Testimony of Anita F. Bales Director, Defense Contract Audit Agency before the House Armed Services Subcommittee On Oversight and Investigations on April 6, 2017 Chairwoman Hartzler, Representative Moulton, and members of the Subcommittee, thank you for the opportunity to appear before you today. I am pleased to provide you with an overview of DCAA’s contract audit mission and responsibilities. I will discuss DCAA’s current operations to include pace and schedule of audits and current ideas on acquisition reform. Background DCAA is a distinct agency of the Department of Defense (DoD) that reports to the Under Secretary of Defense (Comptroller). The DCAA mission is to perform the necessary audits of contractors for DoD components responsible for the negotiation, administration, and settlement of contracts and subcontracts. DCAA’s mission supports DoD’s efforts to obtain maximum value for the dollars spent in defense contracting, thereby protecting the taxpayer’s interest and supporting the warfighter. Our charter was intentionally developed to permit DCAA to provide these same contract audit services to other Federal agencies. Government officials draw on DCAA audit findings throughout the acquisition process. With these recommendations, contracting officers are better able to negotiate prices and settle contracts for major weapons systems, services, and supplies. At the front end, DCAA’s findings can directly impact the price that the government pays for contracted work. Even after a contract is underway, DCAA findings may address instances where the government overpaid contractors for work, uncover potential fraud or misuse of funds, and impact future contract prices by addressing inadequacies early on. Before officially closing out a flexibly price contract, DCAA assesses whether the contractor’s claims for final annual incurred costs during contract performance are allowable and reasonable according to applicable acquisition regulations and contract provisions. This final task in the contract audit process ensures that no excess costs were charged to the Government. 2 DCAA Contract Audit Effort To carry out its mission, DCAA has about 4,500 employees at 300 offices around the world. More than 85 percent of DCAA’s personnel are auditors. In FY 2016, DCAA examined $286.7 billion in contract costs, issued 4,269 audit reports, identified over $9.9 billion in audit exceptions, reported $3.6 billion in net savings, and produced a return on investment of about $5.70 to $1. These savings are actual dollar reductions in contract prices or payments to the Government based on contractor overpayments. In addition to making steady progress on the incurred cost backlog, the Agency also continued to conduct other audits to help contracting officers establish fair and reasonable prices and reduce the risk of contractor overpayments. Today, I would like to highlight forward pricing and incurred cost, which represent the majority of our work and where we have made significant improvements resulting in better processes, higher performance, and increased value for our customers. Forward Pricing We get the highest return on investment (ROI) from forward pricing audits, which have netted the government an average of $3 billion per year. These savings represent actual reductions in negotiated contract prices for the goods and services the government is buying. We continually seek feedback on our forward pricing process to improve our value to our customers, and we have executed several initiatives that have increased efficiency and improved communication. As a result of these actions, we have cut our response time by 20 percent over the last five years and established a consistent practice of proactive, early engagement with contracting officers, which has demonstrably improved audit effectiveness. Customer feedback 3 from approximately 200 surveys a year consistently reflects high satisfaction ratings with audit timeliness, accuracy, communication, and overall satisfaction. In addition, our commitment to early and ongoing communication with contracting officials at all levels allows us to identify the highest risk contract actions and perform the right audit services to meet their needs. We have put a particular emphasis on the highest risk forward pricing rates because they generally represent the major portion of the contract dollars. We have been highly proactive with the Defense Contract Management Agency (DCMA) to reinvigorate our audit processes to make recommended forward pricing rates available to the contracting officer. This collaboration has led to quicker settlements on fair and reasonable prices, which has sped up the overall acquisition process. DCAA has also focused on delivering our product to the contracting officers as promised, which is essential to help the acquisition community keep the contract award process on track. We have seen our on-time rate improve by roughly 50 percent in the last five years. We are consistently seeking out new ways to improve internal processes, communication, and timeliness of audits without compromising audit quality. Incurred Cost Incurred cost audits return less ROI than Forward Pricing, but they carry substantial intrinsic value across our entire portfolio of audits. Incurred cost audits are critically important in the acquisition process, and we audit the incurred cost proposal to ensure that all direct and indirect costs are compliant with contract terms and government acquisition regulations. Beyond ensuring compliance, however, incurred costs give us pertinent information that increases our efficiency on many other audits. For example, an incurred cost audit can reveal poor accounting practices including noncompliance with Business System requirements and Cost Accounting 4 standards. They also provide valuable historical information necessary to close out contracts and establish forward pricing rates that we rely to negotiate new fixed price contracts. The incurred cost audits, particularly the incurred cost backlog, have received a lot of attention by several organizations concerned about us getting the backlog current. First, it is important to understand the root cause of the backlog. Specifically, during 2000-2009, defense contract spending increased in support of the Gulf war, but DCAA resources remained the same (Figure 1). Because we didn’t have sufficient audit staff to perform all the new work, we dedicated our limited resources to high risk defense procurements and deferred incurred cost audits, the only audits that could be postponed without significant risk to the taxpayer or the warfighter. Figure 1. DoD Contract Spending (2012 Constant Dollars) Vs. DCAA Staffing Percent Change from 1990 As a result, by the end of FY 2011, DCAA had an estimated backlog of about 21,000 contractor incurred cost submissions on hand with a total value of about $333 billion. To address 5 this backlog, DCAA developed an action plan for more efficient audits, including executing a four-prong strategy to eliminate the backlog. The four-prong approach included the following: 1. A comprehensive low risk incurred cost sampling process. Contractors that have less than $250 million in incurred costs on flexibly priced contracts and have been determined to be low risk are audited on a sampling basis, similar to the IRS process. Contractors that have been identified as high risk undergo an incurred cost audit every year. 2. Multi-year audits. Instead of auditing only one incurred cost year at a time, DCAA began auditing two or more years during the same audit. This process has been extremely efficient, reducing our labor costs by 40 percent over separate single-year audits for the subject years. 