SECTION II

PHYSICAL INVENTORY

33. Introduction. PR 15-351 and paragraph 8 of PR 15-936 provide that the contractor's inventories be taken in accordance with the instructions contained below.

a. The procedures described in this section have to do with the taking and recording of a physical inventory of materials, supplies, and other property applicable to the contract as of the date of termination.

b. Even when the total cost method is used by the contractor in presenting his proposed settlement, it is desirable that the inventory be priced, so far as this can be done with reasonable accuracy. Such pricing of the inventory will assist the contracting officer in passing upon the propriety of disposal prices.

34. Organization for Inventory Taking and Pricing. The contractor should prepare and put into effect inventory instructions appropriate to the size and complexity of the inventory. The instructions should cover the following points:

a. The designation of the persons responsible for the supervision of the inventory taking.

b. The physical arangement and location of the inventory. These instructions should indicate that materials should be arranged in accordance with natural classifications such as raw materials and work in process. All parts and subassemblies in process should be grouped according to condition and last labor operation performed. Spoiled and defective items should be segregated, as should finished units to be delivered as completed units under the terms of the contract.

c. The accurate and complete description of items and their stage of completion.

d. The checking of the original counts and transcription of original counts to summary sheets.

e. The accounting for inventory tag or sheet numbers before distribution and after collection.

f. The recording of the names of employees who make the original counts, check the original counts, and, if the inventory is priced in detail, price the inventory, check the pricing, make the extensions and footings and check the extensions and footings.

g. The accounting for materials consigned to others for processing.

h. The pricing of the inventory, when this is required. The contractor's procedures for pricing should be in accordance with policies consistently followed in the past. Any acceptable pricing basis may be used, such as first-in, first-out, average cost, or last-in, first-out, as long as it has been consistently followed. Care should be taken that cash discounts, trade discounts, special rebates, and similar price reductions have been reflected in the inventory pricing either in the detail prices or as a single over-all deduction from the total of the inventory.

SECTION III

DISPOSAL CREDITS

35. Introductory. PR 15-357 provides that the contractor's records shall clearly show all sales, with specific detailed identification of the items sold and the individual sales prices. It also states that the contractor's procedures should provide for the separate invoicing of sales and the crediting of these amounts in the proposed settlement, so that such transactions may be traced to the inventory records and the final settlement.

36. Sale of Property to Others.

a. Such sales will ordinarily be made after cessation of operations on the contract and the taking of a partial or complete physical inventory.

b. Any loss on the sale of property approved by the contracting officer will be borne by the Government, although not affecting the gross amount of the proposed settlement. The contractor's procedures should provide for supplying adequate information to enable the contracting officer to pass upon the proposed sale.

37. Retention of Property by Contractor. The values agreed upon by the contracting officer and the contractor for items of the inventory to be retained by the latter are to be shown on the inventory records so that reconciliation may be made with the final settlement records.

SECTION IV

CLAIMS OF SUBCONTRACTORS

38. Introduction.

a. PR 15-431 provides that it is the primary responsibility of the contractor to review or

examine in an appropriate manner all claims of subcontractors arising out of the termination. The problem faced by the contractor's accounting personnel in making the accounting review or examination of claims of subcontractors is similar to the problem faced by the Government auditor with respect to the proposed settlement of the prime contractor. A review or examination of each claim is necessary to some extent.

b. The contractor in this respect should be held to the standard or scrutiny that a businessman would employ in the conduct of his own affairs, but is not required to warrant the accuracy of the facts presented by subcontractors. A certification by the contractor that, upon the basis of his review or examination, he is of the opinion that the claim is fair, just, and reasonable will suffice. (See certificates included in standard termination forms, pars. 28 to 32.)

39. Office Review of Proposed Settlement by Contractor's Accounting Personnel.

a. As a minimum, an office review should be made by qualified accounting personnel of the contractor of each statement submitted by a subcontractor in connection with a fixed-price contract termination.

b. In making the office review, the steps outlined in paragraph 8 should be used as a guide.

c. The accounting personnel will furnish suitable written evidence of the conclusions of the office review.

