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Understanding FAR Overhead Calculations and Audits for Architecture and Engineering Firms

3.30.15

In recent years, more and more architectural and engineering (“A/E”) firms are finding that they must have an audited overhead rate in accordance with the Federal Acquisition Regulation (“FAR”). Trends leading to this include the economic downturn that has reduced development projects and caused more firms to seek work from the government. In addition, the issuance of the new AASHTO Uniform Audit & Accounting Guide in September 2009 has resulted in an increased focus on properly calculated and audited FAR overhead rates rather than the use of estimates by architecture or engineering firms and different rates in various states.

AASHTO stands for the American Association of State Highway and Transportation Officials. After several years of development, in September 2001, AASHTO and its Audit Subcommittee issued the initial Uniform Audit & Accounting Guide to assist engineering consultants, independent CPAs, and state Department of Transportation (“DOT”) auditors with the preparation and/or auditing of Statements of Direct Labor, Fringe Benefits, and General Overhead. These Statements are commonly referred to as FAR Overhead Statements or FAR Overhead Audits as their main purpose is to calculate an A/E firm’s overhead rate in accordance with the provisions of FAR Part 31.

The 2009 update to the AASHTO Uniform Audit and Accounting Guide included significant changes to the guide that was originally published in 2001, and these changes are having a significant impact on FAR overhead calculations and audits. A summary of these changes is presented below.

It should be noted that while FAR is a Federal regulation, because state DOTs construct highway improvements using both state and Federal funds, most state DOTs use rules for selection and pricing of state-funded engineering consultant contracts that incorporate, or are similar to, Federal rules. The AASHTO Uniform Audit and Accounting Guide (the “Guide”) is designed to be used as a tool by state DOT auditors, A/E firms, and CPA firms that perform audits and attestations of architecture and engineering firms.

The techniques presented within the Guide focus on examination, auditing, and reporting procedures to be applied to indirect costs incurred by A/E firms for services performed on various Federal, state, and local transportation projects. While the focus is transportation projects, the Guide is the most comprehensive resource related to FAR audits and, therefore, will also serve as the basis for FAR audits required by other types of Government contracts, including state agencies such as Departments of Environmental Conservation (DECs) and Federal agencies such as the Department of Defense.

Overview of New AASHTO Uniform Audit and Accounting Guide

The updated AASHTO Uniform Audit and Accounting Guide was designed to be used as a tool by state DOT auditors, A/E firms, and CPA firms that perform audits and attestations of architecture or engineering firms. The purpose of the update was to help ensure that the Guide is consistent with current auditing standards and procedures, accounting principles, and Federal regulations. The update also was intended to strengthen the Guide by providing additional guidance and clarification regarding the existing policies and procedures set forth in the FAR. Implementation of the new Audit Guide began in 2010.

Following are some of the significant changes and features of the new Guide.

• States will give up state-specific rules – Many states previously had their own rules for various items, including limits on the allowability of certain expenses and limits on compensation expense. The new Guide will solidify the agreement among states to follow the Guide’s common interpretation of a FAR-based audit and, in turn, give up their state-specific overhead audit rules.

• Increased reliance on CPA FAR audits – Previously, firms operating in multiple states prepared calculations specific to each state and these state-specific rates were either audited by a CPA firm or tested by the respective state. Now, the majority of architecture or engineering firms will have one CPA firm overhead audit that will hopefully be recognized and accepted by all states.

• Small architecture or engineering firm audit exemption – Small firms may be exempt from a CPA audit if the home state DOT conducts a risk assessment and ensures rates were established in accordance with FAR.

• New guidance in determining reasonable compensation costs– architecture or engineering firms should prepare their own independent compensation analysis. The Guide provides a model for demonstrating reasonableness that includes the use of national compensation surveys of A/E firms.

• Criteria for selecting CPA firms – Recognizing the unique nature and complexity of FAR audit engagements, the Guide provides specific criteria to be considered in selecting a CPA firm to perform your FAR audit.

