Compliance: no exception for government contractors.

Commercial suppliers of nondefense products and services must also comply with acquisition regulations.

When they think of government procurement, most people picture multibillion-dollar weapons systems. Media coverage of the termination of large defense contracts reinforces this perception, as did the Persian Gulf War. Admittedly, defense is the largest sector of government procurement and is the focus of the American Institute of CPAs audit and accounting guide, Audits of Federal Government Contractors. However, a number of commercial suppliers provide nondefense products and services to the federal government. It is critical for practitioners auditing these companies and for corporate financial executives to be familiar with the government's system and control requirements if they are to operate successfully in this area.

All federal procurement of supplies and services is governed by a precise set of acquisition regulations outlining the framework within which the government and its contractors or prospective contractors operate. The federal acquisition regulation (FAR) is the principal system. Many departments and agencies, such as the Department of Defense and the General Services Administration (GSA), supplement these rules with their own special requirements. All pertinent regulations are available in Code of Federal Regulations (CFR) form from the Superintendent of Documents, Government Printing Office, Washington, D.C. 20402.

Nondefense government contractors often are lulled into a false sense of security; they fail to realize how pervasive the regulatory aspect of government contracting can be. Regulations and requirements apply no matter what product or service a company sells to the government. The chief financial officer of a company selling fighter planes no doubt understands the rules, but the CFO of an office supply company may not recognize the need for strict compliance. This article's purpose is to clarify this confusion, both for independent auditors and for executives with operational and oversight responsibility.

FEDERAL SUPPLY SCHEDULE PROGRAM

The federal supply schedule program (FSSP) is authorized by FAR part 38. Managed by the GSA, the program provides federal agencies with a simplified means of acquiring commonly used supplies and services, including office furniture, copiers, hand tools and computers.

As the primary buyer for all agencies, the GSA tries to obtain the lower prices associated with volume purchases by awarding contracts from which individual agencies fulfill their needs. The Veterans Administration is an exception; it has been authorized by the GSA to award federal supply schedule contracts for medical, dental and veterinary supplies. In doing so, the VA has adopted GSA policies, procedures and forms.

Under the program, ordering agencies

* Issue orders directly to contractors.

* Receive shipments.

* Pay contractors.

* Administer individual orders.

Contracts are awarded in two ways: by sealed bid and by negotiation. In both cases they are listed according to product type and are commonly referred to as schedules. Sealed-bidding procedures allow the government to award contracts solely on the basis of the lowest price offered by a qualified supplier. Companies awarded schedule contracts by sealed bid do not have to comply with the rules governing negotiated contracts.

For negotiated contracts, the offeror submits a proposal that is the basis for price negotiations. The process results in an agreement between the supplier and the government. These are "bread-and-butter" products with recognized brand names.

Four types of schedule contracts are awarded:

* Single award schedule.

* Multiple award schedule (MAS).

* New item introductory schedule.

* International federal supply schedule.

The principal means of contracting is through the MAS program. This article focuses on MAS contracts because they are highly complex and demand compliance with preaward (for the offeror) and post-award (for contractors) disclosure requirements. Strict compliance is mandatory because GSA auditors have increased their contract audit activity of FSSP contractors. The GSA has been successful in obtaining multimillion dollar refunds when contractors fail to comply with applicable procurement rules. In some situations, civil and criminal penalties have been imposed.

MAS COMPLIANCE

Preaward disclosures. The heart of the preaward disclosures is found in the discount schedule and marketing data (DSMD) form, which is part of the solicitation, offer and award document obtained from the issuing office or buying center. The document contains all forms necessary to prepare a GSA offer. The DSMD form requires discount information on six customer classes:

* Dealers-retailers.

* Distributors-wholesalers.

* Education institutions.

* Original equipment manufacturers (OEM).

* State, county and local governments.

* Others (including national accounts).

Among other things, the DSMD form requires disclosing the highest discount offered each customer class on any product or model within a particular special item number (SIN). A SIN is given by the GSA to designate specific product categories on a schedule. For example, SIN 476-11 is aerosol disinfectants; SIN 476-13 is liquid disinfectants. The DSMD form also requires disclosing sales data on products.

