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claims of immediate and remote subcontractors. The Statement of Principles quoted in paragraph 24 is applicable to the computation of costs in connection with subcontractors' claims, subject to any specific terms of the subcontract affecting costs.

55. Responsibility of Auditor. It is the auditor's responsibility to satisfy himself as to the validity of the data submitted by the contractor. At the same time, it should be recognized that a prompt settlement is desirable in the interests of both the Government and the contractor. Every effort should therefore be made by the auditor to complete his examination without undue delay and with the minimum amount of detailed verification consistent with protecting the interests of the Government.

56. Direction of Audit Effort.

a. The auditor should direct his work in a manner which protects the Government's interests most effectively. The selective method of audit should be applied to the greatest possible extent in the case of those classes of costs concerning the inclusion of which there is ordinarily no question.

b. There should be a more extensive review of other classes of costs concerning the inclusion of which there may be some question. The auditor's working papers should include the analysis of such accounts to disclose the nature of the costs included and their applicability to the contract. Examples of these accounts are executive compensation, depreciation, repairs, donations, and professional services.

c. Special attention should also be given to items which are large in amount, uncommon in nature, or which, because of other circumstances, appear particularly to concern the Government's interests. All unusual matters are to be followed through to a final conclusion.

d. Particular attention should be given to accounts which might contain costs specifically excluded by subparagraphs 3 (a) through 3 (e) of the Statement of Principles for Determination of Costs, set forth in paragraph 24.

57. Audit of a Particular Portion or Phase of the Transactions. In the audit of a given portion of the transactions or phase of the operations, there are certain important requirements to be observed:

a. The portion or phase examined is to be representative of the total group from which it is selected. The selection must be made without regard to convenience or availability of data or to difficulties involved.

b. The portion or phase selected must be checked out completely and without exception. c. To be effective, the selective auditing procedures must be carried out only after the contractor has completed his accounting distribution and record and has submitted his proposed settlement based on that record.

d. The papers and records of the contractor which are applicable to the portion of the transactions under review must be controlled by the auditor until the examination of the particular portion is completed.

e. If the portion audited indicates numerous errors, the scope of the examination must be extended to a detailed check of that phase of the accounts.

58. Representative Number. In this manual, the term "representative number" is frequently used in respect to selection of groups of transactions for auditing. The interpretation of the term is a matter of individual judgment and will depend upon the particular circumstances in each case. In general, however, the factors to be considered in given situations will include dollar amount of items, points of origin, classes of items, departments involved, etc. In all cases, the objective is to obtain a sufficient cross section to justify reliance on the validity of the transactions of the group under examination.

59. Discussion of Accountant's Conclusions With Contractor. In carrying out his work, the accountant will make all inquires necessary to pass upon the accuracy of the items in the statement and will afford the contractor full opportunity to make explanations and furnish additional information concerning items which in the accountant's estimation are questionable. Otherwise, the accountants should communicate his findings and conclusions only to the contracting officer for his use in negotiating the settlement. Under no circumstances should the accountant purport to commit the contracting officer in any way as to the negotiation of the settlement.

60. Working Papers. It is essential that adequate working papers be prepared as the audit

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a. The purpose of these procedures is to establish the credibility of the physical inventory taken at date of termination, including quantities, applicability to the contract, and, if the inventory is priced, the basis and mathematical accuracy of the pricing.

b. The physical verification of inventory quantities will normally be made by Government personnel who are engaged in property disposal activities or who are stationed at or visiting the contractor's plant. Government accounting personnel should utilize the results of such verifications and in addition should obtain information from Government engineers, inspectors, and others having any familiarity with inventory matters in connection with operations under the contract. Instructions to the accountant relating to the physical verification of inventory are for application when it is necessary that accounting personnel perform that function.

c. When the contractor's settlement proposal is presented on the inventory method, it is especially important to check the physical existence of the items of inventory listed. The importance of such a check lies in the fact that errors in quantities will require in all cases an adjustment of the proposed settlement.

d. When the contractor's proposed settlement is presented on the total cost method, the auditor will direct his checks to a greater extent toward ascertaining that all inventory is listed. Greater emphasis must therefore be placed on over-all checks as outlined in paragraphs 84 and 88. Errors may be found by a physical check of the quantities listed, which will require adjustments of the proposed settlement in those cases where they indicate errors in the accounting records.

e. Before determining the audit program and initiating the audit, the auditor will obtain and keep under his control at least one copy of the detailed physical inventory.

f. The audit program will be based upon the review of the contractor's procedures and will

be expanded when deficiencies disclosed by the audit indicate the necessity of more extensive checking.

g. The audit procedure will be extended to inventories of supplies, tools, etc., when they are an important factor in the contractor's proposed settlement.

62. Quantities.

a. Independent physical checks will be made of the quantities shown on the inventory sheets for a representative portion of the inventory. In determining a representative portion, consideration will be given to the following factors:

(1) Money value of items.

(2) Class of inventory, that is, raw material, purchased parts, work in process, and subdivisions under these classes, such as types of material.