• Guidance and tools for Management – The Guide is very specific in indicating Management’s responsibility for determining a firm’s overhead rate in accordance with FAR. In this regard, to assist Management, tools are provided to help in determining allowable or unallowable costs.

Understanding FAR in Establishing Contract Terms

Determining a FAR overhead rate is nothing new for engineering firms that have long been performing work for state DOTs. However, for other architecture or engineering firms that are beginning to perform services for the Government, the complexities of FAR can be confusing and, without proper guidance, these firms can be at a disadvantage in negotiating contracts and can leave money on the table in their dealings with Government customers. While it is obviously critical to understand FAR in order to prepare your firm’s FAR overhead statement, it is equally important to understand FAR in determining and utilizing a FAR overhead rate in establishing terms for Government contracts.

Many firms inexperienced in dealing with FAR do not have a thorough understanding of their overhead rate and do not calculate disallowances under FAR. Therefore, rather than properly determining an overhead rate under FAR, these firms may end up using an estimated FAR overhead rate. These rates might be estimated internally or by clients such as state DOTs. However, you can be sure that, in either case, the estimates will be conservative and in the favor of the customer or else the customer would not agree to the estimated rate!

Maximizing Your FAR Overhead Rate?

We hear many people in the industry, architecture or engineering firms, CPAs and consultants alike, talk about maximizing your firm’s FAR overhead rate. But does this really make sense? Sure, it is critical that you properly calculate your FAR overhead rate using the correct direct labor base, including all allowable overhead, and not disallowing any items that should be allowable, thereby maximizing your firm’s FAR rate within the confines of your firm’s overhead rate structure.

However, remember that on cost plus fixed fee jobs, you are only being reimbursed for your overhead and are not profiting from it, and, on some jobs, there may even be caps on your overhead rate. For lump sum contracts, additional overhead will certainly reduce your firm’s profitability. So please keep in mind that your goal should always be to control your firm’s overhead and not incur unnecessary expenses. Therefore, rather than thinking about maximizing your FAR rate, it might be better to envision minimizing the disallowances between your actual overhead rate and your FAR overhead rate.

Another important consideration is how your FAR overhead rate compares to others in the industry and in your geographic area. While many Government contracts are awarded based solely on qualification, there are still times where a higher FAR overhead rate may actually price you out of the contract. Therefore, it can be very useful to compare your firm’s FAR overhead rate to median rates within the industry. There is great industry data available, including FAR rates by geographic region, individual states, and firm size.

Internal Financial Statements Are the First Step

Determining an accurate FAR overhead rate starts with a properly formatted trial balance and internal financial statements. It is critical for an engineering or architecture firm to establish a chart of accounts that is effective for a number of important uses, including billing and analysis of job profitability, preparation of effective internal financial statements, and comparisons to industry standards. In addition, the chart of accounts should be formatted to allow for a quick and efficient determination of a firm’s overhead rate in accordance with FAR, which might include segregating disallowed expenses into separate general ledger accounts.

In addition, while the focus of FAR audits is often on overhead expenses and disallowances, an architecture or engineering firm is also required to have project-costing and labor-charging systems that properly account for direct and indirect labor costs. This is critical and will be tested in a FAR audit as direct labor is the basis for a firm’s overhead rate and, to determine an accurate overhead rate, payroll costs must be correctly and consistently allocated between direct and indirect labor.

Determining Disallowances Under FAR

In preparing FAR overhead statements, it is important that Management and the CPA auditor understand the cost principles of FAR Subpart 31.2, which lists expressly unallowable costs and establishes criteria for determining the allocability and reasonableness of cost items. Costs are allocable to a contract as either direct costs specifically incurred for the contract or indirect costs if they are incurred for the overall operation of the firm. FAR 31.201-2 then provides that a cost is an allowable charge to a Government contract only if the cost is:

• Reasonable in amount,

• Allocable to Government contracts,

• Compliant with Generally Accepted Accounting Principles and standards promulgated by the Cost Accounting Standards Board (when applicable),

• Compliant with the terms of the contract, and

• Not prohibited by any of the FAR Subpart 31.2 cost principles.