The MAS policy statement of October 1, 1982, which gives the GSA's objective in negotiating contracts, says, "The Government's goal when negotiating MAS contract pricing arrangements is to obtain a discount from a firm's established catalog or commercial price list which is equal to or greater than the discount given to that firm's most favored customer [MFC]. The MFC discount is equal to the best discount given by a firm to any entity with which that firm conducts business, other than the . . . OEM . . . discount."

The statement also says the "GSA will not award an MAS contract to a firm that does not give the Government a price equal to the best price given or available to its large volume end user customers with comparable terms and conditions except where the Government's overall volume of purchases does not warrant the best price."

Commerciality. Commerciality is relevant because this attribute must exist to qualify for an exemption from submitting cost or pricing data. These data refer to the composition of the offered price by detailing individual cost elements such as labor, material and overhead plus profit. Commerciality means

* The price of the items sold is based on established catalog or market price.

* Those sales are substantial and made to nongovernment entities. FAR 15.804-3(a)(2) says cost or pricing data are not required when prices are "based on established catalog or market prices of commercial items sold in substantial quantities to the general public."

Established catalog price (less published discount) means a price recorded in a regularly maintained form such as a catalog, price list or schedule. Market price is determined by buyers and sellers free to bargain and must be substantiated by independent data. Sales are considered substantial based on a ratio test, which divides sales into three categories:

A. Sales to the U.S. government or to contractors for U.S. government use.

B. Sales to the general public at the catalog price.

C. Sales to the general public at other than catalog prices.

FAR 15.804-3(f)(3)(i) says sales to the general public are normally regarded as substantial if

* Category B and C sales are not negligible in themselves and equal at least 55% of total sales of the item.

* Category B sales equal at least 75% of the total of category B and C sales. An illustration of such a calculation can be found in exhibit 1, above. At present there is a proposed revision to the FAR that would change the ratios. Despite this, the principle illustrated in the exhibit remains the same.

Preaward certifications. It is evident the government intends to rely on the discount data supplied by the offeror in the preaward stage for negotiating the contract price(s). It is critical the data supplied be accurate, complete and current. Should the data prove to be otherwise, they are considered defective. The government may then make a downward adjustment in price under the provisions of the "price reduction for defective pricing data" clause.

Additionally, the offeror is asked to certify the commerciality of the offered items. Should the items later be found not to be commercial, the offeror will be required to submit relevant cost or pricing data. For any items sold, the government may request a refund for the difference in the negotiated price (based on sales and discount data) and the data-supported price.

Price reduction for defective pricing data. All MAS contract solicitations contain a clause (FAR 52.215-22) entitling the government to reduce the contract price if, subsequent to the award, it learns it relied on defective contractor data in negotiating that price.

In the certificate of established catalog or market price, the offeror certifies to the best of his or her knowledge

* Prices quoted in the proposal are based on established catalog or market prices of commercial items, as defined in FAR 15.804-3(c), in effect on the date of the offer or of any revisions.

* Substantial quantities of the items have been sold to the general public at such prices.

* All data (including sales data) submitted are accurate, complete and current representations of actual transactions. The certificate also contains a warning that false statements may subject the offeror to penalties.

Experience shows the last item, data, usually proves the most troublesome in terms of potential liability. An example is when the government negotiates a discount from list price in the erroneous belief, based on the information supplied, that it achieved the same discount as the offeror's MFC. Exhibit 2, page 99, illustrates the adjustment made in such circumstances.

Postaward disclosures. Disclosures required during contract performance cover contract price reduction and government orders and sales. Contractors are required to report to the contracting officer (the government official who authorized and administers the contract) all price reductions granted to other government or nongovernment customers. The schedule contract item price may then have to be reduced accordingly. Contractors also must report to the contracting officer all orders received under the contract. This is usually done on a quarterly basis.

By far the most critical postaward disclosure involves price reduction. This type of price reduction should not be confused with the previously described defective data reduction. Price reductions can be classified as (1) those to customers other than federal agencies and (2) those to federal agencies. The nongovernment customers are described first.