(3) Physical location of the items.

b. A record of the extent of the check will be made by appropriate notations on the Government's copy of the contractor's inventory sheets, or on separately prepared schedules. All differences of appreciable amount should be investigated and errors adjusted.

c. Steps should be taken by the Government representative to see that no part of the inventory is physically moved except with his approval during the course of the quantity check.

d. Material on consignment to others for processing should be checked to an appropriate extent by direct communication with the consignee or by physical inspection.

e. The inventory description in respect to stage of completion of the items checked should, where practicable, be compared with the physical condition of the particular items. Notation of the last labor operation performed is essential in checking the pricing of work in process.

f. Since the date of physical check will ordinarily be after the date of termination, appropriate checks should be made for reconciling the physical count with the quantities shown in the inventory at the date of termination, by considering dispositions made with the approval of the contracting officer or other changes during the intervening period. For this purpose, copies of sales invoices, shipping reports, etc., should be utilized, as well as information obtained directly from the contracting officer.

63. Pricing.

a. If the contractor's settlement proposal is submitted on the inventory method, the reliability of the unit cost data should be established in accordance with the procedures set forth in section III of this chapter.

b. The following checks for mathematical accuracy should be made:

(1) A representative portion of the individual item extensions should be checked.

(2) A representative portion of the page totals should be footed.

(3) All sheet totals should be traced to the summary and the summary should be footed.

64. Applicability to the Contract.

a. For the purpose of determining the propriety of costs charged to the contract, a representative portion of the inventory items will be checked (regardless of whether the inventory has been priced) to ascertain if any items are included which are

(1) Not in the specifications and therefore not applicable to the contract. If such items are found by a selective check, a more extended check must be made to discover other such items. All costs of these items will be excluded.

(2) Applicable to the contract in part, but applicable also to other work because they are common items. If items of this nature are disclosed, their costs may be included only to the extent that the quantities of such items have been properly allocated between the contract and other work.

b. In checking the existence of inapplicable or common items, the auditor should utilize the services of Government engineers and other qualified Government personnel who are available. If he cannot obtain such assistance, he should make observations to the extent practicable of the physical materials and parts used in the performance of the contract and other work. He also should select a group of representative inventory items and determine whether these items are used on other work by reference to material control records, purchase records, stock records, etc.

65. Finished Units.

a. The auditor should determine that finished units on hand but not yet billed are properly segregated and not included in the inventory as work in process.

b. It is important that the quantities of such units (or parts applicable thereto) are in agreement with the quantities shown in the schedules submitted by the contractor covering total units completed at contract price. It should be determined that all finished units on hand have been subjected to the same inspection and acceptance requirements as previous shipments.

66. Reconcilement of Disposal Quantities With Inventory Quantities. At the time of settlement the auditor should reconcile, to the maximum extent practicable, the quantities listed in the inventory schedules submitted by the contractor with quantities the dispostion of which is evidenced by disposal credits or records of items taken over by the Government. This reconcilement may indicate discrepancies in the original inventories which will require adjustments in the charges of the contractor.

SECTION III

EXAMINATION OF UNIT COST DATA

67. Introductory.

a. When the inventory at date of termination, priced in detail, is the primary basis of the proposed settlement, it is necessary to establish the general credibility of the unit cost data which are the basis for inventory pricing. The procedures outlined herein are a guide for this purpose.

b. The priced inventory will ordinarily consist of raw materials (including purchased parts) and work in process. In most cases, the work in process will be priced separately for the material, direct labor, and overhead elements, but in any event it will be necessary to check each such element separately.

c. The pricing must be consistently applied on the basis of an acceptable method, such as first-in, first-out, average cost, or last-in, firstout. Where the pricing is based on standard costs such cost, to be acceptable, must not be in excess of actual costs.

68. Raw Materials. Where materials or parts have been purchased, the accuracy of the prices used in the inventory pricing should be established by selective checking of a representative number of items to purchase invoices, together with purchase orders where necessary. No addition to the invoice cost of materials is permissible for handling, etc., unless the general

accounts provide for the computation and segregation of such overhead as applied to all materials.

69. General.

WORK IN PROCESS

a. Data in respect to unit costs of work in process may have been compiled on any one of the following bases:

(1) Statistical costs. Not controlled by general ledger accounts but estimated with varying degrees of care, ranging from rough approximations not in detail to carefully established costs based on thorough engineering studies.

(2) Controlled costs. Subject to control and check by general ledger accounts. Controlled systems may be either historical (actual), in which costs are compiled from accounting records of actual costs incurred, or standard, in which costs are based on specifications, planned manufacturing methods, rates of production, and anticipated prices.

b. The extent of the audit of the unit cost data will depend upon the complexity of the product. If the direct material content, for example, is relatively simple, it will be practicable to check substantially every item of an appreciable amount. If it is complex and consists of a large number of items, a selective check may be used, provided that if important errors are discovered a more intensive or even a complete check will be made in accordance with the principles of selective auditing. The extent of the checking of the direct labor element will be similarly determined.

c. The auditor should make full use of all factory cost reports, including those reports which cover the operations of individual departments and cost centers.

d. Unit cost data, used to price work in process, which are statistical and not controlled by the general ledger accounts, are ordinarily less reliable and should, as a general rule, be subjected to more extensive review and check.

e. A formal list of purchased and manufactured parts and subassemblies entering into the completed product should be obtained by the auditor, preferably from Government sources. If obtained from the contractor, it should be reviewed and checked by a qualified Government representative.

