not know in advance the precise quantities it will need and enables the government to commit itself only for a minimum quantity.
Financial accounting and reporting
The primary objective of a company’s financial system is to allow the entity to report its financial position and results of operations in compliance with generally accepted accounting principles (GAAP). GAAP is a body of standards and rules accountants follow in recording and summarizing transactions in order to prepare an entity’s financial statements. These rules are issued by the Financial Accounting Standards Board (FASB) and include general concepts and specific guidelines for certain transactions and industries. An overriding principle in GAAP is to measure results by recognizing revenues in the period when they have earned and costs when they have been incurred. This principle has led to specific reporting standards that apply to the methods government contractors use to determine their earnings.
Revenue recognition methods
Accounting standard setters have long recognized that all contractors face challenges when reporting revenues. Recognizing that a contractor has not completed the earnings process by simply rendering an invoice or receiving a cash payment, the FASB developed methods to report revenues from long term contracts. For instance, invoicing methods followed by government contractors vary depending on the type of contract and the phase of completion. Most government contracts will provide for progress payments as a means to finance the contract. Progress payments under fixed price arrangements are typically based on costs incurred or the achievement of certain “milestones.” Under cost type contracts, billings are generally based on costs incurred plus a fee percentage. Time and material contracts are usually billed based on pre-established labor prices.
In general, contracts that fall within the scope of these rules must be reported on the “percentage of completion method.” This method requires the contractor to essentially ignore the bills they have submitted to customers and determine their revenue as work on a contract progresses. Progress is typically linked to the amount of costs incurred and revenues are recognized by grossing up project costs by the profit percentage expected to be earned over the course of the entire job. This method requires the contractor to be able to estimate both the contract amount and the estimated costs to complete the entire project. Balance sheet accounts commonly reported as “billings in excess of cost” or “costs in excess of earnings” are used to adjust sales recorded from invoices when a contractor has billed more or less than the revenue determined to be earned.
Receivables and revenues from contracts with the federal government are stated separately from other lines of business and a distinction between billed and unbilled receivables is disclosed in order to provide users with information about the extent of a company’s federal contracting activities. Unbilled receivables may arise from retainages, unapproved change orders, differences in provisional rates on cost type contracts, or from the percentage of completion method describe above.
Cost accumulation
Businesses who work with the federal government must consider regulations beyond GAAP. Those businesses which choose to sell non-commercial services or products must adhere with the government’s cost principles as well.
Cost pools and bases are established to determine indirect rates to allocate business costs to government contracts. A pool is a collection of like expenses that can be allocated over a base of related expenses resulting in a percentage known as an indirect rate. Indirect costs are all those costs which cannot be directly associated with one single contract. The typical pools include:
Fringe benefits are those costs incurred to benefit the employees. The fringe pool often includes federal tax payments, holiday pay, vacation pay, health insurance, and education programs. The fringe expenses are thus allocated across all non-fringe labor.
Overhead costs are incurred because a company holds government contracts but cannot be directly associated with a single contract. Typically the overhead pool consists of rent, labor, travel, and training for contract employees. The overhead expenses are allocated to direct and bid and proposal labor as these costs drive the incurrence of overhead expenses.
General & administrative costs are typical business expenses required to manage the company regardless of the type of work performed. Examples of G&A expenses include the rent associated with corporate employees, accounting and HR departments, business development, and corporate required travel and other business expenses.
An added dimension to the creation of cost pools is the identification of unallowable costs. To be allowable for charging to the government, costs, whether direct or indirect, must be reasonable and allocable. Unallowable costs may not be billed to the government either directly or indirectly. This concept may be confusing since the majority of unallowable expenses are incurred in accordance with GAAP and prudent business practices. Procurement rules explain unallowable costs further and include those items that are expressly unallowable by regulation.
Due to the need to record costs in a manner consistent with the cost principles and by individual pools, a generic chart of accounts is not sufficient. Government contractors must customize their accounting software to clearly show costs by pools and allocate properly to direct projects.
Disclosures
In addition to the matters mentioned above, the financial statements of government contractors commonly include the following disclosures:
Contingencies — Unlike commercial contracts, the federal government, either through contract clauses or as a sovereign, retains the right to terminate an agreement at its discretion. The government can terminate a contract for its own convenience if they deem it to be in the best interest of the public, or for cause if the contractor has failed to meet its obligations. The unusual nature of this contingency should be disclosed.
Concentrations — Government contracting may represent a significant portion of a company’s business. Companies that derive more than 10 percent of their revenues from the federal government must disclose the relative percent of sales and receivables concentrated with the government. Business with all agencies of the federal government should be viewed in aggregate when determining the concentration.
Conclusion
The complexities of doing business with the federal government impact a company’s financial reporting systems as well as other business operations. Understanding the unique aspects of government contracting will help small business owners capitalize on government stimulus programs and provide a stable customer during uncertain economic times.
Peter R. Alfele, CPA, is a partner at Cherry, Bekaert & Holland, LLP, in Virginia Beach. He has more than 12 years of experience providing audit and accounting services to a variety of commercial enterprises and closely held, middle market businesses. Contact him at palfele (at) cbh (dot) com or search and connect with him on LinkedIn.
Melanie Burgess is a Senior Consultant with CB&H and a member of the Firm’s Government Contractor Services Group. Melanie specializes in government contract and subcontract administration, proposal preparation, indirect rate development, incurred cost proposal assistance, and compliance with the FAR and other federal procurement requirements. Contact her at mburgess (at) cbh (dot)com.