As a result of the above, an important focus in preparing a FAR overhead statement is determining which expenses included in a firm’s overhead costs are not allowable under FAR. Major disallowances for prohibited expenses under FAR Subpart 31.2 include the following:

• Advertising,

• Bad debts,

• Contributions,

• Personal use of company vehicles,

• Fines and penalties,

• Lobbying and political activities, and

• Interest expense.

Many of these disallowances are straightforward and easy to apply. For example, all interest expense, bad debts, and donations are not allowable and must be removed from overhead in determining the FAR overhead rate. However, there are nuances related to other disallowances that must be understood and carefully considered to avoid subtracting expenses from overhead that should be allowed under FAR. For instance, determining the disallowance for marketing costs is open to more complex interpretation. Many firms mistakenly disallow all marketing salaries as part of advertising and promotion under FAR 31.205-1. However, direct sales type marketing, including bid and proposal costs, are generally allowable under FAR 31.205-18 and FAR 31.205-38.

In addition to the above prohibited expenses, another common and sometimes significant disallowance is based on the reasonableness of compensation. An architecture or engineering firm is responsible for preparing an analysis to support the reasonableness of claimed compensation costs in accordance with FAR 31.205-6. Typically, this analysis focuses on executive positions because those positions comprise the highest compensation levels and are most likely to exceed reasonable levels.

Chapter 7 of the new AASHTO Guide provides a step by step approach to evaluate compensation reasonableness that includes the use of nationally published compensation surveys for A/E firms. Extreme care should be taken in performing this analysis as the selection of appropriate industry salary categories can have a significant impact on the amount of any potential disallowance for excess compensation.

Another factor to consider is the Facilities Capital Cost of Money (“FCCM”). While interest expense must be subtracted from overhead, firms are allowed to calculate and add an additional amount for the FCCM based on the average amount of fixed assets used in the firm’s operations multiplied by a published interest rate (the prorated average Prompt Payment Act Interest Rate determined by the U.S. Secretary of the Treasury). Although FCCM generally is computed as a rate based on direct labor cost, FCCM should not be included as part of the overhead rate, but must be separately stated on the overhead schedule. The FCCM can be part of the overhead charged to the customer if it is appropriately included in the terms of the contract.

Management Responsibilities for FAR Overhead Statements

The AASHTO guide clearly indicates that Management must not rely on the CPA’s end-of-year audit testing as the sole method for detecting unallowable costs. Management bears the responsibility for identifying, segregating, and removing unallowable costs from all billings to Government contracts. This requirement applies to direct costs, indirect costs, and any cost proposals that are submitted for Government contracts. In establishing a sufficient internal control system, the A/E firm must train accounting staff, including payables clerks and staff members responsible for preparing project billings, in the FAR Subpart 31.2 cost principles so that unallowable cost items can be identified, segregated, and disallowed as transactions occur.

This is critical as too often we see that firms do not know if their FAR overhead rate has increased or decreased from the prior year and, therefore, whether the amounts used in contracts are understated or overstated. Even if a firm cannot always segregate its disallowances during the year, Management should be able to estimate its FAR overhead rate by understanding the relationship to the overall firm overhead rate. For example, if the firm historically has an overhead rate of 160% and disallowances under FAR average 12%, this information can be used to estimate the FAR overhead rate if, for example, the overall overhead rate increases to 170% or decreases to 150%. This will help to reduce surprises when preparing for the annual FAR audit and allow the firm to better negotiate contracts as unexpected changes in the FAR overhead rate can often cost the firm real dollars.

Please also keep in mind that while an audited FAR overhead rate will be required in most circumstances, for smaller Government contracts or possibly when you are functioning only as a subcontractor, it may be possible to avoid obtaining an audit if Management is able to perform a proper FAR overhead calculation and present FAR statements in the correct format, potentially with detailed notes to the FAR statement. This may entail utilizing a consultant to assist Management, but this would certainly be less time consuming than a FAR audit as discussed below. If you are involved in smaller contracts where a FAR audit is requested, you should inquire whether an audit is really needed or just a proper calculation and presentation of the firm’s FAR overhead rate.