70. Material Content.

a. With respect to prices the problem is similar to establishing the accuracy of prices used

for the raw material inventory. The material cost per part (or other unit) may, however, be predicated on a material quantity per part which includes cutting waste and production spoilage. It is necessary for this reason, as well as the ordinary possibilities of error, to check the quantity basis used for the unit material cost.

b. The quantity basis of the material element of unit costs may be checked by reference to engineering specifications or satisfactory records may be available showing the quantities of material actually used in the manufacture of each part. In the latter case, reference can be made to summaries of material requisitions, the requisitions themselves, and records of production of good pieces of particular parts.

71. Direct Labor Content-Controlled Historical Cost System.

a. If a controlled historical cost system is in effect, the unit labor costs may be stated only in terms of money without showing the labor time. per unit and the hourly rate applicable thereto. The labor cost of pieces spoiled in production will generally be reflected in the parts costs of good pieces made.

b. The auditor will make appropriate selective checks of summary labor cost statements and the underlying labor distribution tickets to determine their credibility and the accuracy of reported production quantities.

c. If periodical statements of unit direct labor costs were prepared by the contractor during the life of the contract, such statements should be reviewed for fluctuations in unit costs. The extent of the fluctuations and the general trend in such costs will aid the auditor in determining the direction and extent of the selective check.

72. Direct Labor Content-Controlled Standard Cost System.

a. If a controlled standard cost system is in use, the unit labor costs will commonly be stated in terms of standard direct labor time per unit, a standard labor rate per hour, and the resulting standard unit labor cost. A standard allowance may be added for the labor cost of pieces spoiled in production.

b. Routing or operation sheets will ordinarily be available for each part and subassembly showing the authorized labor operations to be performed on each. A selective test of the standard time for the individual operations should

be made by reference to the latest underlying approved time study reports.

c. Standard hourly labor rates should be appropriately checked by reference to approved occupational rate schedules or employment and pay-roll records.

73. Direct Labor Content-Historical and Standard Cost Systems. The operations shown as direct labor in all cost sheets should be reviewed to an appropriate extent to determine that such operations are classified as direct labor in the accounting distribution of the pay roll.

74. Overhead.

a. The accuracy of the overhead content of the unit cost data is primarily a problem of the general content of overhead and the computation of rates. (See section IV of this chapter.)

b. The auditor should be satisfied, however, by appropriate tests that the overhead rates have been acurately applied in the unit cost data used.

75. Mathematical Accuracy.

a. Appropriate checks should be made of the mathematical accuracy of the cost data.

b. Certain industries may present special problems in this regard. For example, particular attention should be given to the carrying forward of parts costs into subassembly and final assembly cost summaries. Parts costs frequently are stated in terms of 100 units and are converted into costs per subassembly or per completed product when carried forward. Particu lar attention should be directed toward selective checking of these conversion computations.

SECTION IV

EXAMINATION OF GENERAL ACCOUNTS AND UNDERLYING RECORDS

76. Introductory.

a. In the case of proposed settlements submitted under the total cost method, it will be necessary to establish the general credibility of the accounts and records from which the total costs are obtained. The procedures outlined herein are a guide for this purpose. This section is also partially applicable to proposed settlements on an inventory basis, since paragraphs 89 to 93, inclusive, cover the examination which should be made in order to determine that the overhead allocations, included in the unit

cost data used in pricing work in process are proper.

b. Where auditing has been carried on in connection with CPFF contracts with the same contractor, a considerable part of the work previously done may be utilized for the present purposes. This is particularly true in the case of the overhead accounts and to a substantial extent with respect to pay roll distribution. The instructions set forth in this section are necessarily written in terms of a situation where no previous auditing has been done, but the possibility of utilizing previous findings should be kept in mind.

77. Adjusting Journal Entries.

a. All adjusting journal entries affecting the recorded contract cost in any substantial amount should be reviewed as to their nature, accuracy of computations involved, and general propriety.

b. Special care should be exercised with respect to entries which were made in the period or periods just preceding the date of termination or at any time subsequent to that date.

c. Where adjusting entries were made by the contractor to bring book records into agreement with physical inventories, either at date of termination or preceding year ends, these adjustments should be carefully studied as a guide to the general effectiveness of the related internal accounting procedures.

DIRECT MATERIAL COSTS

78. General Objective. The auditor should determine that the amount shown for direct material costs represents materials actually used on the contract or still on hand and which are fairly applicable to the contract at the cost incurred by the contractor.

79. Analysis of Materials Account.

a. The starting point is the general ledger or subsidiary account which shows the total direct material costs applicable to the contract. Where no such account has been kept, the work sheet analyses used when the contractor presented his proposed settlement must be utilized. b. The debits and credits to the account or work sheet schedule should be classified by source of posting. By this procedure those entries originating from the more usual sources such as purchase distributions, summaries of

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