Key Details: Mergers & acquisitions (M&A) involving federal contractors have surged recently as buyers and investors shift their focus to the lucrative contracting marketplace. Increasing valuations and deal volumes have also caused government contractors to consider the M&A route as they look to expand their business. However, buyers and sellers must consider additional legal and financial due diligence items in a highly regulated industry to avoid potential pitfalls. In addition to traditional due diligence considerations such as quality of earnings and tax compliance, transactions involving government contractors must also look towards regulatory and other compliance-related topics. Understanding additional considerations within this unique environment will aid in a smooth transaction.
The following article highlights key considerations for buyers and sellers to understand when structuring a gov con M&A deal. Part one of this four-part series explores contract novation and recertification considerations. Part two analyzes contract types, accounting system compliance, and timekeeping compliance. Part three will dive into incurred cost submissions, budgets, contract compliance, performance risk, and contractor purchasing systems. Finally, part four analyzes changes in ownership considerations, representations and warranties, security clearances, and the False Claims Act.
It is important to note that the topics discussed are for educational purposes and should not be taken as legal advice. Potential buyers and sellers are encouraged to consult legal counsel when structuring an M&A deal. Additionally, the topics below are not all-inclusive, and additional considerations may be discussed with an advisor.
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Consider Contract Types
Buyers considering a government contracting firm as their target must first understand the types of contracts the target company performs. There are several government contract types with key differences in the bidding, performance, and billing process. It is essential to understand the unique characteristics of each contract type before delving headfirst into a transaction. The four primary contract buckets are as follows:
- Time and materials (T&M)
- Cost-reimbursement
- Firm-fixed price (FFP)
- Indefinite delivery indefinite quantity (IDIQ)
T&M Contracts
Under FAR 16.601, T&M contracts provide for the acquisition of supplies or services on the basis of two key items:
- Direct labor hours at fixed hourly rates. This includes wages, overhead (OH) costs, general and administrative (G&A) expenses, and profit.
- Actual cost of materials.
Hourly rates refer to the rates prescribed in the contract for the payment of labor. Hourly rates differ by labor categories. Direct material expenses are the costs of materials that enter directly into the end product to be delivered to the Federal Government. Direct materials also include materials used or consumed in direct connection with the furnishing of the end product or service.
Government contractors performing work under T&M contracts are subject to a wide range of requirements, such as adequate timekeeping and billing systems and proper tracking and allocation of direct and indirect costs by contract.
A critical component of T&M contracts is the accurate tracking of direct and indirect labor to support hours charged to various labor categories. Contractors should aim to have a timekeeping system that can properly allocate direct and indirect labor to projects. This means the timekeeping system must be able to track both employee hours and dollars by job and accounts. Timekeeping compliance will be further discussed later in this article.
Cost-Reimbursement Contracts
Under FAR 16.3, cost-reimbursement contracts allow contractors to request payment of allowable costs incurred. Through this, an estimate of the total cost is established for obligating funds and establishing a ceiling that contractors may not exceed.
There are varying forms of cost-plus contracts, each with different components. Potential buyers are encouraged to understand the following cost-plus contract types:
- Cost-plus fixed fee: payment is given to the contractor of a negotiated fee fixed at the contract's inception.
- Cost-plus award fee: the contractor is awarded a fee for good performance.
- Cost-plus incentive fee: contractors are given a fee if their performance meets or exceeds expectations.
- Cost-plus-percent-of-cost: reimbursement based on the contractor's cost increase is allowed.
Under FAR 16.306, CPFF contracts are a type of cost-reimbursement contract that provides payment of a negotiated fee (profit) amount fixed upon the contract's inception. This negotiated fixed amount does not vary based on the actual cost incurred but can be adjusted due to changes in work performance under the contract. Therefore, accepting a CPFF contract type lowers the risk contractors may face and places more risk on the Government as there is a lower incentive to control costs. This may be especially appealing during periods of high inflation.
Contractors performing on cost-plus contracts are subject to additional regulations. Potential buyers should ensure analysis of the following key items during the due diligence process:
- DCAA compliance
- Timekeeping compliance
- SF 1408 Pre-award Survey for Prospective Contractor (Accounting System) Compliance
- Estimating system compliance
- Provisional billing rates
- Incurred cost submissions
- Funding notifications
Cost-reimbursement contracts bring about various regulations that contractors must comply with. Potential buyers must assess their current accounting and business systems to ensure they are able to meet regulatory standards post transaction.