Choosing a CPA Audit Firm

An architecture or engineering firm should exercise a proper level of due diligence in selecting a CPA to perform its FAR audit. FAR overhead statements are unique and FAR audits should be performed by a CPA that is experienced in working with architecture and engineering firms and in performing FAR audits. In addition, FAR audits must be performed in accordance with Generally Accepted Government Audit Standards (“GAGAS”), which are different than Generally Accepted Auditing Standards (“GAAS”), and require specialized training. The CPA that performs a FAR overhead audit could be the CPA used by an architecture and engineering firm for its other services, or if that CPA does not have the necessary experience, another CPA might be employed that specializes in FAR audit services.

The new AASHTO Guide believes this matter to be so important that it has a section providing specific criteria to consider in selecting a CPA. Among other factors, the Guide indicates that the CPA should:

• Meet all GAGAS requirements, including requirements for adequate continuing professional education (CPE) in governmental auditing,

• Have received favorable peer review reports,

• Be well versed in GAGAS, the provisions of FAR Part 31, Cost Accounting Standards, related laws and regulations, and the guidelines and recommendations set forth in the Guide,

• Have a working knowledge of the A/E industry, including common operating practices, trends, and risk factors,

• Be well versed in job-cost accounting practices and systems used by A/E firms,

• Assign direct supervisory staff to the engagement who have prior experience performing overhead audits in compliance with FAR Part 31,

• Have experience performing FAR audits and have knowledge of Government procurement with regard to various types of contracts and contract payment terms affecting the development and/or application of an allowable overhead rate, and

• Design and execute an audit program that meets the AICPA’s professional standards, as well as the specific testing recommendations described in the Guide.

Performing a FAR Audit

The CPA must follow AICPA professional standards and must obtain sufficient, appropriate audit evidence to support the opinion that the overhead schedule was prepared in compliance with FAR Subpart 31.2 cost principles. In addition, as indicated above, the FAR audit must be performed in accordance with GAGAS. As a result, a FAR audit is a very thorough process that will likely take 100-150 hours for small to mid-sized A/E firms, with additional time needed for larger or more complex entities.

FAR audits include many of the same requirements as financial statement audits under Generally Accepting Auditing Standards, regardless of the size of the A/E firm. These requirements of a FAR audit include the following:

• Execute an engagement letter that clearly specifies the type of engagement to be performed and the roles of each party,

• Understand the environment and the operations of the consultant,

• Understand and test internal controls,

• Assess risk, including potential fraud risks,

• Perform substantive test regarding the overhead report,

o Test overhead costs and potential disallowances

o Test payroll processing and posting between direct and indirect wages

o Test compensation for reasonableness

• Supervision and review of documentation,

• Summarize the audit findings, and

• Develop the report and communication of compliance issues and internal control matters.

Please note that, as indicated above, in addition to the FAR overhead statement, in performing a FAR audit in accordance with GAGAS, the CPA firm is required to prepare a separate report on the A/E firm’s compliance with Government regulations, including FAR Part 31 and related laws, and internal controls related to payroll, cash disbursements, and other transactions impacting the FAR overhead statement. If your CPA firm is not providing such a statement in accordance with its FAR audit, you may want to take another look at Choosing a CPA Audit Firm above!

Conclusion

Performing services for Government clients can be a profitable opportunity for A/E Firms that understand the complexities of working with Federal, state and other Government entities. One such complexity is the requirement that Management determine an overhead rate in accordance with FAR and potentially also contract with a CPA firm to provide an audit of the firm’s FAR overhead rate. Management should make certain that it has a thorough understanding of FAR and the new AASHTO Guide. An A/E firm may also consider aligning itself with a consulting firm with expertise in FAR to provide training and assistance where necessary. If a FAR audit is required, it is critical that an A/E firm hire a properly qualified CPA based on the criteria specified in the AASTHO Guide.



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