3. Dedicated audit staff. To maintain our momentum on reducing the backlog, we dedicated auditors to incurred cost work and ensured that they could not be shifted to other work. 4. Additional resources. We obtained additional resources to close the resource gap that occurred between 2000 and 2009. This four-pronged approach was in full operation by the end of FY 2012. DCAA has made solid, consistent progress since 2011 towards eliminating the incurred cost backlog. However, our progress has been adversely affected by our inability to sustain the fourth prong of the strategy. DCAA’s inability to maintain a steady level of staffing has presented a major barrier and hindered our ability to successfully accomplish our mission. To perform and sustain the full complement of contract audits that pose the greatest risk to the government, DCAA needs to 6 have a stable and well-qualified workforce that can deliver on its mission. Since reaching our target in 2012, DCAA has seen significant staffing fluctuations (Figure 2). 5,400 5,160 5,108 5,200 4,907 5,000 4,851 4,840 4,725 4,800 4,524 4,600 4,328 4,400 4,179 4,200 4,000 2008 2009 2010 2011 2012 2013 2014 2015 2016 Figure 2. DCAA staffing FY2008-FY2016 Sequestration, furloughs, hiring freezes, and other funding limitations have prevented the Agency from hiring to its authorized staffing level for several years. These circumstances, in turn, continue to impact subsequent Agency budgets through Congressional marks that are largely based on DCAA’s under execution of authorized funding levels. We repeatedly find that these staffing upheavals negatively affect workload projections, delay training plans, and disrupt the professional development pipeline critical for meeting the high risk needs of our customers. For example, based on our trajectory on eliminating the Incurred cost backlog (Figure 3), we were planning to be fully current by 2018. However, the passage of the 2016 NDAA (Section 893), which prohibited DCAA from receiving reimbursements from non-DoD agencies, necessitated a hiring freeze that interrupted our progress. Because of that hiring freeze, together with the additional hiring freeze for FY 2017, we are currently reassessing our projections to determine how these events will impact our target dates. 7 Finally, it is important to note that our timeliness also requires cooperation and information from contractors, which can sometimes be challenging on both sides. Regardless of the challenges we have faced, our strategies have clearly been effective. We closed out FY 2016 with the backlog down to 4,677 incurred cost years, representing a 75 percent reduction of the backlog. Figure 3. Incurred Cost Backlog Reduction FY2011-FY2016 We request the help of Congress to ensure that we can hire and maintain a stable staffing level necessary to execute the audits vital for protecting the government’s interests. Acquisition Reform We value the Committee’s commitment to improving the acquisition process. DCAA also upholds that commitment, and we consider process analysis, optimization, and improvements as fundamental in executing our mission to serve the warfighter and protect the taxpayer. We 8 appreciate the opportunity we have had to review acquisition reform and to provide information about what DCAA is already doing, the progress we have made, and the ways we can best help achieve your objectives. I’d like address several areas with the Committee today, including our risk-based approach to audits, materiality thresholds, for the requirement for GS-14 managers to be CPAs, the potential role of Independent Public Accounting (IPA) firms, and mandated timelines for Incurred Cost. Risk-based Approach and Materiality One of the acquisition reform ideas call for providing detailed criteria for defining materiality and for DCAA to develop a risk-based approach to audits. DCAA has a comprehensive risk-based approach, and I’m happy to provide you more information on our processes. DCAA assesses risk at two levels, which allows us to target our resources on the work that provides the most value. The first step is conducting a risk assessment to determine whether the audit engagement represents a significant risk to the Government. We worked with the acquisition community to establish dollar thresholds to identify the point at which an audit is necessary to protect the Government’s interests. For pricing actions, the Department established the thresholds in Table 1. Table 1. Forward Pricing Proposal Audit Threshold Contract Type Audit Threshold Fixed-price Proposals Greater than $10 Million Cost-type Proposals Greater than $100 Million The difference in these thresholds represents the risk inherent in different types of proposals. For example, Cost-type proposals pose a lower risk because they are subject to 9 Incurred cost audits; therefore, the threshold is higher. Fixed-price proposals are not subject to Incurred Cost audits, so there is more risk to the Government if we do not identify unreasonable prices before the contract is awarded. Neither of these thresholds, however, are absolute. If a contract poses a higher risk based on other factors, DCAA will work with the contracting officer and perform the necessary audit services to address the risk. Incurred cost proposals for flexibly-priced contracts are put into three categories based on dollar value and assessed risk to determine if the proposal will be audited to protect the Government’s interest. 1. All proposals exceeding $250 million in incurred costs in a fiscal year must be audited. 2. Proposals less than or equal to $250 million in a fiscal year will be assessed for risk, and any high-risk proposals will be audited. 3. The remaining proposals less than or equal to $250 million that are determined to be low risk and adequate will be randomly selected for audit. Having determined which proposals will be audited, we move to the second step of our process. In this step, DCAA assesses risk of the different cost elements within the proposal to determine the degree to which that element needs to be audited to prevent the potential for overpayment on government contracts. To make their determinations, auditors assess various risk factors such as previous experience with the contractor, reliability of contractor systems, and type of contract. The assessment is also based on the how material each segment is to the overall proposal. Auditors consider materiality when evaluating elements of cost and then assess the findings for an overall material impact. The auditor only reports findings or noncompliances if they will have a significant material effect on contract costs. 10