The 1982 GSA policy statement requires all MAS contracts to contain a price-reduction clause designed to maintain the price relationship that existed between the government and the identified customer category at the time of the original award. A price reduction is any change in the commercial pricing arrangement that disturbs this relationship and places the government in a less advantageous position. Exhibit 3, page 100, illustrates a price reduction calculation triggered by a lowering of prices.

The clause also covers price reductions granted to federal agencies. It specifies that when the contractor gives a federal agency a price lower than the schedule contract price for the item, and the order is within the maximum order limitation (MOL), an equivalent price reduction applies to all subsequent sales. The MOL is a contractual upper dollar limit set on individual contract orders the buying agency can place. A MOL of $10,000, for example, means no orders above this amount should be placed by the government or accepted by the contractor.

Postaward certifications. Within 10 calendar days after contract end, the contractor is required to execute a contractor's statement of price reductions, certifying either (1) there was no applicable price reduction or (2) any price reduction was reported to the contracting officer. A strict reading of the price-reduction clause provisions requires the contractor to report price reductions granted to all customer classes, not just those granted to the identified customer class.

FSSP SYSTEM AND CONTROL REQUIREMENTS

Key to a successful compliance system is an accounting system with the following five capabilities:

1. Customer classification system. To disclose discounts by the customer classes specified in the DSMD form, customers must be properly categorized. A company must establish classification definitions that are clear and concise. It should adopt a data format for information from current and future customers and have a separate category for product sales to government users.

2. Product discounts by customer class. This capability is critical. The discount level disclosed in the DSMD form must be accurate, complete and current, because the company is required to certify it as such. If the data subsequently are found to be faulty, the government is entitled to the previously described downward price adjustment. The discount data submitted by the company are subject to the GSA's preaward and postaward audit.

3. Approval, monitoring and quantification of price reductions. Since price reductions provided other customers must be reported, there must be a system to monitor, report and assure the processing of only management-authorized price reductions. The system also should be capable of quantifying price reductions from rebates, credits and special pricing promotions.

4. Catalog or market price of products. To provide management with reasonable assurance the offered items meet the commerciality test, the system should be able to select individual product sales data on the basis of identified customer end user and determine if in fact sales were made at catalog price.

5. Order entry and processing. The order entry and processing function is important because it is the source of the data needed to ensure compliance. The system must be capable of producing summary data in a statistical fashion encompassing

* Identifying and quantifying discounts from list prices granted to each customer class.

* Identifying price list(s) used to compute discount percentages.

* Identifying and reporting deviations from appropriate discount levels.

* Processing only properly approved price deviations.

* Maintaining product prices negotiated under FSSP contract in order to assure proper billing.

* Identifying orders placed by government agencies and other authorized users of the schedule under contract.

CIVIL AND CRIMINAL PENALTIES

The government frequently performs preaward and postaward audits of MAS contracts. Alleged contractor misstatements found in the preaward stage usually are cleared up with the contracting officer during the negotiation process. The more bothersome are alleged misstatements found in a postaward audit. "Postaward" is the period after the contract has been awarded or, as most often happens, the contract is over. If the government believes it was overcharged because it relied on defective data, it will request a refund.

Lately the Justice Department has pursued these refunds under the False Claims Act, under which each claim for payment (an invoice) under a defectively priced contract is a separate false claim with the potential for a separate penalty. The penalty for each violation can be between $5,000 and $10,000 per claim. The government also can recover three times the damages it sustains and may seek criminal and civil penalties.

DISTINCT MARKETPLACE

Commercial product sales to the government are no different from sophisticated weapons systems sales to the armed services. Selling through the FSSP represents a distinct marketplace with its own peculiar rules and regulations. Just as the independent auditor of a defense contractor must be familiar with the environment in which it operates, so must the auditor of contractors selling commercial products to the government. Failure to comply could lead to loss of the contract or expensive litigation.

The FSSP operates in a regulated environment that must be understood and appreciated. Lack of compliance can have a direct effect on financial statements. It is in a company's best interests, as well as the outside auditors', to be informed so audits are properly focused and CPAs can render sound advice and service.