November 30, 2020
A proposed DFARS change is pending stemming from Section 845 of the FY 2021 NDAA. Our Business Systems Compliance Expert, Craig Stetson, Partner, Capital Edge Consulting provided insight into what the proposed Section 845 language could mean for you and business system adequacy determination purposes.
We invite you to watch the video below for the highlights and scroll below to read in detail Craig’s insight to help you determine how you can prepare for compliance with risk assessment approaches for business systems.
In This Video
1:02 – This revision would change whether or not a business system would be considered adequate
1:18 – Original definition was “significant deficiency”
2:17 – Applies to 6 business systems associated with government contracting
2:48 – Current terminology is not consistent with accepted standards across the industry
3:50 – The root of the change from “significant deficiency” to “material weakness”
4:28 – Differing definitions of “significant deficiency”
6:30 – How to make the changes happen
7:03 – Tiered system to judge gaps in internal control
8:12 – Several new definitions will need to be included to make this change meaningful
9:23 – The deficiencies can cause possibly significant financial with holding of government funds
10:52 – What do you as a contractor want to do to prepare?
A likely DFARS revision appears on the horizon arising from Section 845 of the FY 2021 NDAA. This revision directly affects the DFARS business system rules, implemented at DFARS 252.242-7005 and effective since February 24, 2012.
The proposed Section 845 language will change ‘significant deficiency’ to ‘material weakness’ as the criteria for use by the government for business system adequacy determination purposes.
The House and Senate still each have their own versions of proposed revisions to the original Section 845 language; the focus of which is solely on the definition of a material weakness. Consolidation of the final NDAA for signature by President Trump remains in process and is expected sometime in December 2020. So, as neither the House nor Senate appear to object to the change from a significant deficiency to a material weakness, the new material weakness criteria (however ultimately defined) looks like an immanent outcome.
Material weakness is the highest level of an internal control gap in the financial accounting and reporting world (defined by the SEC and GAAS). The purpose of the proposed change is to align the DFARS criteria with GAAS and is a January 2019 recommendation of the now-dissolved Section 809 Panel.
The Forthcoming Proposed Rule
The forthcoming proposed rule to amend the DFARS should also include several new definitions as well to allow application of the new material weakness standard in its proper context and consistent with GAAS. Otherwise, construction of revised DFARS rules focused only on the ‘material weakness’ criteria will likely result in misinterpretations and improper conclusions related to the true adequacy of contractors’ business systems and the pending contractor consequences derived from.
Applicable New Definitions
Applicable new definitions need to include ‘material noncompliance’, significant deficiency’, ‘other deficiency’ and ‘acceptable contractor business system’. All of these terms are important for inclusion in the DFARS to establish a solid foundation and provide the contractor and government with the wholistic view of considerations necessary when evaluating contractors’ business system design and operating effectiveness. These considerations need to be taken not individually and in isolation; rather, in conjunction with each other.
Internal Control Gaps
Internal control gaps are generally categorized from least to most severe as ‘other deficiency’, ‘significant deficiency’ and ‘material weakness’. Therefore, it is important to understand the full spectrum of possible internal control gaps to allow pause and judgment to reasonably assess materiality or significance and avoid jumping straight to a material weakness determination.
For example, under the potential new DFARS rules, only a material weakness would trigger an inadequate system determination and possible five percent withhold, while a significant deficiency would not.
Clearly, the lines are blurred and there is not a simple answer when an internal control gap is a material weakness or simply a significant deficiency. But, without a more comprehensive definition incorporated in the DFARS, the rules would be silent and there would be no ability to even consider a reasonable analysis or professional judgment of the difference between a material weakness and significant deficiency.
The Inherent Risk with the New Material Weakness
The inherent risk with the new material weakness standard is that its determination is based on a series of judgment calls. Reasonable thought and analysis will be required to properly categorize internal control gaps and their potential current or future effect on contractors’ government contract compliance programs, specific contracts and various financial reporting requirements to the government.
The Three Current Versions of Section 845
The three current versions of Section 845 (initial, House and Senate) contain the term ‘material noncompliance’ as the sole factor and nexus for determining if a material weakness exists. A formal definition of a ‘material noncompliance’ has not yet been proposed; however, the Section 809 Panel in their January 2019 final report offered the following –
‘A misstatement in the information provided to the Government (e.g. billings, incurred cost submissions, pricing proposals, etc.) that will materially influence, and may adversely impact the economic or management decisions of the users of the information.’
It remains to be seen what new DFARS provisions will arise and the resulting framework from which the government will utilize to review or audit contractors’ business systems. To begin preparation for the change, contractors should inform applicable personnel of the pending change, the shift to a GAAS approach when assessing business systems and internal controls and the high level of professional judgment and subjectivity inherent in the overall process.
As always, government contract compliance typically requires a robust and comprehensive level of documentation. In the business system internal controls context discussed above, it would behoove contractors to risk assess their business system compliance posture and make reasonable judgments as to the likelihood and severity of potential gaps. These analyses and resulting judgments need to be adequately documented to support downstream government inquiry, scrutiny, or audit.
Capital Edge Consulting is a professional services company comprised of adept problem solvers who deliver tangible results to address today’s most complex U.S. government contracting challenges. Capital Edge helps clients address the challenging regulatory, contractual, and compliance requirements of U.S. federal contracts and we have experience working with a wide variety of industries that provide goods or services to the federal government including industries such as biotech and healthcare, nuclear energy, education, information technology, non-profit, professional services, defense, and software.