FFP Contracts
Under FAR (Federal Acquisition Regulation) 16.202-1, FFP contracts prescribe a price that is not subject to any adjustment based on a contractor's cost while performing on the contract. As such, FFP contracts place maximum and full risk and responsibility on the contractor regarding costs and the resulting profit or loss. Therefore, contractors are incentivized to control costs to maintain efficiency and profit margins. Furthermore, performing on an FFP contract places additional inflation risk on the contractor as prices remain constant throughout the lifetime of a contract. As such, potential buyers must consider the impact of inflation on any current or future FFP contracts.
IDIQ Contracts
IDIQ contracts are used when the quantity of products or services to be delivered has not yet been determined. This will provide the government with more flexibility in the future in determining the quantity of products or services required. Single-award IDIQ contracts are more straightforward and occur when an agency establishes and awards a single contract to a single contractor. Multiple-award IDIQ contracts are used when the Government prefers to work with more than just one contractor. Potential buyers should be cognizant of the potential scope, determination conditions, and limitations of work (especially on contract vehicles).
Accounting System Compliance
Government contractors must implement and maintain an adequate accounting system that can accurately track and allocate costs for final invoicing. A compliant accounting system begins with the accurate setup of the chart of accounts, determination of pools and bases, and tracking of expenses. Accounting policies and procedures must also be developed and implemented to assist with accounting system compliance. Potential buyers are encouraged to consider the following items within the realm of a government contractor's accounting system to ensure they are compliant with standard contracting requirements. Note that the topics below are not exhaustive, and certain contractors may be subject to additional accounting system requirements such as Cost Accounting Standards. Speak with legal counsel to determine additional requirements.
Chart of Accounts
The Chart of Accounts (CoA) provides a basis for government contractors to build a DCAA (Defense Contract Audit Agency) compliant accounting system. The CoA is a list of all general ledger accounts grouped by function or category. As such, each account holds individual transactions for that type of account. A standard CoA includes the following categories:
- Assets
- Liabilities
- Equity
- Revenue
- Expenses
- Direct Expenses
- Fringe
- Overhead
- General & Administrative
- Facilities
- Unallowable
Each section can be further broken down into subcategories that are sorted by account number. This means that assets and liabilities can be broken into current and non-current sections, and expenses can be broken into direct, indirect, and unallowable sections. Further subcategories can be made for indirect expenses, which will aid in the eventual calculation of indirect rates. These costs can be separated into fringe, general & administrative (G&A), and overhead (OH). Government contractors must ensure they follow the allowability criteria under FAR 31.201-2 and use the following factors when determining the allowability of an expense:
- Reasonableness
- Allocability
- Cost accounting standards or otherwise generally accepted accounting principles and practices.
- Terms of the contract
- Limitations set forth in FAR subpart 31.2
Potential buyers are also encouraged to examine the CoA of their target company to ensure expenses are easily segregated into appropriate categories. Additionally, potential buyers should examine the target company's use of cost pools to ensure costs are accumulated into the correct areas, and indirect cost pools are grouped logically and consistently.
Government Contracting Policies and Procedures
During the due diligence process, buyers are encouraged to examine the policies and procedures the target has in place and if they are sufficient. Key policies and procedures to ensure a compliant accounting include, but are not limited to, the following:
- Billing policy
Adequate controls and procedures that outline how the Company bills their U.S. Government customers based on accurate cost and fee/profit information. The policy should include how billings comply with contract terms, limitations, and other relevant government regulations. The contractor should be able to reconcile the final invoiced amount to the job cost accounting system, plus any fee or profit provisions (this is not applicable to certain special financing provisions).
- Bonus Policy
This policy should outline any bonus or special award plans that the target company uses to reward eligible employees for their contributions to company goals and objectives. The policy should outline how bonuses will be awarded and if the awards will conform to the requirements under the FAR.
- Direct cost policy
The contractor’s direct cost policy should outline how costs will be classified consistently and how they will be charged to final cost objectives / projects. This should also outline how the contractor will track direct costs by contract and the reconciliations performed between the P&L by job report and the Company’s general ledger to ensure adequate recording of direct costs.
- Indirect cost policy
An indirect cost policy should outline how the contractor’s accounting system records costs incurred for the benefit of several contracts. These costs cannot be identified as part of a specific contract/project and should be allocated to final cost objectives in accordance with FAR, CAS, and other regulatory requirements. The contractor should also ensure that all costs are consistently classified and charged to final cost objectives.