40. Records of Accounting Reviews. A copy of any report by accounting personnel covering an office review or field examination should be retained in the files of the contractor receiving the claim, together with a copy of the subcontractor's settlement proposal, so that these records will be available to Government accounting personnel if needed by them in making any subsequent review requested by the contracting officer.

41. Appropriate Extent of Examination Beyond Office Review.

a. It is the contractor's responsibility in the first instance to determine what further examination, if any, should be made of the subcontractor's proposed settlement beyond the office review. In making this decision, the following should be considered:

(1) Amount and complexity of the proposed settlement.

(4) Any information available from personnel having contacts with the operations under the subcontract.

b. The contractor should then determine the further examination, if any, which is to be made. The following steps are illustrative:

(1) The subcontractor may be requested to submit additional data or explanations in writing.

(2) Accounting personnel of the contractor may be instructed to visit the subcontractor's plant to discuss the statement and, in some cases, to make any necessary reference to the accounting records.

(3) An audit may be made by qualified accounting personnel of the contractor in accordance with the procedure outlined in chapter 3. 42. Responsibility of Subcontractors. It is the responsibility of subcontractors in each case to prepare their claims accurately in accordance with the terms of their respective contracts when they are presenting such claims to contractors or to intermediate subcontractors. While an individual subcontractor does not make a certification of fact directly to the Government, Procurement Regulations provide that the contractor should advise all subcontractors that the statement of charges submitted by them may be subject to an audit by Government auditors and that an inspection of the supplies and materials covered by the purchase order or subcontract may be made by a Government inspector (PR 15-912.2). The subcontractor is put on notice that his claim will be used by the contractor in compiling the latter's proposed settlement either directly with the Government or through another contractor. 43. Statement of Principles for Determination of Costs. The Statement of Principles for Determination of Costs upon Termination of Government Fixed Price Supply Contracts, quoted in paragraph 24, is applicable to subcontractors' claims, subject to any specific terms of the subcontract.

44. Subcontractors' Inventories. The contractor should ascertain that the subcontractors have taken physical inventories of materials pertaining to the terminated contracts substantially in the manner outlined in paragraphs 33 and 34.

32

SECTION I

GENERAL

45. Purpose of Administrative Audit.

a. The purpose of the administrative audit of a contractor's statement of a proposed settlement is to determine that it is in accordance with the termination provisions of the contract and is substantiated by the contractor's records and other supporting evidence. The role of the auditor is to carry out appropriate auditing procedures to establish the reliability and accuracy of the data submitted by the contractor and thus provide the contracting officer with a factual basis for making a settlement.

b. The major audit objective should be to determine that the costs included in the contractor's settlement proposal are accurately presented in accordance with the terms of the contract and the principles set forth in this manual. Another important objective may be to check the accuracy of the information presented by the contractor with respect to profit.

46. Flexibility of Audit Program. The audits actually made will vary as to the program followed. Not all of the procedures prescribed in this manual are applicable to every audit. On the contrary, it is intended that the auditor select in each case only the procedures which are appropriate and necessary in the individual circumstances, and that he apply them with judgment and without consuming time not necessary to protect the interests of the Government.

47. Preparing Audit Program. The audit program should be developed in accordance with the procedures set forth in this manual, based upon the nature and composition of the proposed settlement and the contractor's system of internal control. The nature and scope of the audit program should also depend upon the completeness of the accounting data available.

48. Type of Audit To Be Made. The audit, made in connection with the termination of a fixed

price supply contract at the option of the Government, has several major aspects:

a. Detailed checking is to be kept at a minimum. Reliance is to be placed upon the system of internal control, so far as practicable, and major emphasis is to be placed on establishing the reliability of the bases of the individual elements of cost.

b. The costs incurred near the date of termination (as soon as termination might reasonably have been expected) are to be given special attention.

c. Special emphasis is to be placed upon the principles of accounting applied by the contractor and practices based thereon.

d. The auditor is especially concerned with the accuracy of distribution of costs between the contract and other work.

e. It is also important that the auditor consider constantly the adequacy of his program in the light of his day-to-day findings. Where particular checks disclose errors or irregularities, the scope of the audit must be extended to protect the interests of the Government.

