CHAPTER 5
Audit Rights

Many companies’ terms and conditions take the liberty of allowing them the opportunity to conduct an independent audit of seller’s time tickets, clock cards, actual labor rates, labor classification and employment records, and other proprietary information. The following example is a standard audit clause found in many contracts. Given the level of risk associated with audit rights clauses, seller should pay particularly close attention to them.

Sample audit right clause: Seller shall maintain complete and accurate records supporting all services performed, allowances claims, and costs incurred by seller in the performance of this contract including, but not limited to those factors which comprise or affect direct labor hours, direct labor rates, material costs, burden rates, and subcontracts. All such records and other physical data, as required, shall be capable of verification through audit and analysis by buyer or buyer’s chosen independent agency, and shall be available to buyer at seller’s facility for examination.

RISK

Any time seller opens their financial statements directly to buyer, seller’s proprietary rates are exposed, providing buyer a major advantage in the negotiation process given that they have full visibility into seller’s numbers. Exposure to labor rates, forward pricing rates, profit/fee, labor hours, and material and subcontract costs provides buyer with strong leverage to drive seller’s price down. Built-in financial safeguards not otherwise discernable are now vulnerable as well.

Apart from providing buyer a negotiation advantage that they would not otherwise have, an audit clause also may offer buyer an advantage when competing against seller on future contracts given that buyer knows seller’s rates and factors. Even when a non-disclosure agreement is in place, buyer still retains this knowledge and may unconsciously realize the potential bid of seller when competing for a program. Additionally, there is always the possibility that the individual who conducted the audit will go to work for seller’s competition and consciously or unconsciously use the information to their advantage in future solicitations.

Buyer will often include language in their government flow-down provisions specifying that all rights reserved for the government are likewise reserved for buyer. By accepting this language without exception, seller has given up audit rights that may be of a confidential or proprietary nature directly to buyer that would otherwise be reserved to the United States Government. Such FAR clauses that seller should look for include the following:

52.214-26 Audit and Records—Sealed Bidding (Apr 1984)

52.215-2 Audit and Records—Negotiation (Jun 1999)

52.215-12 Subcontractor Cost or Pricing Data (Oct 1997)

52.215-13 Subcontractor Cost or Pricing Data (Oct 1997)

52.215-15 Pension Adjustments and Asset Reversions (Oct 2004)

52.215-18 Reversion for Adjustment of Plans for Postretirement Benefits (PRB) Other Than Pensions (Jul 2005)

52.222-6 Davis-Bacon Act (Jul 2005)

52.222-8 Payrolls and Basic Records (Feb 1988)

52.222-12 Contract Termination—Debarment (Feb 1988)

52.222-41 Service Contract Act of 1965 (Nov 2007)

52.230-2 Cost Accounting Standards (Apr 1998)

52.230-3 Disclosure and Consistency of Cost Accounting Practices (Apr 1998)

52.230-6 Administration of Cost Accounting Standards(Apr 2005)

RESPONSE

As a matter of policy, seller should limit any exposure of proprietary information, rates in this instance, contained in a proposal and/or contract. This includes provision of seemingly innocuous information such as travel expenses or a subcontractor’s cost minus seller’s burdens. Buyer can easily back into such seemingly harmless data to expose seller’s burden rates, which can be used to buyer’s advantage during the negotiation process. For example, if buyer knows the actual procurement cost of seller’s subcontracts, buyer may be able to use this information to debate the cost of that procurement. Limiting the exposure may require authorization of an assist audit early in negotiations by the Defense Contract Audit Agency (DCAA) if the procurement falls under a government prime contract and falls within the $650,000 limits noted in the Federal Acquisition Regulations (FAR) or other applicable government regulations.

If seller has no choice but to allow buyer audit access, consider a third impartial party to conduct the audit. There are firms that perform independent, impartial audits on behalf of corporations.

A non-disclosure agreement (NDA) should be in place between the audit team and seller prior to commencement of the audit. An NDA, also referred to as a confidential disclosure agreement (CDA) or confidentiality agreement (CA), is defined as an agreement between parties for the handling and disposition of material, both verbal and written, that each may consider separately as proprietary, but which they may have the necessity or desire to disclose to each other over a specified period of time. The NDA should specify that the auditor may not divulge company proprietary data to buyer or any other party. Information relayed from auditor to buyer should solely consist of a notation that the rates proposed are considered fair and reasonable.

With regard to buyer’s assertion that all rights reserved for the government are likewise reserved for buyer, seller should propose that buyer agree to a Defense Contract Audit Agency (DCAA) assist audit. DCAA is a DOD agency responsible for performing contract audit services for the department. If the dollar threshold does not allow for a DCAA assist audit or DCAA does not cater to the contract in question, either refuse an audit of any kind or incorporate language into the contract that allows for an impartial third party to conduct the audit on behalf of buyer. The former is the better option of the two. Remember to ensure that a non-disclosure agreement is in place between seller and the third party audit agency as noted above.