- Job cost policy
A contractor’s job cost policy should identify how actual allowable direct and indirect costs incurred are identified separately by project or job. This should enable compliance with various contract terms, FAR cost principles, and billing requirements. Additionally, the contractor's accounting system should allow for interim identification of incurred costs by project for management review. If necessary, costs should also be collected and segregated by individual task orders, contract line items, or other lower-level project reporting. As such, the goal of an adequate job cost policy is to maintain a cost collection system that can guarantee accurate and reliable identification of costs by contract for reporting and billing purposes.
- Timesheet preparation policy
This policy should outline how the contractor’s timesheets are prepared, whether accurate and timely and if all employees adhere to the procedures. The policy should also outline the procedures for accurately recording labor charges, timesheet reviews and approvals, how audit trails are maintained, and other system security requirements.
- Travel policy
The contractor should have a travel policy that outlines how employees will be paid or reimbursed for essential costs. This should include allowable business expenses consistent with the Federal Travel Regulations published by the Department of Defense.
- Unallowable cost policy
A contractor’s unallowable cost policy should align with FAR Part 31, Cost Accounting Standard 405, and other applicable regulatory provisions in the identification and segregation of unallowable expenses in a consistent manner.
As outlined above, government contractors should have a set of accounting policies and procedures that provide for an accurate and reliable process in cost segregation, tracking, and timesheet preparation. Buyers are encouraged to thoroughly review their internal policies and procedures and compare them to the targets to ensure alignment and compliance post-transaction.
Standard Form 1408 Requirements
The SF 1408, titled "Pre-Award Survey of Prospective Contractor Accounting System," is a checklist used by the Government before the award of a contract and is not considered an audit. It is typically advisable and encouraged for contractors to meet the basic requirements set forth in the SF 1408, even if they are not currently required by the Government to do so. Potential buyers are encouraged to request information regarding SF 1408 compliance and whether the target's accounting system was recently reviewed.
Timekeeping Compliance
A critical component of government contracting is the development and maintenance of a timekeeping system that can accurately track direct and indirect labor hours to various labor categories. Potential buyers must examine the target's timekeeping system and associated policies and procedures to ensure compliance with various federal contract requirements. The focus should be placed on the proper allocation of direct and indirect labor to projects and reconciliation of the timekeeping system to the payroll system, general ledger, and job cost system. Key aspects of an adequate accounting system that potential buyers should investigate include are not limited to, the following:
- Employees record time daily and are not allowed to record time in advance or days after the fact.
- Employees record time by day, project, and direct or indirect accounts. Each employee must record all time, including vacation or sick leave.
- Project names or job codes are entered into the system and clearly distinguishable. These projects or job codes should also only be made to employees who are authorized to perform work on that particular project.
- Supervisors are required to approve employee timesheets and any corrections made to time entries.
- Documentation and retention of employee timesheets and corrections must be maintained, and the system should provide a clear audit trail.
- Electronic timekeeping systems must be password protected.
Conclusion
As discussed above, M&A transactions involving government contractors bring about additional considerations that must be investigated and analyzed pre- and post-deal. Buyers should be aware of the unique topics that should be examined during the due diligence process and begin the process early to lower any transaction or business risk. Understanding these unique considerations and speaking with an advisor will ensure a smooth transaction process. Businesses are also encouraged to review the following action items to get started:
- Request a contract matrix that contains a current, complete, and accurate list of each government contract that includes the contract name and number, customer, award date, period of performance, contract type, contract amount and revenue, as well as any other set-aside or reserved basis. This will enable both parties to identify all contracts that will impact on the transaction.
- Review the target company’s accounting system and associated policies and procedures and test compliance with the SF 1408.
- Perform a walkthrough of the target company’s accounting system and test timekeeping compliance by reconciling timesheet entries to invoices.
- Review the target company’s chart of accounts structure and if it provides for an adequate segregation and allocation of costs to the correct cost pools.
- Ensure accounting policies and practices reflect and are applicable to the contract type being performed. For example, FFP contracts generally use the percentage of completion as revenue recognition, which requires calculations for costs in excess of billings and billings in excess of costs. As such, job schedules and backlogs should be reviewed.
- Ensure accurate calculations of funded backlog and unfunded backlog amounts and assess the contract pipeline.
Readers should discuss these items with legal counsel before implementing any strategies, as each deal has unique characteristics.
For further information and expertise, contact Ryan & Wetmore today.
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About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Rosie Cheng
Finance Consultant
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.