49. Examination of Contractor's Internal Control. a. When the auditor begins his audit of the contractor's proposed settlement, he should first study the individual items included therein and, taking into consideration the amounts involved and the nature of the items, should appraise the complexity of the audit problem. Every item in the statement inescapably involves the contractor's internal control, since the data submitted are based upon underlying papers and records which have been handled by personnel of the contractor. Closely related also are the accounting policies followed by the contractor in maintaining his accounts and developing his proposed settlement. However, there will be considerable variation as to how involved the internal procedures may be which relate to the particular items, and also as to the extent that reliance may be placed upon those internal procedures.

b. In situations where the contractor's proposed settlement is such that the items are not

of a complex nature and can be checked individually, there is less dependence upon the internal procedures of the contractor. In such cases, the auditor need not make a separate review of internal control and can proceed immediately with his audit of those items. He will make inquiries with respect to physical operations, accounting policies, and all related internal procedures at the same time that he carries out his auditing. The examination of the internal procedures is thus interwoven with the audit program and is carried out in a way to satisfy the auditor as to the accuracy of the individual elements of the contractor's statement.

c. In other situations, the items will be of such size and complexity and involve such detail that, instead of making an audit on a direct basis, the auditor must first make a systematic review and appraisal of all, or a substantial portion, of the contractor's system of internal control before he proceeds with his regular audit program. The review of internal control should, in such cases, also be preceded by a brief survey of physical operations, and a statement of accounting policies should be obtained. Working papers should likewise be prepared in which the auditor will set forth the nature and scope of the review and the conclusions. With this preliminary work as a background, the auditor should then proceed with his regular audit in accordance with the principles of selective auditing.

50. Reliance on Audit of Independent Public Accountants. In many contractor organizations involved with terminations, there have been regular audits by independent public accountants. These audits deal to a considerable extent with the system of internal control and otherwise establish the general credibility of the contractor's records and accounts to a substantial degree. The Government auditor should give consideration to this work in reaching a decision as to the extent of the review of the internal control which will be necessary.

51. Use of Reviews of Internal Control Made on CPFF Audits. In certain cases, the contractors involved in terminations will also have had CPFF contracts, and reviews of internal control will therefore have been made in accordance with the audits incident to those contracts. Such reviews should be utilized by the auditor

to the extent that they are appropriate for the present purposes.

52. Emphasis on Distribution. It should be recognized that the internal procedures which involve the distribution of costs as between the contract and other work are of special importance. While the auditor must always be concerned with evidence which establishes the fact that the basic transactions are bona fide, the risk that the recorded transactions are false is ordinarily less than the risk that the allocations or distributions of the results of these transactions are not based upon sound principles or are not accurately handled in accordance with sound principles. The auditor should therefore give special attention to all parts of the internal procedures which bear on these distributions.

53. Supplementary Data for Use in Audits.

a. In making an audit of the proposed settlement, such data as the following, if relevant, should be used to the extent available:

(1) Cost estimates used in connection with original bid.

(2) Engineering or other estimates of cost. (3) Statistical computations of cost. (4) Reports of independent public accountants available in the files of the contractor. (5) Federal income tax returns.

(6) Minutes of conferences with Price Adjustment Boards.

(7) Data parepared by cost analysis sections of any War Department agency, the Navy Department, or Maritime Commission.

b. It is important to be sure that the data used are compiled according to the same general classification as is shown by the contractor's proposed settlement; the same types and kinds of costs should be included.

c. The auditor should familiarize himself with the terms of the contract, paying particular attention to the terms covering such subjects as free issue materials, Government-furnished equipment, and price redetermination. He should also review all pertinent correspondence bearing on the performance of the contract.

54. Applicability to Subcontractors. The claim of a subcontractor against the prime contractor is similar to the statement of the prime contractor submitted to the Government. The principles and procedures set forth in this chapter for audit of the proposed settlements of prime contractors are equally applicable to the